Question from Past Macroeconomics Qualifying Exam (Spring, 2003 - Question two) at George Mason UniversityEdit
Hartland is a small open economy with nearly perfect capital mobility, stable prices, a government debt to GDP ratio of approximately 50 per cent, but with a chronically high rate of unemployment. Policymakers in Hartland want to reduce the unemployment rate without significantly increasing the rate of price inflation. Discuss how each of the following policies might or might not help the policymakers to achieve their goal:
- a. fiscal and/or monetary interventions;
- b. exchange rate management and/or exchange rate controls;
- c. labor market reforms and/or other institutional reforms.
- d. Which of these policies would you most favor? Explain
- (a) Monetary expansions would eventually increase the price level, so this would be as productive as the persistance of the short-run. Fiscal policy interventions would take on more debt. Since the debt is so high, it is likely that people in this economy will be sensitive to the higher taxes in the future the fiscal expansion would change the capital flows, making exports shrink. Assuming however that this is accepted by the citizens, the expansion has a better chance in acheiving stated aims than the monetary expansion. Unemployment decreases when output increases.
- (b) Exchange rate or management has a great chance of actually reducing the output of the economy. Interfearance can only have a bad side, with adverse moves the economy could slump and then unemployment would rise.
- (c) labor market reforms: as fare as minimum wage laws; these intereventions are theoretically harmful to the number of employed workers. There is much desire to prove otherwise and only a few studies which cast doubt on the traditional thesis have been offered, but none conclusively. Increasing Health and Safty standards (or unions friendly laws) may increase wealth for the people working (questionable empirics again), but it does not reduce the unemployment.
- (d) I would favor a classical hands-off approach. If I had to pick from these, I would favor fiscal expansion, maybe some of the capital investment in the country would pan out.