ME- Tutorial 4

East Caribbean is a small island country with big economic problems. Currently the unemployment rate is 16 percent and the price level is increasing at a rate of 20 percent a year. Gross Domestic Product fell again this year, marking the second straight year of a prolonged recession. Income taxes (where the federal government receives most of its revenue) are highly progressive and the top marginal tax rate is 90 percent, impacting the incomes of 30 percent of the population. You have been hired by the government of East Caribbean and given vast power to recommend both monetary and fiscal policy. Over the past several years the money supply has been increasing at a 30 percent annual rate and the country has run both a federal budget surplus and a trade surplus. Tariffs on foreign goods are some of the highest in the world and many countries have retaliated by placing quotas on exports from East Caribbean. Thus, exports are a small part of the country’s economic output. With national elections two years away, the governing authorities are anxious to get the economy turned around before they have to stand for reelection.

Q1. What would be the appropriate fiscal policies (taxes and spending) given the current economic situation? What problems might your recommendations best address? Why?Q2. What types of monetary policy might be best for addressing the current situation? What problems might your recommendations best address? Why?

Q3. How might you address the current situation with respect to international trade? What policies would you recommend and how will these policies improve on the current situation? Identify the likely beneficiaries of your policies and who might be opposed to your recommendations.

ME- Tutorial 4

East Caribbean is a small island country with big economic problems. Currently the unemployment rate is 16 percent and the price level is increasing at a rate of 20 percent a year. Gross Domestic Product fell again this year, marking the second straight year of a prolonged recession. Income taxes (where the federal government receives most of its revenue) are highly progressive and the top marginal tax rate is 90 percent, impacting the incomes of 30 percent of the population. You have been hired by the government of East Caribbean and given vast power to recommend both monetary and fiscal policy. Over the past several years the money supply has been increasing at a 30 percent annual rate and the country has run both a federal budget surplus and a trade surplus. Tariffs on foreign goods are some of the highest in the world and many countries have retaliated by placing quotas on exports from East Caribbean. Thus, exports are a small part of the country’s economic output. With national elections two years away, the governing authorities are anxious to get the economy turned around before they have to stand for reelection.

Q1. What would be the appropriate fiscal policies (taxes and spending) given the current economic situation? What problems might your recommendations best address? Why?Q2. What types of monetary policy might be best for addressing the current situation? What problems might your recommendations best address? Why?

Q3. How might you address the current situation with respect to international trade? What policies would you recommend and how will these policies improve on the current situation? Identify the likely beneficiaries of your policies and who might be opposed to your recommendations.

Solution

Q1. What would be the appropriate fiscal policies (taxes and spending) given the current economic situation? What problems might your recommendations best address? Why?

Ans : With the government running a budget surplus, there should be expansionary fiscal policy, increased public sector spending and reduced taxes. You may want to ask for specifics and this will allow for some creativity by the students. With the income tax rate so high and broad, cutting this should be obvious. Also, a rate reduction here may actually expand government revenue as some people choose to work more and others move their income from the underground economy into the reported sector.

Q2. What types of monetary policy might be best for addressing the current situation? What problems might your recommendations best address? Why?

Ans : While typically expansionary monetary policy is recommended during a recession, the past, rapidly expanded money supply might take this suggestion off the table. To address the inflation problem, reducing the rate of growth in the money supply would appear to be the appropriate recommendation. For creativity, the students might be asked what tools they would recommend (higher interest rates, higher reserve requirements at banks, or selling government securities).

Q3. How might you address the current situation with respect to international trade? What policies would you recommend and how will these policies improve on the current situation? Identify the likely beneficiaries of your policies and who might be opposed to your recommendations.

Ans : The high tariffs have greatly hurt the international trade sector of the economy. These should be reduced so that other countries might follow suit. Exporting industries would gain at the expense of industries that would now have to compete with imports. Consumers would benefit from lower prices for goods.