Question

The graph below depicts an economy where an increase in aggregate demand has caused inflation. The economy's current level of real GDP (Y) is above its long-run equilibrium. This is illustrated by the long-run aggregate supply curve (LRAS) and a price level 2) above the equilibrium value of Pe Fiscal Policy Price Level Real GDP Which of the following is an example of an automatic stabilizer that would help this economy move toward full employment again A reduced need for government transfer payments An increase in the average tax rate A reduction in the average tax rate A decrease in government purchases

Answer 1

1. Automatic stabilizers are income tax and transfer payments which work automatically and reduce the intensity of business cycle. During times of boom or overfull employment, the income of the people increase. Thus the people have to pay higher taxes which reduce the disposable income of the people. This fall in income will reduce the aggregate demand. Again the government transfer payments in the form of unemployment allowance and other social security measures decline. This reduces the consumption of the people. Thus the aggregate demand automatically declines during times of boom without any deliberate intervention of the government. This mitigates the intensity of inflation and helps the economy reverse to the former level of fullemployment GDP. Answer: A reduced need for government transfer payment. LRAS ASI Price level AD AD1 Real GDP a. The decrease in investment shifts the aggregate demand down from AD to ADI. The price level and output decrease. As the price level decrease the resource price including wage declines. This reduces the cost of production and as the cost decrease the aggregate supply curve shift right from AS to ASI. Thus the economy moves back to fullemployment level of output. b. In comparison with new equilibrium and the equilibrium before the decrease in investment, in new equilibrium the price level is lower than the initial equilibrium but the output is the same. Answer: The price level is lower, but output remains the same. LRAS AS ASI Price level AD3 AD2 Real GDP Answer: The AD3 shows the effect of both fiscal policy and multiplier. In this situation output goes beyond fullemployment. This will increase the cost of production and the AS curve shift to left and the economy will reach to ſullemployment with the same output but higher price level. Answer: The price level is higher, but the output remains the same.