Question

Create a graph with an aggregate demand curve and an aggregate supply curve in the short-run. Use the variable ‘Price Level’ for the vertical axis and ‘Real GDP’ for the horizontal axis. Indicate the equilibrium level of output and the price level. In essay form, describe a fiscal policy scenario that could result in a reduction of unemployment. Show the new equilibrium level of output and price level as a result of this policy in your graph. Explain how the implementation of this policy is related to the simple spending multiplier. Explain how the fiscal policy could solve the problem of unemployment. Use your graph to illustrate your explanation. (200 to 300 words). Reference and cite your course textbook. The graph can be hand or computer generated. You can copy graph from any source, but you need to explain the labels clearly.

Answer 1

Below is the graph with an aggregate demand curve AD and an aggregate supply curve SRAS interacting in the short-run. Price Level is measured on the vertical axis and Real GDP is measured along the horizontal axis. At the current equilibrium level E, the real GDP or the output level is Y1 and the price level is Pl. It is presumed the economy has a higher rate of unemployment because of a recession going on in the economy. When the employment is less than its full employment level, there is a recessionary gap where unemployment rate exceeds its natural rate. In such a case an increase in aggregate demand is required. Government can use its fiscal policy tools to boost aggregate demand and reduce the level of unemployment when it reduces the tax rate or increases its spending on goods and services. Both are the measures of fiscal expansion and they stimulate aggregate demand. This uses the spending multiplier (1/(1 - MPC) or tax multiplier (-MPC/(1 - MPC)) where a likely increase in government spending is multiplied with the spending multiplier and a likely decline in tax rate is multiplied with the tax cut to get the desired increase in real GDP. This helps in generating employment as demand for goods and services is increased which encourages firms to produce more and hire more workers. Eventually, after the multiplier effect has taken place, real GDP reaches its potential and level and employment also reaches its full employment level. At this new level, the rate of unemployment is reduced and is reached to its natural rate.

Price level SRAS AD1 Yi Y2 Real GDP