Question

4. 25 points a. How can the Federal Government help to reduce or close the inflationary gap moving the economy back toward full employment using demand side fiscal policy. > Carefully explain your policy measure. > Account for the role of the spending multiplier in your answer. b. Explain carefully the potential impact, if applicable, on i. Aggregate Demand Aggregate Supply The Price Level The Level of real GDP The Interest Rates, The Budget Deficit, and The Trade Deficit. i. iV V. vi vi.

Answer 1

Inflationary Gap refers to the difference between the potential level of output and the actual level of output.

Inflationary Gap occurs when actual level of output > potential level of output.

To reduce or close the Inflationary Gap, the Fed shall adopt a CONTRACTIONARY FISCAL POLICY to bring actual output close to the potential level of output. Fed shall use this policy measure as it would decrease the aggregate demand in the economy and help it to reduce the inflationary pressures. Reduced aggregate demand would in turn reduce the output making it close to the potential level of GDP.

Fed Government can do this by reducing its expenditure i.e. by reducing government expenditure. Reduced government expenditure will cause a reduction in spending multplier.  A low spending multiplier will reduce the real GDP and eventually bring it close to the Potential level of GDP.

b)

i. Aggregate Demand will decrease due to fall in government purchases.

ii. Aggregate Supply will remain unchanged.

iii. The price level will fall

iv. The level of Real GDP will fall bringing it close to potential GDP

v. Not applicable to interest rates

vi. Improvement in Budget Deficit. There will be Budget Surplus due to reduced spending.

vii. Not applicable to Trade Deficit.