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2. In a Keynesian framework, using an AD/AS diagram, which of the following government policy choices offer a possible soluti

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Answer #1

a. With a tax increase on consumer income, disposable income of the households falls. As a result consumption and aggregate demand falls. This will cause AD curve to shift to its left from AD to AD' resulting in lower GDP (output) Y' and price level P' both.

AD SAD -Output Y Y

b. With a surge in military spending, aggregate expenditure increases. As a result, AD curve shifts to the right from AD to AD' resulting in higher GDP (output) Y' and price level P' both.

AD AD -Output үү

c. With reduction in taxes that increases investment, level of investment rises. As a result, aggregate expenditure increases and AD curve shifts to the right from AD to AD' resulting in higher GDP (output) Y' and price level P'. This is shown in diagram (b).

d. If US government increases its expenditure on healthcare, aggregate expenditure increases and AD curve shifts to the right from AD to AD' resulting in higher GDP (output) Y' and price level P'. This is shown in diagram (b).

Options b, c and increases aggregate demand and thereby can solve the problem of recession. Option a cannot solve recession as here AD falls.

In options b,c and d both price level increases. Thus, these solutions are incapable in solving problem of inflation. Only option a can solve the problem of recession by decreasing price level.

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