Question

Use AS/AD diagram to show tools of a discretionary fiscal policy in response to a positive aggregate demand shock. Comment briefly.

Answer 1

When there is a positive aggregate demand shock due to an increase in consumption,government expenditure,an increase in investment or rising net exports then the AD curve shifts to the right at which the price level rises and there will be an inflationary gap of Y2-Y.

To close this gap, the government uses discretionary fiscal policy tools such as a tax cut and a decrease in government spending.This will cause the available money supply in the economy to decrease and the disposable income to fall thus aggregate expenditure decreases and the AD curve shifts to the left which will bring the economy back to its natural rate of output of Y.