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1. Explain how monetary and fiscal policy can be used to eliminate a deflationary gap.

Expansionary Monetary policy
A. One goal is to change economic activity by affecting interest rates and investment.
1. Increasing investment will increase economic activity.
a. The Federal Reserve increases the money supply which may lower interest rates. 
b. Low interest rates increase investment which increases AD which causes an increase in Real GDP.
2. Decreasing investment will decrease economic activity.
a. The Federal Reserve decreases the money supply which may increase interest rates. 
b. High interest rates decrease investment which decreases AD which causes a decrease in Real GDP.

B. Affecting the non-investment components of aggregate demand
1. Lower interest rates also increase C, G, and X_N
a. Consumption increases as credit purchases become cheaper.
b. Refinancing existing debt at lower interest rates by individuals, businesses, and governments frees funds for spending.
c. Lower interest rates also decrease the international value of the dollar investors buy (demand) other currencies to earn more interest. The lower dollar increases X_N as U.S. goods are less expensive and foreign goods more expensive.

Expansionary fiscal policy consists of reversing an economic downturn by increasing AD with deficit spending.
A. Lower taxes to increase Consumption (C) and Investment (I)
1. Personal income taxes  
2. Capital gains taxes paid on the profit from the sale of commercial real estate, a company, and financial
assets (stocks and bonds)
3. Investment tax credit which is a direct lowering of the tax liability of companies investing in 
certain approved types of plant and equipment 
B. Increase government spending (G)
C. The result will be a fiscal stimulus through deficit spending. 
D. The impact of a fiscal stimulus, once implemented, will affect AD. 

2. Explain the strengths and weaknesses of monetary policy in affecting economic activity.
A. Strengths
1. Speedy and flexible
2. Somewhat isolated from political pressure
3. Hard money, restrictive policy by the Federal Reserve, has worked well recently. 
B. Weaknesses
1. Easy money has not worked well.
a. In the early 1900's, it didn't stop a recession. 
b. Low profit expectations by business and fears over possible employment loss by workers make
lower interest rates ineffective.
c. Interest rate cuts in 2001 were not able to stop a recession.
2. Bank deregulation has made commercial banks a less important supplier of investment funds thus diminishing the effectiveness of monetary policy.
3. Changes in the velocity of money may negate some of the effects of monetary policy.