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... [continues]
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