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
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