Question B4

Suppose the central bank of a closed economy chooses to target money supply.

(a) Suppose the economy is in a severe recession, with many unemployed resources, and prices are fixed. Draw the related IS-LM-Yn and AD-SRAS-LRAS diagrams, and label the initial positions of the economy in the two diagrams as points "A". (5 marks)

(b) Suppose, as the finance minister of the economy, you decide to use strong enough fiscal expansion to bring the economy out of the recession. Use the IS-LM-Yn and AD-SRAS-LRAS diagrams to show the effects of such a fiscal expansion. What types of crowding out effects you might encounter, and how will these affect your choice on the size of the fiscal expansion? (10 marks)

(c) After succeeding in the great task of using fiscal expansion to bring the economy back to full employment, some people recommend you to use more fiscal expansion to push for higher GDP. Should you adopt the recommendation? Use the IS-LM- Yn and AD-SRAS-LRAS diagrams to support your decision. (10 marks) (TOTAL: 25 marks)