Question

The graph shows an economy that is above full employment. To restore full employment, the government decreases government expenditure by $0.5 trillion. Draw a curve to show the effect of the decrease if this is the only change in spending plans. Label the curve AD0-ΔE The decrease in government expenditure sets off a multiplier process. Draw a curve that shows the multiplier effect that returns the economy to full employment. Label it AD Draw a point at the full-employment equilibrium Choose the correct statement. Price level (GDP price index, 2009:100) Potential GDP 12 AS 120 O A. An increase in taxes will decrease aggregate demand, but because the tax multiplier is smaller than the government expenditure multiplier, the economy will not return to potential GDP Eliminating an inflationary gap is very simple-calculate the size of the gap, the size of the multiplier and then change government expenditure for an immediate decrease in real GDP back to potential GDP O B. ° C. Contractionary fiscal policy can eliminate inflationary pressure O D. An equal decrease in government expenditure and taxes cannot return the economy 13 to full employment. 12 13 Real GDP (trillions of 2009 dollars)

Answer 1

(1) Full employment is at the point indicated where AD1 intersects AS and Potential GDP curves.

Price level (GDP price index, 2009-100) 145 Potential GDP 135- 125 AS 120 ADo 15 105- AD1 13 13 95- 14 12

(2) Option (C)

Contractionary fiscal policy decreases aggregate demand, shifting AD curve leftward and lowering price level (inflation).