Question

Quantitative Reasoning Assignment on Fiscal Policy

1. Assume the economy is currently in short run equilibrium but experiencing a recessionary gap, what combination of fiscal policies might the Federal government pursue to correct problem? Graphically illustrate and explain.
2. Assume the economy is currently in short run equilibrium but experiencing an inflationary gap, what combination of fiscal policies might the Federal government pursue to correct problem? Graphically illustrate and explain.

Answer 1

In each graph, initial long-run equilibrium is at point A where initial aggregate demand (AD0) intersects initial short-run aggregate supply curve (SRAS0) and long-run aggregate supply curve (LRAS0), with long-run equilibrium price level P0 and real GDP (potential GDP) Y0.

(1)

A recessionary gap arises when aggregate demand falls, shifting AD curve leftward, decreasing both price level and real GDP. In this case government pursues expansionary fiscal policy, by increasing government spending and/or by decreasing taxes, to increase real GDP and pull the economy out of recession.

In following graph, with recession, position of economy is at point B where aggregate demand is lower at AD1 which intersects SRAS0 with lower price level P1 and lower real GDP Y1. Recessionary gap is (Y0 - Y1). When government spending rises or tax falls, aggregate demand rises and AD1 shifts rightward to AD0, eliminating recessionary gap.

(2)

An inflationary gap arises when aggregate demand rises, shifting AD curve rightward, increasing both price level and real GDP. In this case government pursues contractionary fiscal policy, by decreasing government spending and/or by increasing taxes, to decrease real GDP and ease out the inflationary pressure.

In following graph, with expansion, position of economy is at point B where aggregate demand is higher at AD1 which intersects SRAS0 with higher price level P1 and higher real GDP Y1. Expansionary gap is (Y1 - Y0). When government spending falls or tax rises, aggregate demand falls and AD1 shifts leftward to AD0, eliminating expansionary gap.