Prepared BY: Madhupriya, Nanjila, Pratima, Shromona

US Economic Background
The economic recovery that began in the middle of 2009 appears to have strengthened in the past few months, although the unemployment rate remains high. The initial phase of the recovery, which occurred in the second half of 2009 and in early 2010, was in large part attributable to the stabilization of the financial system, the effects of expansionary monetary and fiscal policies, and the strong boost to production from businesses rebuilding their depleted inventories. But economic growth slowed significantly last spring and concerns about the durability of the recovery intensified as the impetus from inventory building and fiscal stimulus diminished and as Europe's fiscal and banking problems roiled global financial markets. More recently, however, US have seen increased evidence that a self-sustaining recovery in consumer and business spending may be taking hold. Notably, real consumer spending rose at an annual rate of more than 4 percent in the fourth quarter. Although strong sales of motor vehicles accounted for a significant portion of this pickup, the recent gains in consumer spending appear reasonably broad based. Business investment in new equipment and software increased robustly throughout much of last year, as firms replaced aging equipment and as the demand for their products and services expanded. Construction remains weak, though, reflecting an overhang of vacant and foreclosed homes and continued poor fundamentals for most types of commercial real estate. Overall, improving household and business confidence, accommodative monetary policy, and more-supportive financial conditions, including an apparently increasing willingness of banks to lend, seem likely to result in a more rapid pace of economic recovery in 2011 than in last year. While indicators of spending and production have been encouraging on balance, the job market has improved only slowly. Following the loss of about 8-3/4 million jobs from 2008 through 2009, privatesector employment expanded by a little more than 1 million in 2010. However, this gain was barely sufficient to accommodate the inflow of recent graduates and other new entrants to the labor force and, therefore, not enough to significantly erode the wide margin of slack that remains in our labor market. Notable declines in the unemployment rate in December and January, together with improvement in indicators of job openings and firms' hiring plans, do provide some grounds for optimism on the employment front. Even so, with output growth likely to be moderate for a while and with employers reportedly still reluctant to add to their payrolls, it will be several years before the unemployment rate has returned to a more normal level. Until we see a sustained period of stronger job creation, we cannot consider the recovery to be truly established. On the inflation front, US have recently seen increases in some highly visible prices, notably for gasoline. Indeed, prices of many industrial and agricultural commodities have risen lately, largely as a result of the very strong demand from fast-growing emerging market economies, coupled, in some cases, with constraints on supply. Nonetheless, overall inflation is still quite low and longer-term inflation expectations have remained stable. Over the 12 months ending in December, prices for all the goods and services consumed by households (as measured by the price index for personal consumption expenditures) increased by only 1.2 percent, down from 2.4 percent over the prior 12 months. To assess underlying trends in inflation, economists also follow several alternative measures of inflation; one such measure is so-called core inflation, which excludes the more volatile food and energy components and therefore can be a better predictor of where overall inflation is headed. Core inflation was only 0.7 percent in 2010, compared with around 2-1/2 percent in 2007, the year before the recession began.
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Wage growth has slowed as well, with average hourly earnings increasing only 1.7 percent last year. These downward trends in wage and price inflation are not surprising, given the substantial slack in the economy. GDP of US economy over the period

2008 GDP( Purchasing Power Parity) GDP( Real Growth Rate) GDP( Per Capita) $14.64 trillion 0% (est.) $48100

2009 $14.25 trillion - 2.6% $ 46400

2010 $14.66 trillion 2.8% $47200

Factors of US economy in 2009 and 2010 2009 Unemployment Rate Public Debt Inflation Rate Reserve of Foreign Exchange and Gold Budget( in 2010) Taxes(2010) Budget Deficit Labor Force Population below Poverty Line 9.3 % 54.1 % - 0.3 % $130.8 billion Revenue: $ 2.162 trillion 2010 9.6 % 62.9 % 1.6 % $132.4 billion Expenditure: $3.456 trillion 14.7% of GDP 8.8% of GDP 153.9 million 15.1%

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Answer the following Questions: 1. What Monetary Policies would you recommend you generate for GDP Growth; to Reduce Unemployment and Stabilize Inflation? Ans. Monetary policy is controlling of the quantity of money in circulation for the expressed purpose of stabilizing the business cycle and for reducing the problems of unemployment and inflation. In days gone by, monetary policy was undertaken by printing more or less paper currency. In modern economies, monetary policy is undertaken by controlling the money creation process performed through fractional-reserve banking. The Federal Reserve System (or the Fed) is U.S. monetary authority responsible for monetary policy. In theory, it can control the fractional-banking money creation process and the money supply through open market operations, the discount rate, and reserve requirements. In practice, the Fed primarily uses open market operations, the buying and selling of U.S. Treasury securities, for this control. An important side effect of money supply control is control of interest rates. As the quantity of money changes, banks are willing to make loans at higher or lower interest rates. Monetary policy comes in two basic varieties--expansionary and Contractionary: Expansionary monetary policy or easy money results if the Fed increases the money supply and lowers interest rates and is the recommended policy to counter a recession. Contractionary monetary policy or tight money occurs if the Fed decreases the money supply and raises interest rates and is the recommended policy to reduce inflation.

The general goal of monetary policy is to keep the economy healthy and prosperous. More specifically, monetary policy seeks to achieve the macroeconomic goals of full employment, stability, and economic growth. That is, monetary policy is used to stabilize the business cycle and in so doing reduce unemployment and inflation, and the while promoting an environment that is conducive to an expanding economy. Full Employment: This results when all available resources (especially labor) willing and able to engage in production are producing goods and services. Falling short of this goal results in unemployment. Because some degree of unemployment naturally exists in a modern complex economy, full employment is achieved if the unemployment rate is about 5 percent. Unemployment means the economy forgoes the production goods and services. Stability: This exists when fluctuations in prices, production, and employment have been eliminated. While stability for all aspects of the economy are important, monetary policy tends to be most concerned with price stability, that is, keeping the price level in check and eliminating inflation. Inflation erodes the purchasing power of financial wealth. Economic Growth: This occurs when the production capacity of the economy increases over time, which is achieved by increasing the quantity and/or quality of resources. When the
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economy grows and production capacity expands, then more goods and services are available to satisfy wants and needs. Without economic growth, the economy stagnates, and often even experiences a falling living standard. In general, monetary policy induces changes in aggregate expenditures, especially investment but also consumption, which then results in changes in aggregate production (gross domestic product), the price level, and employment. However, the actual transmission mechanism runs through a variety of routes, termed the channels of monetary policy. Interest Rate: The most noted monetary policy channel works through interest rates. Monetary policy, particularly open market operations, trigger changes in interest rates which affects the cost of borrowing by both the household and business sectors and subsequently investment expenditures and consumption expenditures. The result is changes in aggregate production and other macroeconomic variables. Exchange Rate: A monetary policy channel that has become increasingly important with the integration of the global economy works through exchange rates. Monetary policy induced changes in interest rates also affect the flow of financial capital between countries, which then affects currency exchange rates. Currency exchange rates consequently impact the relative prices of imports into and exports out of a country. The resulting change in net exports then changes aggregate production and other macroeconomic variables. Wealth: One of two related monetary policy channels works through the value of financial assets. By changing the financial wealth of the economy, monetary policy induces an adjustment in the portfolio of consumer assets. In particular, consumers are induced to modify the relative mix of financial and physical wealth, which is accomplished through consumption expenditures and which then affects aggregate production and other macroeconomic variables.

Factors considered by the Monetary Policy Committee Before each meeting of the Monetary Policy Committee, a huge raft of economic information is put before members of the MPC rate-setting board. Much of the data that is considered will be information that you may have become familiar with during your AS and A2 economics courses. The economic data considered each month by the MPC includes the following: GDP growth and spare capacity: The rate of growth of real national output and the estimated size of the output gap are central to discussions within the MPC about setting the appropriate level of interest rates. Their main task is to set monetary policy so that demand grows more or less in line with the increase in the countrys productive potential. Bank lending and consumer credit figures including the levels of mortgage equity withdrawal from the housing market and also monthly data on credit card lending. Equity markets (share prices) and house prices - both are considered important in determining household wealth which then feeds through to borrowing and retail spending. The state of play in the UK housing market has been influential in shaping interest rate decisions over the last two

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to three years although we must remember that the monetary policy committee has no official target for the annual rate of house price inflation. Consumer confidence and business confidence indicators confidence surveys are thought to provide useful advance warning of possible turning points in the economic cycle. So for example, a sharp dip in consumer optimism might herald a retrenchment of spending which could lead to slower GDP growth and a weakening of inflationary pressure. The growth of wages, average earnings and unit labor costs in the labor market these are considered important as indicators of demand pull and cost push inflationary pressure. The Monetary Policy Committee might become concerned if the annual rate of wage inflation surged above the 5% mark as this might eventually feed through into a rise in consumer prices. Unemployment figures and survey evidence on the scale of shortages of skilled labor these are also labor market indicators as was mentioned in the last bullet point. Trends in global foreign exchange markets for example the trend in the value of sterling against the Euro or the US dollar. A weaker exchange rate could be seen as a threat to inflation because it raises the prices of imported goods and services. International economic data including recent macroeconomic developments in the twelve member nations of the Euro Zone and the worlds largest economy, the United States. Forward looking indices such as the Purchasing Managers Index and quarterly surveys of business confidence including data from the Confederation of British Industry and the British Chambers of Commerce.

Aggregate demand and Aggregate supply: Aggregate demand: aggregate demand is the quantity of goods and services that household, firms, the government and customers abroad want to buy at each price level. Aggregate supply: aggregate supply is the quantity of goods and services that firms choose to produce and sell at each price level.

Fig: Aggregate Demand curve and Aggregate Supply curve in Short run
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On the vertical axis, the overall level of prices. On the horizontal axis is the economys total output of goods and services. Output and the price level adjust to the point at which the aggregate supply and aggregate demand curves intersect. Change in the price level changes the demand of goods and services. There is inverse relationship between price level and quantity of goods and services demand.

Fig: Long run Aggregate Demand and Supply curve A fall in the price level P1 to P2 increase in the quantity of goods and services demanded from Y1 to Y2. There are three reasons for this negative relationship. As the price level falls real wealth rises, interest rates falls, and the exchange rates depreciates. These effects stimulate spending on consumption, investment, and net exports; increased spending on any or all of these components of output mean a large quantity of goods and services demanded. An economys GDP (Y) is the sum of consumption (C), investment (I), government purchase (G), and net export (NX). Each of four components contributes to the aggregate demand and for the goods and services. Y= C + I + G + NX Suppose the government spending remain constant in the short run period. The change in price level change the remaining three component of GDP affected and aggregate demand changes. The price level and Consumption: The Wealth Effects: a decrease in the price level raises the real value of money and makes consumers wealthier, which in turn encourages them to spend more. The increase in consumer spending means a large quantity of goods and services demanded. Conversely increase in price level reduces the value money, in turn reducing wealth, consumer spending, and the quantity of goods and services demanded. The price level and Investment: The Interest Rate Effects: a lower price level reduces the interest rate, encourages the greater spending on investment goods and thereby increases the quantity of goods and

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services demanded. Conversely higher price level raises the interest rate, reducing investment spending and the quantity of goods and services demanded. The price level and Net Exports: The Exchange Rate Effects: when the fall in US price level causes US interest rate fall, the real value of the dollar declines in foreign exchange markets and this depreciation stimulates US net export and thereby increases the quantity of goods and services demanded. Conversely, when the US price level rises and cause interest rates to raises the real value of dollar increases, and this appreciation reduces US net exports and the quantity of goods and services demanded. Aggregate supply curves tells us the total quantity of goods and services that firms produce and sell at any given price level. An aggregate supply curve shows the relationship that depends crucially on the time horizon. In the long run the aggregate supply curve is vertical, whereas in the short run, the aggregate supply curve is upward slopping. In the long run, an economys production of goods and services i.e. real GDP depends on its supplies of labor, capital, and natural resources and on the available technology used to turn these factors of production into goods and services.

As the economy become better able to produce goods and services over time, primarily because of technological progress, the long run aggregate supply curve shift to the right. At the same time Fed increases the money supply aggregate demand curve also shift to the right. In the figure output grows

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from Y1980 to Y1990 and then to Y2000 and the price level rises from P1980 to P1990 and then to P2000. In this way increase in technological sector gives positive movement in the economy. The US economy is going through recession from 2008 to 2009 and gradually recovering in 2010 but the ratio is very low so we would like to suggest US economy to implement Expansionary monetary policy. Expansionary monetary policy or easy money results if the Fed increases the money supply and lowers interest rates and is the recommended policy to counter a recession. Although the growth rate of economic activity appears likely to pick up this year, the unemployment rate probably will remain elevated for some time. In addition, inflation is expected to persist below the levels that Federal Reserve policymakers have judged to be consistent over the longer term with statutory mandate to foster maximum employment and price stability. Under such conditions, the Federal Reserve would typically ease monetary policy by reducing its target for the federal funds rate. However, the target range for the federal funds rate has been near zero since December 2008, leaving essentially no room for further reductions. In particular, over the past two years the Federal Reserve has further eased monetary conditions by purchasing longer-term securities--specifically, Treasury, agency, and agency mortgage-backed securities--on the open market. These purchases are settled through the banking system, with the result that depository institutions now hold a very high level of reserve balances with the Federal Reserve. Although large-scale purchases of longer-term securities are a different monetary policy tool than the more familiar approach of targeting the federal funds rate, the two types of policies affect the economy in similar ways. Conventional monetary policy easing works by lowering market expectations for the future path of short-term interest rates, which, in turn, reduces the current level of longer-term interest rates and contributes to an easing in broader financial conditions. These changes, by reducing borrowing costs and raising asset prices, bolster household and business spending and thus increase economic activity. By comparison, the Federal Reserve's purchases of longer-term securities do not affect very short-term interest rates, which remain close to zero, but instead put downward pressure directly on longer-term interest rates. By easing conditions in credit and financial markets, these actions encourage spending by households and businesses through essentially the same channels as conventional monetary policy, thereby strengthening the economic recovery. Indeed, a wide range of market indicators suggest that the Federal Reserve's securities purchases have been effective at easing financial conditions, lending credence to the view that these actions are providing significant support to job creation and economic growth. It is worth emphasizing that the Fed's purchases of longer-term securities are not comparable to ordinary government spending. In executing these transactions, the Federal Reserve acquires financial assets, not goods and services; thus, these purchases do not add to the government's deficit or debt. Ultimately, at the appropriate time, the Federal Reserve will normalize its balance sheet by selling these assets back into the market or by allowing them to run off. In the interim, the interest that the Federal Reserve earns from its securities holdings adds to the Fed's remittances to the Treasury; in 2009 and 2010, those remittances totaled about $125 billion. If the Fed sell those securities there will be increase in the fund and it can supply more money to the market which will enhance the purchasing power of the consumer, decrease the interest rate and increase the investment. There will be positive balance in the net export. This leads the US economy to

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Stabilize and there will be natural rate of unemployment, increase in productivity which ultimately increase the US GDP. 2. What Fiscal Policies would you recommend for GDP Growth, to Reduce Unemployment and Stabilize Inflation? Ans. Fiscal policy is the setting of the level of government spending and taxation by government policymakers. Fiscal policy is based on the presumption that aggregate expenditures, especially business investment, are the primary source of business-cycle instability. The means of correcting this instability is thus also accomplished through aggregate expenditures. The goal of fiscal policy is to manipulate aggregate expenditures, and thus the macro economy, either directly through government purchases or indirectly through taxes and transfer payments. If a decrease in private planned expenditure threatens to send the economy into a recession, an increase in government purchases or a cut in net taxes can be used to shift the aggregate demand curve to the right, thereby restoring the economy to its natural level of real output. In the income-expenditure model, such expansionary fiscal policy will shift the planned-expenditure schedule upward. If an excess of private planned expenditure threatens the economy with inflation, a cut in government purchases or an increase in net taxes can shift the aggregate demand curve to the left, thereby restoring stability. In the income-expenditure model, restrictive fiscal policy will shift the planned-expenditure schedule downward. Policy Tools In general, fiscal policy works through the two sides of the government's fiscal budget - spending and taxes. However, it's often useful to separate these two sides into three specific tools - government purchases, taxes, and transfer payments. Government Purchases: These are the expenditures by the government sector, especially the federal government, on final goods and services. They are the portion of product purchased by the government sector. Any change in government purchases, as such, directly affects aggregate expenditures and thus the macroeconomic. Taxes: These are involuntary payments from the household sector to the government sector. Taxes are the primary source of revenue used by government to finance government spending. Taxes affect the amount of disposable income available for consumption and saving. As such, any change in taxes indirectly affects aggregate expenditures and the macroeconomic through consumption expenditures and investment expenditures (via saving). Transfer Payments: These are gifts made to the household sector. Unlike government purchases, these payments are not made in exchange for goods and services. Because these are financed with taxes, transfer payments are, in effect, the transfer of income from one person to another. Because transfer payments also affect the amount of disposable income available, any change in transfer payments also as an indirect effect on aggregate expenditures.

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Although the government sector can and does make use of all three fiscal policy tools, it's often convenient to consolidate taxes and transfer payments into a single tool -- net taxes. Net taxes are the difference between taxes and transfer payments. Individually, taxes and transfer payments represent similar, but opposite flows between the household and government sectors. Taxes reduce disposable income and transfer payments increase disposable income. When combined, net taxes are then the net flow between the household and government sectors; and thus capture the net impact on disposable income. Expansionary and Contractionary Fiscal policy comes in two basic varieties--expansionary and contractionary. Each is recommended to correct different problems created by business-cycle instability. Expansionary Fiscal Policy: The recommended fiscal policy to correct the problems of a business-cycle contraction is expansionary fiscal policy. Expansionary fiscal policy includes any combination of an increase government purchases, a decrease in taxes, or an increase in transfer payments. This fiscal policy alternative is intended to stimulate the economy by increasing aggregate expenditures and aggregate demand. It is primarily aimed at reducing unemployment. Contractionary Fiscal Policy: The recommended fiscal policy to correct the inflationary problems of a business-cycle expansion is contractionary fiscal policy. Contractionary fiscal policy includes any combination of a decrease government purchases, an increase in taxes, or a decrease in transfer payments. This fiscal policy alternative is intended to restrain the economy by decreasing aggregate expenditures and aggregate demand. It is primarily aimed at reducing inflation. There are two important aspects to take into account while analyzing fiscal policy effects on economic growth. First, it should be made clear whether Keynesian short-run or classical long-run effects are the object of interest. Second, the relations between different fiscal and macroeconomic variables should be identified all possible simultaneous changes in other fiscal and macroeconomic indicators should be taken account of while analyzing the effect of any fiscal policy decision on economic growth. Keynesian principles do not seem to hold as fiscal policy cannot have any remarkable impact on economy in a short run. But it is confirmed that in the long run, expansionary fiscal policies are not beneficial to the economy generally. For a government it is essential to recognize that changes in different revenue and expenditure categories may have the same impact on budget balance and on total government revenue and expenditure but they have different effects on economic growth in the long run. For example, fiscal policy decisions have different effects depending on whether to save increased revenue, to spend it for current expenditure or to use it for public investment. GDP refers to the market value of all final goods and services produced within a country within a certain period of time. It is the addition of consumption, investment, government purchase and net exports. In order to increase the GDP, the factors like consumption, investment, government purchase must be increased. For increasing GDP, expantionary fiscal policy can be used. As it is recommended to correct the problems of a business-cycle contraction .Expansionary fiscal policy includes any combination of an
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increase government purchases, a decrease in taxes, or an increase in transfer payments. This fiscal policy alternative is intended to stimulate the economy by increasing aggregate expenditures and aggregate demand. Purpose of fiscal policy is to increase GDP in a closed economy, expansionary fiscal policy consists of lowering taxes or raising government spending this leads to an initial increase in the aggregate demand and an initial increase in real GDP However, expansionary fiscal policy also leads to a shift toward a budget deficit, which leads to more borrowing by the government and leads to an increase in interest rates the increase in interest rates chokes off private investment and partially reverses the rise in real GDP (crowding out effect) in an open, developed countrys economy, the rise in interest rates causes an increase in capital inflows which keeps interest rates from rising as much and reduces the crowding out effect therefore, in a developed countrys open economy, fiscal policy is made more effec tive than in a closed economy Fiscal policy is more effective in an open economy than in a closed economy if there is capital mobilityotherwise, neither had an advantage Developing countries have less room to run a budget deficit because there are perceptions of default risk

Fiscal Policy and Aggregate Demand Traditionally fiscal policy has been seen as an instrument of demand management. This means that changes in government spending, direct and indirect taxation and the budget balance can be used to help smooth out some of the volatility of real national output particularly when the economy has experienced an external shock. The fiscal policy transmission mechanism

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This flow-chart above identifies some of the possible channels involved with the fiscal policy transmission mechanism. The multiplier effects of an expansionary fiscal policy depend on how much spare productive capacity the economy has; how much of any increase in disposable income is spent rather than saved or spent on imports. And also the effects of fiscal policy on variables such as interest rates. For example: the increase in government purchases of $20 billion initially shifts the aggregate demand curve to the right from AD1 to AD2 by exactly $20 billion. But when consumer responds by increasing their spending, the aggregate demand curve shifts further to AD3. The multiplier effect arising from the response of consumer spending can be strengthened by the response of investment to higher levels of demand.

Fiscal Policy and Aggregate Supply Changes to fiscal policy can affect the supply-side capacity of the economy and therefore contribute to long term economic growth. The effects tend to be longer term in nature. Labor market incentives: Cuts in income tax might be used to improve incentives for people to actively seek work and also as a strategy to boost labor productivity. Some economists argue that welfare benefit reforms are more important than tax cuts in improving incentives in particular to create a wedge or gap between the incomes of those people in work and those who are in voluntary unemployment. Capital spending: Government capital spending on the national infrastructure (e.g. improvements to the motorway network or an increase in the building programme for new schools and hospitals) contributes to an increase in investment across the whole economy.
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Lower rates of corporation tax and other business taxes might also be used as a policy to stimulate a higher level of business investment and attract inward investment from overseas. Entrepreneurship and new business creation: Government spending might be used to fund an expansion in the rate of new small business start-ups. Research and development and innovation: Government spending, tax credits and other tax allowances could be used to encourage an increase in private business sector research and development designed to improve the international competitiveness of domestic businesses and contribute to a faster pace of innovation and invention. Human capital of the workforce: Higher government spending on education and training (designed to boost the human capital of the workforce) and increased investment in health and transport can also have important supply-side economic effects in the long run.

Problems with Fiscal Policy as an Instrument of Demand Management In theory a positive or negative output gap can be relatively easily overcome by the fine-tuning of fiscal policy. However, in reality the situation is complex and many economists argue for ignoring fiscal policy as a tool for managing aggregate demand focusing instead on the role that monetary policy can play in stabilizing demand and output. Inevitably, it takes time to for government policy-makers to recognize that AD is growing either too quickly or too slowly and a need for some active discretionary changes in spending or taxation. It then takes time to implement an appropriate policy response government spending plans are subject to a three year spending review and cannot be changed immediately. Likewise the tax system is highly complex for example income tax can only normally be changed once a year at the time of the Budget. Indirect taxes can be changed more quickly but they have less of an effect on the level of aggregate demand. It then takes time for the change in fiscal policy to work, as the multiplier process on national income, output and employment is not instantaneous. The Fiscal crowding-out effect The crowding-out hypothesis became popular in the 1970s and 1980s when free market economists argued against the rising share of national income being taken by the public sector. The essence of the crowding out view is that a rapid growth of government spending leads to a transfer of scarce productive resources from the private sector to the public sector. For example, if the government seeks to reflate AD by reducing taxation, or by increasing government spending, then this may lead to a budget deficit. To finance the deficit the government will have to sell debt to the private sector. Attracting individuals and institutions to purchase the debt may require higher interest rates. A rise in interest rates may crowd out private investment and consumption, offsetting the fiscal stimulus. This type of crowding out is unlikely to make fiscal policy wholly ineffective but large budget deficits do require financing and in the long run, this requires a higher burden of taxation. Higher taxes affect both businesses and households neo-liberal economists believe that higher taxation acts as a drag on business investment, labor market incentives and productivity growth all of which can have a negative effect on economic growth potential in the long run.

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Reaction to Tax Cuts Rational Expectations When the government sells debt to fund a tax cut or an increase in expenditure, then a rational individual will realize that at some future date he will face higher tax liabilities to pay for the interest repayments. Thus, he should increase his savings as there has been no increase in his permanent income. Any change in fiscal policy will have no impact on the economy if all individuals are rational. Fiscal policy in these circumstances may become incapable. Partly because of the limitations of fiscal policy as a tool of demand management, many governments have switched the focus of fiscal policy towards using it to improve aggregate supply as a means of creating the conditions for sustainable economic growth. This is certainly the case with the current government. Government borrowing The level of government borrowing is an important part of fiscal policy and management of aggregate demand in any economy. When the government is running a budget deficit, it means that in a given year, total government expenditure exceeds total tax revenue. As a result, the government has to borrow through the issue of debt such as Treasury Bills and long-term government Bonds. The issue of debt is done by the central bank and involves selling debt to the bond and bill markets. There is a consensus that a persistently large budget deficit can be a problem for the government and the economy. Financing a deficit: A budget deficit has to be financed and day-to-day, the issue of new government debt to domestic or overseas investors can do this. In a world where financial capital flows freely between countries, it can be relatively easy to finance a deficit. But it may be that if the budget deficit rises to a high level, in the medium term the government may have to

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offer higher interest rates to attract sufficient buyers of government debt. This in turn will have a negative effect on economic growth. Crowding-out - the need for higher interest rates and higher taxes. Eventually the budget deficit has to be reduced. This can be achieved by either by cutting back on public sector spending or by raising the burden of taxation. If a larger budget deficit leads to higher interest rates and taxation in the medium term and thereby has a negative effect on growth in consumption and investment spending, then a process of fiscal crowding-out is said to be occurring. In the long run, government borrowing adds to the accumulated National Debt. This means that the Government has to spend more each year in debt-interest payments to holders of government bonds and other securities. There is an opportunity cost involved here because this money might be used in more productive ways, for example an increase in spending on health services or extra investment in education. It also represents a transfer of income from people and businesses that pay taxes to those who hold government debt and cause a redistribution of income and wealth in the economy.

In Long-run: Fiscal policymakers also face significant challenges. U.S fiscal position has deteriorated appreciably since the onset of the financial crisis and the recession. To a significant extent, this deterioration is the result of the effects of the weak economy on revenues and outlays, along with the actions that the Administration and the Congress took to ease the recession and steady financial markets. However, even after economic and financial conditions return to normal, the federal budget will remain on an unsustainable path, with the budget gap becoming increasingly large over time, unless the Congress enacts significant changes in fiscal programs. For example, under plausible assumptions about how fiscal policies might evolve in the absence of major legislative changes, the Congressional Budget Office (CBO) projects the deficit to fall from its current level of about 9 percent of gross domestic product (GDP) to 5 percent of GDP by 2015, but then to rise to about 6-1/2 percent of GDP by the end of the decade.2 In subsequent years, the budget situation is projected to deteriorate even more rapidly, with federal debt held by the public reaching almost 90 percent of GDP by 2020 and 150 percent by 2030, up from about 60 percent at the end of fiscal year 2010. confronting the nation are especially daunting because they are mostly the product of powerful underlying trends, not short-term or temporary factors. The two most important driving forces behind the budget deficit are the aging of the population and rapidly rising health-care costs. Indeed, the CBO projects that federal spending for health-care programs will roughly double as a percentage of GDP over the next 25 years. The ability to control health-care spending, while still providing high-quality care to those who need it, will be critical for bringing the federal budget onto a sustainable path.
The long-term fiscal challenges

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The CBO's long-term budget projections, by design, do not account for the likely adverse economic effects of such high debt and deficits. But if government debt and deficits were actually to grow at the pace envisioned, the economic and financial effects would be severe. Sustained high rates of government borrowing would both drain funds away from private investment and increase our debt to foreigners, with adverse long-run effects on U.S. output, incomes, and standards of living. Moreover, diminishing investor confidence that deficits will be brought under control would ultimately lead to sharply rising interest rates on government debt and, potentially, to broader financial turmoil. In a vicious circle, high and rising interest rates would cause debt-service payments on the federal debt to grow even faster, resulting in further increases in the debt-to-GDP ratio and making fiscal adjustment all the more difficult. In thinking about achieving fiscal sustainability, it is useful to apply the concept of the primary budget deficit, which is the government budget deficit excluding interest payments on the national debt. To stabilize the ratio of federal debt to the GDP--a useful benchmark for assessing fiscal sustainability--the primary budget deficit must be reduced to zero.4 Under the CBO projection earlier, the primary budget deficit is expected to be 2 percent of GDP in 2015 and then rise to almost 3 percent of GDP in 2020 and 6 percent of GDP in 2030. These projections provide a gauge of the adjustments that will be necessary to attain fiscal sustainability. To put the budget on a sustainable trajectory, policy actions--either reduction in spending, increases in revenues, or some combination of the two--will have to be taken to eventually close these primary budget gaps. Of course, economic growth is affected not only by the levels of taxes and spending, but also by their composition and structure. In addressing the long-term fiscal challenges, the Congress and the Administration will have to undertake reforms to the government's tax policies and spending priorities that serve not only to reduce the deficit, but also to enhance the long-term growth potential of the economy--for example, by reducing disincentives to work and to save, by encouraging investment in the skills of the workforce as well as new machinery and equipment, by promoting research and development, and by providing necessary public infrastructure. 3 Would you prefer to have a mix of Monetary and Fiscal Policies and if so why not and/or what would the mix comprise of? Ans. The policy mix is the combination of the monetary policy and the fiscal policy of a country. These two channels influence growth and employment, and are generally determined by the central bank and the government respectively. US Economy Background The economic recovery that began in the middle of 2009 appears to have strengthened in the past few months, although the unemployment rate remains high. The initial phase of the recovery, which occurred in the second half of 2009 and in early 2010, was in large part attributable to the stabilization of the financial system, the effects of expansionary monetary and fiscal policies, and the strong boost to production from businesses rebuilding their depleted inventories. But economic growth slowed significantly last spring and concerns about the durability of the recovery intensified as the impetus from
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inventory building and fiscal stimulus diminished and as Europe's fiscal and banking problems roiled global financial markets. Although strong sales of motor vehicles accounted for a significant portion of this pickup, the recent gains in consumer spending appear reasonably broad based. Business investment in new equipment and software increased robustly throughout much of last year, as firms replaced aging equipment and as the demand for their products and services expanded. Construction remains weak, though, reflecting an overhang of vacant and foreclosed homes and continued poor fundamentals for most types of commercial real estate. Overall, improving household and business confidence, accommodative monetary policy, and more-supportive financial conditions, including an apparently increasing willingness of banks to lend, seem likely to result in a more rapid pace of economic recovery in 2011 than last year. While indicators of spending and production have been encouraging on balance, the job market has improved only slowly. Following the loss of about 8-3/4 million jobs from 2008 through 2009, privatesector employment expanded by a little more than 1 million in 2010. However, this gain was barely sufficient to accommodate the inflow of recent graduates and other new entrants to the labor force and, therefore, not enough to significantly erode the wide margin of slack that remains in US labor market. Notable declines in the unemployment rate in December and January, together with improvement in indicators of job openings and firms' hiring plans, do provide some grounds for optimism on the employment front. Even so, with output growth likely to be moderate for a while and with employers reportedly still reluctant to add to their payrolls, it will be several years before the unemployment rate has returned to a more normal level. Until US have a sustained period of stronger job creation. US cannot consider the recovery to be truly established. On the inflation front, US have recently seen increases in some highly visible prices, notably for gasoline. Indeed, prices of many industrial and agricultural commodities have risen lately, largely as a result of the very strong demand from fast-growing emerging market economies, coupled, in some cases, with constraints on supply. Nonetheless, overall inflation is still quite low and longer-term inflation expectations have remained stable. Over the 12 months ending in December, prices for all the goods and services consumed by households (as measured by the price index for personal consumption expenditures) increased by only 1.2 percent, down from 2.4 percent over the prior 12 months. To assess underlying trends in inflation, economists also follow several alternative measures of inflation; one such measure is so-called core inflation, which excludes the more volatile food and energy components and therefore can be a better predictor of where overall inflation is headed. Core inflation was only 0.7 percent in 2010, compared with around 2-1/2 percent in 2007, the year before the recession began. Wage growth has slowed as well, with average hourly earnings increasing only 1.7 percent last year. These downward trends in wage and price inflation are not surprising, given the substantial slack in the economy. Going through the economic background of US we prefer to have mix policy implement in US economy. Because both the economies policies plays a vital role in the stabilization in the economy. As monetary policies refers to the controlling of quantities of the money circulation in the economy and fiscal policy refers to the controlling of government expenditure and taxation by government policymakers, both should be on the same path for the good economy. If the monetary policies increases the

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unemployment, inflation and decrease the growth of economy the role of fiscal policies arises because it controls the government expenditure and taxation.

Over time as a change in the expected price level cause wages, prices and perception to adjust, the short run aggregate supply curve shift to the right and the economy return to its natural rate of output at a new lower price level. So the change in the aggregate demand and aggregate supply may be cause by the perception of the consumer, money supply in the market and the government policies. As Obama did in US economy he cut down the taxation so that employment in the economy increases and the saving of the household increases. If the saving of the household increases and the employee increase their consumption which ultimately increase the money supply in the economy and the fiscal policies defines the govt. expenditure and taxation. In recent case, the govt. has been spending more than required in the military forces to win over other countries like Iraq. Government should decrease the expenditure on these factors and invest it in the infrastructure development, medical facilities, pension funds for the aging population, etc of the country as this leads to the employment generation. This generation of employment increases the ability of the consumer to spend more which shows the ability of the consumer to pay its taxes more often these results in inflow of govt. funds. There is a circular flow in the economy which stabilizes the economy. The taxation cut off only ensures the economic stabilization for the short run only because the collection of the fund in the government fund gets lower and US have more import that export in oil consumption which leads to go money out of the market. Similarly US have higher public debt and less income revenues it has budget deficit. The taxation rule and decrease in government expenditure, borrowing public debt may help to sustain the economy for the stabilization but it does not work for the economy for long run.

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For the long run economic stabilization, US should focus on the investment areas, increase in the capital, increase in the production depend on the natural resources like mineral, land, and increase in the technological sectors, which influence in the shift of aggregate demand and due to raise in the aggregate demand of produce goods and services the supply of goods and services also arises which increases the consumption parity of the household and the GDP of the economy will increased. The increase in the investment, capital by the economy will shift the demand curve and supply curve into a point where there is stabilization in the economy and the economy will have natural rate of unemployment.

If the monetary policy increase the money supply in the market consumer becomes more wealthier and they tends to spend in more luxurious goods which creates higher demand in the market and increase the flow of money in the market. When the price of the goods decreases consumption of the goods increases and the excess money the consumer have will be invested in the interest earning investment and reduces the interest rate. When the fiscal policy cut of the government spending aggregate demand decreases, the Federal Reserve should increase the money supply. A monetary expansion would reduce interest rates, stimulate investment spending and expand aggregate demand. If the monetary policy responds appropriately, the combined change in the monetary policy and fiscal policy could leave aggregate demand unaffected. That means the production and the employment in the economy will not be affected by decrease in the government spending. Ideally, the policy mix should aim at maximizing growth and minimizing unemployment. However, the central banks and governments are sometimes theorized to have different time horizons, with the elected governments having a shorter time range. Both can have other objectives and must apply to
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some constraints, diverting them from these primary objectives: obeying a deficit rule, securing the financial sector, courting popularity, etc. Monetary policy is typically accomplished by the central bank which, by the control of interest rates and the money supply, balances control of inflation and unemployment. The government determines labor market conditions, public investment and public spending, automatic stabilizers and in severe recessions possibly discretionary fiscal policy. Central bank independence is generally held to be positive, because it prevents a single authority from simultaneously issuing debt and paying it off with newly created money, which would result in severe inflation.

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