Question

Given a closed, private economy where aggregate demand (AD) can be represented as AD = c0 + c1Y + I0 where c0 is autonomous private consumption, c1 is the marginal propensity to consume, I0 is autonomous business investment, and Y is national income.Given an economy that is operating well below potential real GDP, use a well labelled diagram to show that it is possible to use expansionary fiscal policy to increase real GDP without causing the price level to increase as well.

Answer 1

If an economy is operating at below potential GDP level or there occurs recessionary gap where national income (Y0) is less than potential level 9Y1). Expansionary fiscal policy which will raise government spending and reduce tax such that people hold more money to spend on goods and services after paying taxes which will raise consumption spending and raise marginal propensity to consume (c1) where change in consumption > change in income. It will shift aggregate demand curve to its right from demand to new demand where supply curve is perfectly elastic and take economy to its long run equilibrium where it vanish recessionary gap. It will keep price at P0 and raise output level from Y0 to Y1.