Question

Figure: Effects of Contractionary Fiscal Policies LRAS SRAS AD Aggregate Output (Q) ot t Expansionary fiscal policy should be used to ensure a higher price level Contractionary fiscal policies should be used to reduce inflation Contractionary fiscal policy should be used to ensure a higher price level Expansionary fiscal policy should be used to increase aggregate demand Which of the following statements is true regarding the diagram above

Answer 1

Answer

Option B

The short-run equilibrium is at SRAS=AD which is right of the LRAS means the potential output is less than the actual output level so there is an inflationary gap. To eliminate the gap and control prices the government should us a contractionary policy. The policy decreases government spending or increase taxes or both and decreases disposable income. It decreases aggregate demand and shifts to the left which decreases price level and eliminate the inflationary gap.

Without intervention, the input prices will adjust and it increases because of inflationary pressure. It decreases SRAS and that shifts to SRAS left. It also eliminates the gap but increases the price level and increases inflation.