Question

Consider a situation where current output (real GDP) is currently below potential GDP. What type of fiscal policy will the government use to get to potential GDP? Draw an AD-AS diagram to illustrate this situation (including the initial situation)

Explain the figure in some detail. By this, we mean do not just explain the changes in the diagram, but also state what components of the AD and AS curves are changing (if any), and in which direction.     

Answer 1

When current GDP is below the level of potential GDP, then there is a recessionary gap in the economy. To help economy achieve the potential GDP level, the government will implement expansionary fiscal policy in the economy. As a part of it, government will increase spending and or decrease tax . It will cause aggregate demand and AD curve will shift to the right. It will make output to reach potential output level and price level also increases. It is shown by the following diagram.

As per the above diagram the initial position is at equilibrium E with output to be Q and Price to be P. It is a real output to be less than the potential output level Q'. When government implements expansionary fiscal policy, then AD curve shifts to the right and reaches to the level of AD' curve. It makes economy to achieve equilibrium E' where the output is Q' and price level is P'. It is a long run equilibrium achieved.