April 2021, Q19 & Q26

[Naga Sai Shivanee]

Q19.
If both government spending and the money supply are increased, and the economy
has a high degree of unemployment, then:
A the national income and interest rates will both rise.
B the national income and interest rates will both fall.
C the effect on both national income and interest rates is uncertain.
D the national income will rise but the effect on interest rates is uncertain.

While trying to solve this question, I chose option C, but turns out that the answer is D. But I didn't exactly understand why D is the right option.
Government spending increases, hence aggregate demand increases. But due to high unemployment, people will demand less because they don't have money to buy, so the effect on aggregate demand and national income should be uncertain right? We can't say how much each is affecting aggregate demand...increase in govt expenditure or reduced consumption. So I thought it was option C.

Q26.
Other things being equal, if there is an unexpected fall in money supply, there is no
change in the expected rate of inflation and the unemployment rate is above the
natural rate of unemployment, then the long-run Phillips curve would suggest that the
inflation rate will eventually:
A fall and the unemployment rate would rise.
B fall and the unemployment rate would fall.
C rise and the unemployment rate would fall.
D rise and the unemployment rate would rise.

In this question, I felt option C is the right answer but option B is the right answer. Phillips curve shows inverse relationship between inflation and unemployment. So here unemployment will fall in the long run for sure as long run Phillips curve unemployment is not affected by inflation. But if unemployment has to fall, doesn't inflation rise due to the inverse relationship? How do both inflation and unemployment fall? Or is it that in the long run unemployment rate and inflation rate are unrelated? I saw that the long-run Phillips curve is vertical at the natural rate of unemployment. So with this in mind, I see that since the the unemployment rate is currently above the natural rate it would fall to the natural rate. But why does inflation also fall?

So these were the queries I had. In short, I just want to understand why option D is correct for Q19, and option B is correct for Q26. Can anyone explain this?

Thankyou in advance.

 

[helloworld123]

I'm studying this exam myself currently, and although I don't know for certain, I'll have a go - I think for Q19:
Both measures increase aggregate demand and hence national income (increased gov spending is obvious, and increased money supply means lower interest rates, hence C and I go up). So the national income part of the options is certain - has to go up.

As for interest rates, I think even though initially, we expect lower interest rates (higher money supply), the fact that we have high unemployment means there is 'slack' in the economy - as we are far away from the full level of employment, as output increases (due to an increase in money supply and increased gov exp), the spare capacity is utilised so prices do not move up much? I think the curve slopes upwards as we move towards full utilisation. Ultimately, we don't know how much unemployment there is relative to how much interest rates fall. So the effect on interest rates is uncertain.

For Q26) - a fall in money supply leads to an increase in interest rates, reducing AD (as C and I fall due to high costs of borrowing). So as AD falls, prices then have to fall too in the long run. I didn't even relate this part of the question to unemployment, I just looked at it from the perspective of lower prices due to a fall in demand.

This is just my guess, I am not certain.

 

[Naga Sai Shivanee]

Thankyou So Much! I got a better understanding now.