Fiscal Policy For each of the

Fiscal Policy

For each of the event below, show the short-run effects onoutput, price and unemployment and explain how the Fed shouldadjust the money supply and interest rates to stabilizeoutput   

A. President Bush’s tax cut the individual income tax by $2000per household in 2003.

B. Federal government issues the treasury bonds to finance thewar in Iraq, and sell them to U.S citizens.

C. Illinois state government increases income tax for theresidents in Illinois to pay for education and pensiondeficits.


A. This will reduce the consumption spending of the citizens andhence reduce the aggregate expenditure in the economy. This willresult in decrease in the output, price and employment in theeconomy. To counter this, the Fed can reduce the interest ratewhich will increase the investment spending and aggregateexpenditure. This will then stabilize the output.

B. In this case, the govt borrows from citizens. Thus, overallmoney supply in the economy will reduce. This could result in anincrease in interest rates. As interest rates increase, the cost ofborrowing increases. This will decrease aggregate spending asinvestment expenditure will decline. The output and price levelwill decline. The unemployment will increase with decrease inspending. The Fed can increase the money supply by reducinginterest rates and hence stabilize the output.

C. This case is similar to part A. The overall aggregate outputand price will fall with an increase in income tax. Theunemployment will also increase. To counter this, the Fed canreduce the interest rate which will increase the investmentspending and aggregate expenditure. This will then stabilize theoutput.

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