Question

a 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. Inflationary gap is defined to be a situation when actual GDP is higher than the anticipated GDP. This means the demand for goods exceeds the actual Production in the economy . This condition can be tackled by the Canadian govt by introducing contractionary fiscal policy. A contractionary fiscal policy includes tools like high tax rates or low govt spending. These tools causes the aggregate demand to fall short . Due to falling aggregate demand , the GDP levels also falls due to fall in exchange activities in market. Also falling aggregate demand also causes the price levels to fall down , given aggregate supply curve. This is how inflationary gap can be covered with fiscal policy.

b. Consumption expenditure calculates the consumption spendings done by the people in the economy. These spendings are mainly counted to be that of goods and services. Govt can reduce consumption spendings by rising tax rates . This can cause a negative impact in the disposable income , which thus cause a reduction in consumption expenditure levels. Further with rising rate of interest on savings can cause individuals to save more. Then also consumption on expenditure tend to fall.

LRAS SRAS, 1 Price level PL Shift caused by contractionary policy P3 Inflationary gap AD2 AD YpY Real GDP per year

A decrease in consumption spending is a good way out to deal with inflationary gap. With decreasing consumption spending , the GDP levels falls hence covering for the additional GDP recorded , hence covering for the inflationary gap.