Question

Suppose you are in charge of deciding the appropriate fiscal policy for an economy in which real GDP is less than potential GDP. One of your economic advisers recommends a reduction in government spending. Describe the potential impacts of this plan in the short and long run. Did you receive good advice from your economic adviser?

Answer 1

Real GDP is less than potential GDP

Policy advisors advice to reduce government spending

When real GDP is less than potential GDP then the gap is called recessionary gap

This occurs when SRAS = SRAD left to LRAS

Now if govet spending is decrease then SRAD will decrease this shifts to left . This will further increase the gap between real GDP and potential GDP so recessionary gap will increase

Leading to lower price level and output and greater unemployment

This advice id nit good instead of lowering, govt expenditure should rather increase to increase SRAD to shift it to right to decrease recessionary gap