Macroeconomics: Analyzing Policy for Lalaland - Semester Report

This report analyzes the macroeconomic situation of Lalaland, focusing on its increasing inflation rate, steady unemployment, and declining economic growth. The student proposes a combined policy approach: a tight monetary policy to curb inflation and an expansionary fiscal policy to stimulate aggregate demand and economic growth. The analysis uses the Liquidity Preference Framework and the IS-LM model to illustrate the effects of a tight monetary policy on interest rates, investment, and inflationary pressure. Furthermore, the report explains how an expansionary fiscal policy, through increased government spending or reduced taxes, can boost aggregate demand, increase output, and promote economic growth. The student provides figures to support the analysis and references key macroeconomic literature.

Running head: MACROECONOMICS
Macroeconomics
Name of the Student
Name of the University
Course ID

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Table of Contents
Proposed policy for Lalaland...........................................................................................................2
Effect of proposed policy changes on macroeconomic variables....................................................3
Tight monetary policy..................................................................................................................3
Expansionary fiscal policy...........................................................................................................4
References........................................................................................................................................6

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Proposed policy for Lalaland
The policy decision of a nation depends on performance of different macroeconomic
variables. The three important macroeconomic variables affecting policy decision include rate of
economic growth, inflation and unemployment rate (Uribe and Schmitt-Grohe 2017). In
Lalaland, the inflation rate shows that an overtime increasing trend. Inflation rate in Lalaland in
year 1 was 10 percent followed by 15 percent in year 2 and 20 percent in year 3. The
unemployment rate remained steady at 3 percent. Economic growth in contrast shows a
continuous declining trend. For Lalaland, policy therefore should be taken that can reduce
inflation along with stimulating aggregate demand.
In order to curb inflation government should adapt a contractionary or tight monetary
policy. It is the responsibility of monetary authorities of a nation to keep the inflation rate within
targeted range. Central bank here can reduce the money supply though open market operation of
selling government securities (Goodwin et al. 2015). This policy helps to reduce liquidity in the
economy. The ‘liquidity preference theory’ suggests a decline in money supply given money
demand increases interest rate in the money market. Central Bank can also reduce money supply
by increasing cash reserve ratio of banks.
Apart from fighting inflation, focus should also be given to stimulate output growth. The
appropriate policy here to take an expansionary fiscal policy. Fiscal policy expansion can be
done either by increasing government expenditure or by reducing the tax rate. When government
increases spending on goods and services, there is an expansion of aggregate demand resulting in
an expansion of aggregate output. A decline in taxes increases disposable income of people.
People are then able to spend more on goods and services raising aggregate demand of the

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economy (Johnson 2017). As aggregate demand increases, there is an expansion of aggregate
output stimulating economic growth.
Effect of proposed policy changes on macroeconomic variables
Tight monetary policy
The working of monetary policy first affects the interest rate. Following the theory of
liquidity preference, a decline in money supply shifts the money supply curve to the left. Given
the money demand, the fall in money supply increases equilibrium interest rate. In the IS-LM
model, the contractionary monetary policy affects the LM curve. A tight monetary policy causes
LM curve to shift inward (Uribe and Schmitt-Grohe 2017). As interest rate increases, there a
decline in investment. With contraction in investment, productivity in the economy contracts
which reduces employment and lowers inflationary pressure.
Figure 1: Liquidity preference theory and tight monetary policy

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Figure 2: Impact of tight monetary policy
Expansionary fiscal policy
Figure 3: Impact of expansionary fiscal policy
The expansionary fiscal policy attempts to increase aggregate demand in the economy.
An increase in government expenditure has a direct impact on aggregate demand. A decline in
tax raise disposable income of people. As income increase, people can spend more on different

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goods and service pushing up the aggregate demand (Heijdra 2017). The increased demand
encourages productive activities raising aggregate output and ensures a higher economic growth.

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References
Goodwin, N., Harris, J.M., Nelson, J.A., Roach, B. and Torras, M., 2015. Macroeconomics in
context. Routledge.
Heijdra, B.J., 2017. Foundations of modern macroeconomics. Oxford university press.
Johnson, H.G., 2017. Macroeconomics and monetary theory. Routledge.
Uribe, M. and Schmitt-Grohé, S., 2017. Open economy macroeconomics. Princeton University
Press.