Question

You're a member of the Council of Economic Advisers, an agency within the executive branch that advises the president

economic policy. The economy, as shown, is in recession, suffering from a negative output gap. One of your colleagues
argues that, with interest rates already low, the Fed can do little to return the economy to potential output by lowering
interest rates. She therefore concludes that the government should employ fiscal policy to bring the economy out of its
current slump. Potential output is $33 trillion. Actual output is $30 trillion. The multiplier is 2. The government could
engineer an economic recovery by:

Answer 1

To bring the economy out of recession with a $3 trillion output gap and potential output at $33 trillion, the government could implement an expansionary fiscal policy. This would involve either a government spending increase or tax cuts that cause an initial aggregate demand boost of $1.5 trillion, which would be amplified by the multiplier to achieve the necessary $3 trillion increase.

Step-by-step explanation:

If the economy is suffering from a recession, characterized by high unemployment and output that is below potential GDP, the government can consider applying an expansionary fiscal policy. This involves either decreasing taxes or increasing government spending to stimulate economic growth. In the scenario where potential output is $33 trillion but actual output is $30 trillion, the government needs to close a $3 trillion output gap.

Given that the multiplier is 2, the government would need to increase its own spending or cut taxes in such a way that an initial increase in aggregate demand of $1.5 trillion occurs, because this will be doubled by the multiplier effect, leading to a total increase in aggregate demand of $3 trillion to reach the potential output. Reducing interest rates further may not be effective if they are already low because of the liquidity trap situation, where changes in the interest rate no longer stimulate borrowing and spending.

A combination of fiscal and monetary policies can be beneficial. While the former aims directly at increasing demand through government intervention, the latter typically involves the central bank lowering interest rates to stimulate investment and consumption however, as noted by your colleague, with low-interest rates, this might have limited impact, hence the need for a fiscal stimulus.

Answer 2

In response to a recession with low interest rates, an expansionary fiscal policy, such as increasing government spending or cutting taxes, is recommended to increase economic output by an amount that leverages the multiplier effect.

Step-by-step explanation:

If the economy is in a recession with high unemployment and actual output is below potential GDP, both expansionary fiscal policy and expansionary monetary policy can be employed to stimulate economic activity. Considering that interest rates are already low, which limits the effectiveness of further reductions, your colleague suggests utilizing fiscal policy. With a potential output of $33 trillion and actual output of $30 trillion, and given the multiplier is 2, the government can close the $3 trillion gap by injecting $1.5 trillion (since 2 x $1.5 trillion = $3 trillion). This could be achieved through increased government spending or tax cuts. Therefore, to bring the economy out of its slump and back to potential output, an expansionary fiscal policy that injects $1.5 trillion into the economy would be suggested.