Question

(10 points) If the government decided today that aggregate demand was excessive and causing an inflationary gap, how could the government use the tools of fiscal policy to correct this problem? Explain what could be done using each of the three tools. Explain the impact on prices in comparison to the self-correcting mechanism discussed in Chapter 10. (All three methods are the same In this respect.) Think in terms of aggregate supply and demand curves with aggregate supply unaffected by fiscal policy

Answer 1

To close the inflationary gap, the government uses contractionary fiscal policies. The contractionary fiscal policy is used to reduce the aggregate demand to the left and close the inflationary gap. The inflationary gap shows in the given diagram,

LRAS Aggregate price level SRAS Iflationary gap YO Real GDP

The inflationary gap closes by using decreasing in government purchases, increase in taxes and a decrease in transfer payments. It is discussed below:

The decrease in government purchases

Contractionary fiscal policies include a diminishing in the funds appropriated to these various organizations. The offices at that point diminish their purchases which diminish the rate of inflation, aggregate production and income. It will shift the aggregate demand to the left.

Increase in tax rates

Contractionary fiscal policy includes either an expansion of the income tax rates or a one-time extra charge. The expansion in taxes gives the household sector less disposable income that can be utilized for consumption expenditures, which at that point diminishes total output and employment and prompts further diminishes in income, hence lessening inflationary pressure.

Decreases in transfer payments

Contractionary fiscal policy includes either a diminishing in payments schedule for at least one of the transfer systems or maybe some in all cases decrease in payments to all who qualify. The diminishing in move transfer payments lessens the disposable income accessible to the household sector, which at that point powers a decrease in consumption expenditures, prompting less aggregate production and employment and consequently an abatement in inflationary pressure.