Refer to the table below. Suppose that aggregate demand increases such that the

Question

Refer to the table below.

Suppose that aggregate demand increases such that the amount of real output demanded rises by $21 billion at each price level.

Instructions: Enter your answers as whole numbers.

a. By what percentage will the price level increase?  percent.

     Will this inflation be demand-pull inflation or will it be cost-push inflation? (Click to select)Cost-push inflationDemand-pull inflation.

b. If potential real GDP (that is, full-employment GDP) is $510 billion, what will be the size of the positive GDP gap after the change in aggregate demand? $ billion.

c. If the government wants to use fiscal policy to counter the resulting inflation without changing tax rates, would it increase government spending or decrease it? (Click to select)DecreaseIncrease.

Real Output Demanded, Billions Price Level Real Output Supplied, Billions 494 118 515 502 109 512 510 100 510 518 90 507 526 82 500

Explanation / Answer

(a)

As per the given table, at present, real output demanded is equal to real output supplied corresponding to price level of 100.

So,

The current equilibrium price level is 100.

Now, aggregate demand has increased by $21 billion at each price level.

New table is as follows -

As per the new table, real output demanded is equal to real output supplied corresponding to the price level of 118.

So,

The new equilibrium price level is 118.

Calculate % increase in price level -

% increase = [(118 - 100)/100] * 100

% increase = (18/100) * 100 = 18%

The price level will increase by 18 percent.

This increase in price level is due to increase in aggregate demand.

So, this inflation will be demand-pull inflation.

(b)

The new equilibrium real GDP is $515 billion.

Potential real GDP is $510 billion.

So,

Positive GDP gap = $515 billion - $510 billion = $5 billion

The size of positive GDP gap is $5 billion.

(c)

As per the new table, real output demanded is equal to real output supplied corresponding to the price level of 118.

So,

The new equilibrium price level is 118 and the new equilibrium real GDP is $515 billion.

New equilibrium real GDP is greater than the potential real GDP.

So, there is need to decrease real GDP.

For this government should administer contractionary fiscal policy.

This involves increasing taxes or reducing government spending.

As government do not want to change tax rates, it must decrease government spending.

So, the correct answer is the Decrease.

Real Output Demanded Price Level Real Output Supplied 515 118 515 523 109 512 531 100 510 539 90 507 547 82 500

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