Question

Suppose the economy is initially in equilibrium, and real and potential GDP are equal. Now, suppose export orders increase. Under these circumstances, which of the following statements is true?

If the countercyclical fiscal policy response is made correctly, the new equilibrium will in the long run have a higher rate of inflation than if no response had been made.

If the countercyclical fiscal policy response is made correctly, the new equilibrium will in the long run have a lower rate of inflation than if no response had been made.

The inflation rate in the new long-run equilibrium will be the same, whether or not countercyclical fiscal policy is used.

If the countercyclical fiscal policy response is implemented too late, the new long-run equilibrium will have a higher rate of inflation than if no response had been made.

Countercyclical fiscal policy is unable to counter the effect of changes in export orders on real GDP.

Answer 1

Correct Answer:

B

Due to the export orders increase, the inflationary gap is created in the economy. As a result, the countercyclical fiscal policy of the reduced government spending and increased tax is applied. It makes the AD curve to shift to the left direction. As a result, the economy achieves the long run equilibrium, but at a lower price.

If no action is taken, then demand pull inflation is created. It will make the SRAS curve to shift to the leftward direction. It will also help the economy to achieve long run equilibrium of potential output, but at a higher price. So, it is countercyclical fiscal policy that causes decreased price than if no action is taken.