Assume you run the central bank of a large open economy with floating exchange rates. Output, unemployment and inflation are where you want them to be. Now the fiscal authorities pass a large tax cut. What policy should you follow to stabilize output? What effects do you anticipate?

Expansionary fiscal policy

Explanation:

Tax cut would decrease the output, but in order to boost it difference between government expenditures and revenues needs increase. Also, unemployment benefits could rise, which would have positive effects on purchasing power and consumer demand. Demand can also rise with higher government spending. Either way, higher deficit or lower surplus lead to increase in output.

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