Supposing the status quo of the United States today states that: there is no real unemployment, the consumer price index is rising at 2 percent annually, and the federal government budget deficit, 200 billion dollars, is equal to 5 percent of the gross national product. Now, the question is how and what changes will result from fiscal and monetary policy.For example, if legislation has just passed which holds government spending constant and raises personal income taxes enough to balance the budget, then obviously the deficit would cease growing, as mentioned, along with other fluctuations of the gross national product as a whole. Because the government will stop borrowing money, it will also cut down on the spending, which will cause the economy to slow down as is illustrated by the equation: Y = C + I + G + X. In the short run people will respond to the raised taxes by decreasing their consumption, while simultaneously the marginal propensity to consume will increase because people will have less money to save. Therefore, the short run effects of this fiscal policy will force companies to lower wages, produce less, and/or lay off a portion of the work force.All the while The Fed is working up their counter cyclical monetary policy to keep deviation from the potential GDP to a minimum. The Federal Reserve Bank goes public with its goal to significantly increase the money supply. Due to rational expectations of the consumer, people might begin to consume more, looking forward to a rise in prices in the near future. If the Fed happens to achieve its goal, then the interest rates will drop in the short-run because they have a tendency to be positively related to government expenditure. The surge in the money supply will not only up the multiplier, but will hopefully lead to a balanced budget multiplier. The Fed intends to do this by matching the change in government spending with an equivalent change in taxes. With more money circulatin...
