Problem
Governments use monetary and fiscal policy to manage the economy in the short run. Use the aggregate demand and supply model to discuss how
1) If the economy started in a neutral state, how would we expect monetary and fiscal policy to respond to an external reduction in aggregate demand, such as a reduction in export demand? Would monetary or fiscal policy be likely to be more effective?
2) If the economy is in a boom (higher than normal GDP, lower than normal unemployment), how would a monetary policy authority normally respond. Explain. If the federal government responded to that situation by significantly reducing taxes, how would this affect the monetary policy response?