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Question
Statistics
Posted 10 months ago
The Council of Elrond has decided to increase taxes, and the central bank of Elrond has decided to conduct open market purchases of financial assets.
Assuming that wages are sticky, which of the following best describes the impact of these actions on real output and the price level?
Choose 1 answer:
(A) Impact on real output indeterminate; impact on the price level indeterminate
(B) Real output increases; the price level increases
(C) Real output will decrease; the price level will decrease
(D) Impact on real output is indeterminate; price level decreases
(E) Real output decreases; impact on the price level is indeterminate
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Answer from Sia
Posted 10 months ago
Solution by Steps
step 1
To analyze the impact of fiscal and monetary policy on real output and the price level, we must understand the individual effects of each policy. An increase in taxes is a contractionary fiscal policy, which tends to decrease aggregate demand
step 2
Open market purchases of financial assets by the central bank is an expansionary monetary policy, which tends to increase the money supply and lower interest rates, leading to an increase in aggregate demand
step 3
Assuming wages are sticky, when aggregate demand decreases due to higher taxes, real output decreases and the price level may not adjust immediately
step 4
Conversely, when aggregate demand increases due to the central bank's open market purchases, real output increases and the price level may rise over time
step 5
The net effect on real output and the price level depends on the relative strength of the fiscal contraction and the monetary expansion. However, since the question assumes sticky wages, the price level is less responsive in the short run
step 6
Given that the price level is less responsive due to sticky wages, and considering the opposing directions of the fiscal and monetary policies, the impact on real output is indeterminate. The price level is likely to decrease due to the initial impact of the contractionary fiscal policy and the delayed response of prices to monetary policy
Answer
D
Key Concept
Fiscal and monetary policy interactions
Explanation
The combination of contractionary fiscal policy and expansionary monetary policy has indeterminate effects on real output due to opposing forces and sticky wages, but the price level is likely to decrease in the short run.
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