Question

Suppse the government wants to use fiscal policy to return the economy from a recessionary gap to a full-employment equilibrium.What policies mught they consider? with the as-ad graph, discuss the adjustment process in the private sector by the fiscal stimulus

Answer 1

Government has to consider the expansionary fiscal policy to help economy return from the recessionary gap and achieve the full employment GDP equilibrium again. As a part of the, the government will increase spending and or decrease the taxes so that AD is stimulated and it shifts to the right. Besides, spending and taxation multiplier effect is set in the economy and impact of government spending or increase in income due to lower tax, is maximized to achieve the full employment economy.

It is shown in the following graphs. In figure 1, the economy is facing a recessionary gap. But, a government spending, makes AD to move to the right and achieve full employment GDP in figure 2.

Figure 2 Figure 1 LRAS LRAS Price Price AS AS AD1 Real GDIP Real GDIP 《集

When government spending increases, then it creates demand. this demand is catered by the supply made by the private sector. It creates new jobs by the private sector and employment is created. It further creates demand and a positive chain of action is initiated to achieve long run equilibrium as shown in figure 2.