Question

Refer to the table below 

Suppose that aggregate demand increases such that the amount of real output demanded rises by $7 billion at each price level

a. By what percentage will the price level increase?

Will this inflation be demand-pull inflation or will it be cost-push inflation?

b. If potential real GDP (that is, full-employment GDP) is $510 billion, what will be the size of the positive GDP gap after the change in aggregate demand?

c. If government wants to use fiscal policy to counter the resulting inflation without changing tax rates, would it increase government spending or decrease it?

Answer 1

a. Initially the price level is 100. Now with increase the AD, the new price level is 112 at which Real GDP demanded = Real GDP supplied = 513. Hence price rises by (112 - 100)*100/100 = 12%.

This inflation will be demand-pull inflation since AD has increased by $7 billion at each price.

b. If potential real GDP is $510 billion, the current GDP is 513 billion and so there is an inflationary gap of $3 billion.

c. If government wants to use fiscal policy, it has to decrease the government spending to discourage aggregate spending and eliminate the GDP gap.