Question

If an economy at full employment experiences a fall in aggregate demand, what can the government...

If an economy at full employment experiences a fall in aggregate demand, what can the government do to help the situation?

increase government spending

decrease government spending

increase taxes on individuals and businesses

reduce taxes on individuals and businesses

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Answer #1

When the economy is at full employment level and aggregate demand falls, the leftward shift of aggregate demand curve causes the recessionary gap, that is actual output is less than the potential output. In such a case, the government would take an expansionary fiscal policy measure to boost the aggregate demand which would shift the aggregate demand curve to the right, thus bringing back the economy to the potential output level.

Since expansionary fiscal policy measures include rise in government spending and decline in taxes on individuals and businesses, option 1 and 4 are correct.

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