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
bank, which in turn raises the banks reserves to increase. The required
reserves are increased by the amount of the check times the required reserve
ratio, and excess reserves increase by the difference between the check and the
amount of the required reserves. Because the excess reserves of the bank have
increased, the bank is now able to loan out more money. The bank will continue
to make new loans until it is loaned out. The lower interest rates that are
caused by the higher bond prices encourages more consumers to borrow money.
This increase in the amount of loans causes a raise in the money supply by a
multiplied effect.
Because of the increased desire to loan money by banks and the increased
desire to borrow money by consumers companies receive more loans which is used
for investment. This rise in loans that are used for investment increases
investment spending. This increase in investment spending causes the total
spending to increase by a multiplied effect. This increase in total spending
then causes an increase in aggregate demand which causes the aggregate demand
cure to shift to the right. Spending is now greater than output. As a result
of spending being greater than output many suppliers and manufacturers expand
production of their goods. Prices will also increase because production costs
rise as well. The increase in production causes a increase in the level of
aggregate quantity demand supplied to consumers is increased. The increase of
prices makes the value of money and wealth decrease. Because of this decrease
consumption becomes less desirable by consumers and the aggregate quantity
demand decreases. Another result of this increase in prices is the decrease of
exports because the higher prices make U.S. products less desirable.
Consumption and net exports are now decreasing. The level of aggregate quantity
supplied continues to rise and the level of aggregate quantity demanded
continues to fall until aggregate quantity demanded and aggregate quantity
supplied are equal. This causes the U.S. economy to enter a state of long-run
equilibrium at full employment.