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