Suppose the President appointed you the macroeconomic czar for the United States in 1991. With this title goes many powers and responsibilities. Among your powers is the ability to raise or lower taxes and increase or decrease the money supply. Because you wanted this appointment, you promised to lower the Federal budget deficit (3.3% of GDP in 1991) without worsening the growth rate of GDP (-0.9% in 1991 ). How can you do this?

First, concentrate on the budget deficit. As you learned in the Shifts of the IS curve exercise, one way to lower a budget deficit is to increase taxes. Grab the IS curve in this graph and move it in the direction implied by a tax increase. If you are not sure which direction the IS curve should move, go back to the Shifts of the IS curve exercise.

  1. How does the tax increase affect the interest rate and output ?

Now try using fiscal policy to get us out of the recession.

  1. How should taxes be changed to increase output ?
  2. What happens to the deficit as you use fiscal policy to get us out of the recession ?

Let's see if you can use both fiscal policy and monetary policy to help solve this problem.

  1. First, increase taxes to solve the deficit problem. What has happened to output ?
  2. What should you do with monetary policy to solve the recession ?
  3. Are you able to get the U.S. out of the recession without worsening the budget deficit ?

This is exactly what President Clinton, Congress, and Federal Reserve Chairman Alan Greenspan did in the early 1990s. President Clinton and Congress passed budgets that eliminated the Federal budget deficit. Greenspan offset the contractionary effects of the fiscal policy with expansionary monetary policy. The U.S. has enjoyed unprecedented growth ever since.