Question

2. Suppose the Canadian economy is in inflationary gap. Explain how fiscal policy is used by the government to close the gap. Explain all the steps. b. How a government can reduce consumption expenditure? How decrease in consumption expenditure will affect economy with inflationary gap.

Answer 1

a) when there is an inflationary gap actual GDP is greater than potential GDP and generally there is a demand pull inflation. Fiscal policy can be used to close this gap in which government uses fiscal contraction. Government can increase taxes or it can reduce its spending as well as transfers. The effect of this policy can be seen in the form of reducing the aggregate expenditure and aggregate demand. This shifts the aggregate demand curve to the left until all the inflationary gap is eliminated.

b) government can reduce consumption expenditure by increasing taxes and decreasing transfers. these transfers are generally the welfare transfers the such as unemployment insurance or social security benefits. When taxes are increased disposable income is reduced and this reduces consumption expenditure. because consumption expenditure is a part of aggregate demand its reduction will reduce aggregate demand. As a result it is going to decrease the inflationary gap.