Question

1. (a) Consider a situation where current output (real GDP) is currently above potential GDP. What type of fiscal policy will the government use to get to potential GDP? Draw an AD-AS diagram to illustrate this situation (including the initial situation). Explain the figure in some detail. By this, we mean do not just explain the changes in the diagram, but also state what components of the AD and AS curves are changing (if any), and in which direction.

(b) Briefly explain if the existence of a fiscal multiplier would help the government in terms of its spending commitments to reach full employment output?

Answer 1

1.a) When the real GDP is above potential GDP the gap is called inflationary gap.Increase in GDP causes the economy to increase consumption which in turn causes prices to increase.in the long run Contractionary fiscal policy will bring down demand through decreasing government spending or by increasing taxes . This is the most effective method to use when the economy is producing above potential GDP.

In the fig the economy is in equilibrium at Yo which is above potential GDP. Contractionary fiscal policy will shift demand down from ADo to AD1and new equilibrium is at E1 This happens at potential GDP ie where AD1 intersects LRAS curve. So AD needs to be reduced to reach potential GDP.

b)Fiscal multiplier is referred as the ratio of change in national income to change in government spending that is causing it.The multiplier effect can arise when initial spending leads to increase in income and thus increase consumption.This leads to increase in national income which is more than the initial spending.Thus aggregate output will change as a result of initial change in aggregate demand.