Question

Question 3

1. The hypothetical information in the following table shows the possible situation in 2016 if the government does not use any policy.

Year	Potential Real GDP	Real GDP	Price Level
2016	RM165.8 billion	RM178.3 billion	150

1. What problem will occur in the economy if no policy is pursued?                    

2. If the government wants to keep real GDP at its potential level in 2016, should the central bank implement a contractionary or expansionary fiscal policy?

3. Draw an aggregate demand and supply diagram to illustrate how the economy adjusts after the policy mentioned in part (ii).                                                                  

2. Assume that now Malaysia is experiencing recession and high unemployment. What is the appropriate stance of monetary policy to be used by the government to combat the situation? Use an aggregate demand and aggregate supply diagram to explain how the policy affects real GDP and the price level.                                                                                                

Answer 1

A)

a) As Potential GDP is less than real GDP, there occurs inflationary gap in the economy.

b) If government wants to reduce its GDP such that it is equal to potential GDP, central bank should adopt contractionary fiscal policy which raise tax rate and reduce government spending which will leave less money with consumers to spend on goods. It will reduce the aggregate demand in the economy.

c) Fall in demand curve shifts from demand to new demand which reduce price level from P0 to P1 and reduce output level from Y0 to Y1.

B) If Malaysia is experiencing recession and high unemployment, there must be recessionary gap in the economy. Expansionary monetary policy should be adopted which will raise money holding by people and raise aggregate demand by them. A shift in aggregate demand from demand to new demand will raise price level from P to P1 and raise output level from Y to Y1 which tends to vanish the recessionary gap in the economy.