Question

I need help with this question for my Principles of Macroeconomics class!

E. 1) Illustrate the consumption function and the corrective fiscal policy for an overexpansion or inflationary gap. 2) Explain the fiscal policy that would be recommended. 3) Fully explain the limit of this policy.

Answer 1

Consumption function explains the relationship between an individual's autonomous consumption (i.e., consumption that is independent of his income) and his induced consumption that is what he consumes based on his disposable income.

$C = \overline{C} + c (Y - T)$

$\overline{C}$ is the autonomus consumption. The consumption that is independent of his income.

Y-T is the disposale income. Income after paying off the taxes.

c is the marginal propensity to consume. The proportion of income that an individual consumes out of his disposable income.

Inflationary Gap - A situation when the demand for goods and services exceed the production causing actual GDP to be grater than the potential GDP. In other words, Aggregate demand exceeds aggregate supply at full employment level of output.  This may happen because of increased government spending or higher level of unemployment.

Aggregate demand consists of consumption function (C) , investment function (I) , government spending (G) and net exports (NX).

Infaltionary gap is a situation when

C+I + G + NX > Yf

Aggregate Expenditure AD Inflationary Gap AD Output

In order to correct this situation, the government may use fiscal policy tool. The government may raise taxes or reduce government spending so as to reduce the aggregate expenditure. The output reduces by multiplier times the autonomus spending. This happens till the aggregate demand is back to its original position at equilibrium E where actual ouptut equals potentail output at Yf.

Contractionary fiscal policy is thus recommended in order to correct the inflationary gap created in the economy.

Limitations of contarctionay fiscal policy

1. Increasing taxes may reduce incentive to work, reducing productibvity, thereby causing aggregate supply to suffer/fall.

2. Reduced government spending may impact public services adversely.

3. Taking decisions on spending and tax changes takes time and so its implementation.

4. Contractionary fiscal policy may impact consumption through disposable income. Other components of aggregate demand may impact output adversly.