Fixing Unemployment

A) Explain to the president which fiscal policy she should pursue in order to reduce this type of unemployment. In order to do this, you need to tell her what policy tool to use, as well as explaining exactly how this policy is going to reduce inflation.

A) Elbonia will want to employ an expansionary fiscal policy. This policy will aim to target government spending or taxes. Government spending should be increased, imitating a multiplier effect on the economy, boosting disposable income. A cut on taxes will also be effective in creasing disposable income of households or businesses. This boost in income incentives more consumption, increasing demand for goods and services. Companies have more incentive to hire new workers, lowering unemployment

B) You will also want to explain the effect this will have on Elbonia's nominal exchange rate and why fiscal policy is particularly effective with your exchange rate regime. Oh, and she's going to want graphs, including IS-LM to illustrate all of this.

B) Elbonia has a fixed exchange rate. When the fiscal policy works to boost aggregate demand, the interest rates increase (ie2). Under a fixed exchange, this is not possible, as the domestic return adjusts in accordance to interest rate. The monetary authority (CB)) will get involved to adjust the LM curve to the right. This ensures that the volume of the currency stays the same. An added bonus of this system is that when LM shifts right and interest returns to its original position, y increased again.

C) Despite your precise, concise, and illuminating explanation of your recommendation, the president tells you that she really doesn't want to use fiscal policy at all and wants you to use ONLY monetary policy instead. Why might that be the case? What would the downside of using fiscal policy be in this case?

C) Why use monetary policy? Monetary policy has less of an internal lag, and will work quicker than fiscal policy. Also increasing Government spending and lowering taxes will lower government revenue, and the budget deficit will increase. If they are hoping to join the EU, they need to meet their standards.

D) Explain in detail to the president why monetary policy will not be effective. This means you'll have to explain to her precisely how monetary policy works. She hasn't had much econ theory, so you'll need to use our two graphs of money and foreign exchange markets to explain this. In other words, explain to the President step-by-step what would happen if you used monetary policy to decrease inflation/unemployment and why you can't do that. (Remember, no fiscal policy is being used, just monetary here.)

D) Monetary policy would not be effective because our domestic rates will decrease. Capital outflows will lead to downward pressure on the currency. In order to maintain the peg, the central bank will sell foreign reserves and buy domestic currency which undoes our monetary expansion. The result is that our CB cannot control the money supply independent, which means monetary policy is ineffective

E) She still isn't happy. Explain in detail why you would need to give up the fixed exchange rate to do this, and how it would make monetary policy particularly effective. You may want to use graphs for this as well.

E) We need to give up the fixed exchange rate because the central bank would be able to control money supply under floating exchgnate rates, which means it would not have to intervene in FX markets. Expansionary monetary policy would lower interest rates and lead to a depreciation of our currency, which would make our goods look cheaper. Therefore, our net exports would rise. As a result, monetary autonomy would be restored which is why monetary policy would be particularly effective.

F) Just to be clear, explain in detail to the president why fiscal policy would now be less effective under floating exchange rates.

F) Fiscal policy with a floating exchange rate is now less effective. When fiscal policy boost demand, the interest rate rises, causing an appreciation in homes currency. This leads to a rise in imports and fall in exports, since home exports look more expensive relative to the rest of the world. This causes recessionary pressure, and not as effective. The result is crowding out via exchange rate due to increased gov’t spending