For each situation, give an example of a fiscal policy and a monetary policy solution. (p. 15) 1. Rapid investment during a boom period threatens to overheat the economy.
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Fiscal policy solution:
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Monetary policy solution:
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2. Layoffs lead to an economic slowdown.
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Fiscal policy solution:
o
Monetary policy solution:

Monetary Policy refers to the use of money supply and interest rates by the Central bank of a country to help achieve Economic goals such as inflation, consumption and economic growth. An expansionary monetary policy increases money supply and a contractionary policy decreases it.

Fiscal Policy has the same aim of helping the Government achieve economic goals but this time done by regulating government spending or taxes. An expansionary fiscal policy sees increased government spending and reduced taxes while a contractionary policy sees decreased government spending and higher taxes.

1. Rapid investment during a boom period threatens to overheat the economy.

Fiscal policy solution:  Contractionary Fiscal Policy

The Economy might overheat because of a high amount of investment in production. This means that Aggregate Demand is moving too fast. To rein this in with Fiscal Policy, the Government can increase taxes and reduce spending. This way people have less money to save to be used for investment and companies have less money to do the same.

Monetary policy solution: Contractionary Monetary Policy

The Central bank should reduce money supply and increase interest rates. They can do this by increasing the reserve requirement rate for banks and engage in Open Market Operations to sell securities to the public. This reduction in money supply will increase interest rates thereby reducing the amount of money left for investing.

2. Layoffs lead to an economic slowdown.

Fiscal policy solution:  Expansionary Fiscal Policy

The goal here is to stimulate the economy so that employers can hire more people. The Government can increase spending which would lead to a multiplier effect in income. They should also reduce taxes so that the people can have more money after paying taxes. These two things will have the effect of increasing investment spending which will enable companies to embark on new projects that will increase employment.

Monetary policy solution: Expansionary Monetary Policy

The Central bank should also aim to increase interest rates and money supply at least in the short run. By decreasing the Discount rate as well as the Reserve requirement, and embarking on Open Market Operations where they buy securities from the public, they can increase money supply. This increase in money supply will mean that there is excess money for investment which will lead to increased employment.