Question

Suppose the economy is currently $100 billion above potential GDP, and the government wants to pursue discretionary fiscal policy to cool off the economy. Show this situation using an AD-IA diagram.

Answer 1

If the economy is above the potential level of the GDP It will lead to an inflationary gap. At this point, the government can use a discretionary fiscal policy in terms of increasing the taxes or introducing a surplus budget. This will decrease the demand and bring the economy back to the potential level of output.

IN the graph here, the present point of equilibrium is shown as A, where the output is 100 billion above the potential output. Fro this point the government will use the discretionary policy and increase the taxes which will reduce the disposable income in hand of people and they will reduce the demand. The AD1 curve will shift to AD2 and the price level will come down to P2 from P1. The economy will be back at the potential output level and the new output will be Y.