Outline a program of monetary and fiscal policies to reduce the level of unemployment in an economy. Use graphs, specifically IS-LM analysis.
Unemployment is a state where the equilibrium settles below the maximum employment level of Gross Domestic Product (GDP). To reduce unemployment the GDP must be increased and to increase GDP spending must increase. The Federal Reserve Bank can control spending using three ways. The first way is for the Federal Reserve Bank (Fed) to purchase bonds in the open market to increase the money supply. The purchasing of bonds from the open market increases money supply because more money is provided to the people. Later it will be explained how an increase in money supply can increase spending thereby reducing unemployment. The second way is for the Fed to increase the proportion of total assets that banks must hold in reserve with the central bank. In this manner, the Fed can control a number of loanable funds. An increase in the total assets that banks must hold in reserve increases the loanable funds. The higher the loanable funds, the higher the money supply because it stimulates loans. The third way is for the Fed to decrease the discount rate. A decrease in discount rate increases loans and thereby increases the money supply.
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To explain how an increase in money supply decreases unemployment, let us use figure 1 and figure 2 which shows money market, investment expenditure, and real GDP curves. The values shown are for discussion purposes which are relative to the given conditions but the shifting and directions of increase and decrease are in accordance with the laws of supply and demand.
Figure 1. “Monetary Policy – Initial Money Supply Sm=1200″ (MacConnell & Brue 2005)
Figure 2. “Monetary Policy – Increase Money Supply Sm=1800 ” (MacConnell & Brue 2005)
Supply increases (Sm shifts to the right) from 1200 to 1800, the interest rate falls from 12% to 8% to compensate for the increase in money supply. These follow the law of supply and demand that when the supply of money increases the demand decreases and so the interest rate falls. This decrease in interest rates stimulates investment spending causing an increase in spending from 600 to 1200. More people are willing to invest money due to the lower interest rates. We can also think of this directly from the increase in money supply results in less tight money availability which stimulates people to spend. Since investment spending is a component of aggregate demand, aggregate demand also increases. An increase in aggregate demand shifts the aggregate demand curve to the right. So that after equilibrium point is met, the price level increases. This increase also increases real GDP. Since GDP increases unemployment decreases. The increase in aggregate demand is actually due to the increase in investment spending. More investment means more places for people to work and thus lesser unemployment.
Notice that the price level also increases which basically increases inflation. The government must also control inflation, and to control inflation, Fed must lower the money supply which is opposite of what we have done to increase employment. So basically, unemployment can be solved but will likely increase inflation so that the two opposing effects must be balanced properly by the government.