Question 4 8 p There are three separate questions for this question. 1. If emplo

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Question 4 8 p There are three separate questions for this question. 1. If employment is above the full employment, what fiscal policy should the government pursue and what actions can the government take? 2. What is the effect on the AD curve from either a decrease in government expenditure o a raise in taxes? 3. If the government cuts taxes on labor income and interest income, explain how potentia GDP and economic growth are affected. HTML Editor U A Para Question 5 0 pts This question is worth 10 points and to be answered on paper and then upload the file onto Canvas. Suppose the economy is experiencing a rising inflation.

Explanation / Answer

1.

An inflationary gap is the condition in which the Real GDP that the economy is producing is greater than the Natural Real GDP and the unemployment rate is less than the natural unemployment rate. In inflationary gap the short run equilibrium real GDP is greater than the natural real GDP.

To combat or off set the inflationary gap the economy needs to produce less than what it is producing in the short run. Thus it needs to decrease its aggregate expenditure and real GDP. Hence the government took a contractionary fiscal policy of either increasing taxes or decreasing government spending. The decreased government spending decreases the aggregate expenditure and thus shifts the aggregate demand curve downward until the economy reaches the long run equilibrium.

2.

The government earns from the tax revenues and spends it in on public goods and various program including transfer payments. Now if the revenues from tax exceeds the government expenditure a budget surplus results. On the other hand if the government spending exceeds its revenue the budget deficit results. If the current budget shows a surplus an increase in government spending will decrease the surplus.

As the government spending increases from the identity above we can see that it will decrease the surplus.

An increase in taxes decreases the disposable income; only one part of the disposable income is used as consumption. Hence consumption decreases less than the increase in tax and decreases aggregate demand. Thus increase in tax has indirect effect on aggregate demand and increase in taxes results in less decrease in aggregate demand than same increase in government spending.

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