Question
Asked Dec 7, 2019
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 Suppose the government cuts transfer payments in an economy with an inflationary gap. How would this policy affect bond prices, interest rates, investment, the exchange rate, net exports, real GDP, and the price level? Show your results graphically.

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Expert Answer

Step 1

When the government cuts transfer payments in an economy with an inflationary gap, various variables in an economy are affected, some positively while others in negative manner. Inflationary gap refers to a situation in the economy when the potential GDP of the economy differs than the actual GDP of that economy at full equilibrium level.

Step 2

Thus, when government cuts its transfer payments, it decreases the borrowing by the government.  This decrease by borrowing from government affects the bonds prices. The policy effect is that it causes the supply of bonds to fall with given demand for them, thus, prices of bonds increase. Since there is an inverse relationship between the price of a bond and the interest rates, interest rates in an economy will fall. This is shown in the following diagram.

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s'(bond) S (bond) Price P' P D AS interest rate Г AD `AD' Y' Y Output

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Step 3

When interest rates fall in an economy, it provides a way for cheaper borrowing by businesses and households. Since, it is now easier to avail credit because of fallen interest rates, it reduces the cost of pr...

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