The U.S. economy currently is operating at less than the full-employment level of GDP. Interpret and illustrate this equilibrium with an AD/AS and an IS/LM graph. Discuss how either monetary or fiscal policy may be used to eliminate the recessionary gap. Be certain to discuss the process by which the gap us eliminated. Illustrate your answer with Ad/AD and IS/LM graphs. Discuss at least one factor that will determine the effectiveness of your policy as a counter-cyclical tool.
The current situation in the United States economy is one in which the aggregate demand (AD) curve has shifted to the left (refer to Graph 1) which moved the intersection of the AD1 curve from Point A (the intersection of the long run aggregate supply [LRAS] curve and the short run aggregate supply [SRAS]) to Point B (the intersection of the AD2 curve and the SRAS curve. The resulting recessionary gap is the difference in output reflected by the distance between Y1 (output at full employment) and Y2 (output at recessionary levels).
In a monetary and fiscal context, a solution to the recessionary gap is reflected in the IS-LM model. The IS-LM model derives from the two curves included in its structure. The IS curve reflects the various combinations of national income and interest rates for which leakages will be equated with injections. The LM curve reflects the combinations of interest rates and income levels that are consistent with equilibrium in the monetary sector (Franke & Asada, 1994).
The IS curve reflects a negative relationship between the equilibrium values of aggregate output (Y) and the interest rate in the goods market. The LM curve reflects a positive relationship between the equilibrium values of aggregate output (Y) and the interest rate in the money market (Case 7 Fair, 1999).
The important question at this point is which of the several solution alternatives is likely to restore the United States economy to a point of equilibriu...