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Actions of the government and the increase in prices

Actions of the Government and The Increase in Prices

The United States economy is currently producing at a level of full

employment in long-run equilibrium. The government then decides to increase

taxes and to reduce government spending in an effort to balance the budget. The

results of the actions taken by the government is the decrease of real GDP.

When taxes are increased that the amount of disposable income that is available

to consumers is lowered. This lowered level of disposable income leads to a

decrease in consumption spending as well as a decrease in savings. This

decrease in consumer and government spending causes the total spending to

decrease by a multiplied amount, As a result of the decrease in total spending

the aggregate demand decreases and the aggregate demand curve shifts to the left.

This decrease in consumer and government spending also causes businesses to have

a surplus of inventories. At this point the output is greater than spending and

as a result prices begin to fall. Because of the surplus of goods and falling

prices consumption becomes more desirable to consumers and the level of consumer

spending rises. The fall in prices causes business to become less profitable

and producers decrease the level of production. This results in the decrease of

the aggregate quantity supplied to decrease. This continues until aggregate

quantity demanded equal the aggregate quantity supplied and a period of short-

run equilibrium is established. The real GDP and the price level have both

decreased from the original long-run equilibrium level and the economy is

operating under the full employment level. At this point the U.S. economy is at

a recessionary gap and a monetary policy must be used to pull the economy from

the current recession.

There are three options that the Federal Reserve has to try and end the

current recession. The federal funds rate could be lowered, the discount to

banks could be lowered, or open market operations could be used. The most

effective of these three options is the use of expansionary monetary policy

through open market operations. The first step in this option is for the

Federal Reserve to start to purchase bonds from consumers. As the Federal

Reserve begins to buy these bonds back the bond prices are increased to make the

selling of these bonds more attractive to consumers. When the Federal Reserve

purchases a bond from a consumer a check is issued to the seller for the agreed

price. This higher bond prices also lowers interest rates. The seller then

deposits this check into his/her bank. This action increases deposits in the

bank, which in turn raises the banks reserves to increase. The required

reserves are increased by the amount of the check times the required reserve

ratio, and excess reserves increase by the difference between the check and the

amount of the required reserves. Because the excess reserves of the bank have

increased, the bank is now able to loan out more money. The bank will continue

to make new loans until it is loaned out. The lower interest rates that are

caused by the higher bond prices encourages more consumers to borrow money.

This increase in the amount of loans causes a raise in the money supply by a

multiplied effect.

Because of the increased desire to loan money by banks and the increased

desire to borrow money by consumers companies receive more loans which is used

for investment. This rise in loans that are used for investment increases

investment spending. This increase in investment spending causes the total

spending to increase by a multiplied effect. This increase in total spending

then causes an increase in aggregate demand which causes the aggregate demand

cure to shift to the right. Spending is now greater than output. As a result

of spending being greater than output many suppliers and manufacturers expand

production of their goods. Prices will also increase because production costs

rise as well. The increase in production causes a increase in the level of

aggregate quantity demand supplied to consumers is increased. The increase of

prices makes the value of money and wealth decrease. Because of this decrease

consumption becomes less desirable by consumers and the aggregate quantity

demand decreases. Another result of this increase in prices is the decrease of

exports because the higher prices make U.S. products less desirable.

Consumption and net exports are now decreasing. The level of aggregate quantity

supplied continues to rise and the level of aggregate quantity demanded

continues to fall until aggregate quantity demanded and aggregate quantity

supplied are equal. This causes the U.S. economy to enter a state of long-run

equilibrium at full employment. This new level of equilibrium should be very

similar to the original long-run equilibrium. The total real GDP has not been

affected. Government spending and consumption have both decreased. Investment

spending has risen because of the new lower interest rates. Because of this

real GDP is not effected in the long run.

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