Fiscal policy Using the IS-MP framework, starting at natural output, show graphi

Question

Fiscal policy

Using the IS-MP framework, starting at natural output, show graphically and explain the effects of a fiscal expansion when the central bank changes policy only in response to actual changes in output or inflation.

How might your answer to a. differ if the central bank policy is based on forecasts of output and inflation? Show graphically and explain.

Using the IS-MP framework, show the effect of a fiscal expansion when Ricardian Equivalence holds.

Assume the government’s budget constraint is:

where:

G = government purchases

t = the net tax rate

i – the nominal interest rate

Y – real GDP

D = nominal debt outstanding

= change is debt.

Currently, the total federal debt approximately equals GDP. The average interest rate on the debt is approximately 1.5%. Assuming no other changes, if the average interest on the debt increases to 4.5%, what happens to government spending and the deficit as a percentage of GDP? Is this likely sustainable? Explain.

Explanation / Answer

Foreign fiscal expanison increases the aggregate demand in foreign. It increases the income in foreign country and at the same time the pricelel in foreign also goes up. The goods in foreign become more expensive than in domestic nation. Thus the demand for (domestic output) imports (exports from nation) rises in foreign. Thus, A foreign fiscal expansion is likely to increase domestic output.

The Foreign monetary expansion has ambiguoius effect on domestic output because with increase in supply of money in foreign, the interest rate in foreign falls. This increase investment in foreign. On one hand due to increased money supply, the purchasing power of people in foreign increase and thus the demand for (domestic output) imports (exports from nation) rises in foreign. But at the same time due to fall in interest rate the investmnet also rises that increases the output in foreign. This makes it uncrear wherther the domestic output will be demanded more of not in foreign.

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