The United States economy is currently producing at a level of full employment in long-run equilibrium. The government then decides to increase taxes and to reduce government spending in an effort to balance the budget. The results of the actions taken by the government is the decrease of real GDP. When taxes are increased that the amount of disposable income that is available to consumers is lowered. This lowered level of disposable income leads to a decrease in consumption spending as well as a decrease in savings. This decrease in consumer and government spending causes the total spending to decrease by a multiplied amount, As a result of the decrease in total spending the aggregate demand decreases and the aggregate demand curve shifts to the left. This decrease in consumer and government spending also causes businesses to have a surplus of inventories. At this point the output is greater than spending and as a result prices begin to fall. Because of the surplus of goods and falling prices consumption becomes more desirable to consumers and the level of consumer spending rises. The fall in prices causes business to become less profitable and producers decrease the level of production. This results in the decrease of the aggregate quantity supplied to decrease. This continues until aggregate quantity demanded equal the aggregate quantity supplied and a period of short-run equilibrium is established. The real GDP and the price level have both decreased from the original long-run equilibrium level and the economy is operating under the full employment level. At this point the U.S. economy is at a recessionary gap and a monetary policy must be used to pull the economy from the current recession.
There are three options that the Federal Reserve has to try and end the current recession. The federal funds rate could be lowered, the discount to banks could be lowered, or open market operations could be used. The most effective of these three options is the use of expansionary monetary policy through open market operations. The first step in this option is for the Federal Reserve to start to purchase bonds from consumers. As the Federal Reserve begins to buy these bonds back the bond prices are increased to make the selling of these bonds more attractive to consumers. When the Federal Reserve purchases a bond from a consumer a check is issued to the seller for the agreed price. This higher bond prices also lowers interest rates. The seller then deposits this check into his/her bank. This action increases deposits in the bank, which in turn raises the banks reserves to increase. The required reserves are increased by the amount of the check times the required reserve ratio, and excess reserves increase by the difference between the check and the amount of the required reserves. Because the excess reserves of the bank have increased, the bank is now able to loan out more money. The bank will continue to make new loans until it is loaned out. The lower interest rates that are caused by the higher bond prices encourages more consumers to borrow money. This increase in the amount of loans causes a raise in the money supply by a multiplied effect.
Because of the increased desire to loan money by banks and the increased desire to borrow money by consumers companies receive more loans which is used for investment. This rise in loans that are used for investment increases investment spending. This increase in investment spending causes the total spending to increase by a multiplied effect. This increase in total spending then causes an increase in aggregate demand which causes the aggregate demand cure to shift to the right. Spending is now greater than output. As a result of spending being greater than output many suppliers and manufacturers expand production of their goods. Prices will also increase because production costs rise as well. The increase in production causes a increase in the level of aggregate quantity demand supplied to consumers is increased. The increase of prices makes the value of money and wealth decrease. Because of this decrease consumption becomes less desirable by consumers and the aggregate quantity demand decreases. Another result of this increase in prices is the decrease of exports because the higher prices make U.S. products less desirable. Consumption and net exports are now decreasing. The level of aggregate quantity supplied continues to rise and the level of aggregate quantity demanded continues to fall until aggregate quantity demanded and aggregate quantity supplied are equal. This causes the U.S. economy to enter a state of long-run equilibrium at full employment. This new level of equilibrium should be very similar to the original long-run equilibrium. The total real GDP has not been affected. Government spending and consumption have both decreased. Investment spending has risen because of the new lower interest rates. Because of this real GDP is not effected in the long run.