Question

Refer to the table given below. Suppose that aggregate demand increases such that the amount of real output demanded rises by $7 billion at each price level.

Real Output Demanded (Original)	Price Level	Real Output Supplied
$506	110	$513
508	105	512
510	100	510
512	95	507
514	90	502

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)   Demand-pull inflation   Cost-push inflation

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

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)   Increase   Decrease

Answer 1

1) Equilibrium occurs when demand equals supply. Given the data above, equilibrium occurs when price is $100 and quantity traded is 510 units.

If quantity demanded rise by 7 billion at each price level, equilibrium occur when price is 110 and quantity traded is 513 because quantity demanded at this price rises from 506 to 513 which is equal to quantity supplied.

Price rises from 100 to 110 which means there is [(110 - 100) / 100] * 100 = 10% rise in price.

2) This is demand pull inflation which occurs due to rise in demand. If there is rise in demand of goods, consumers are willing to pay more price for a good which result in rise in price.

3) If potential GDP = 510 billion and current level of GDP is 513 after change in quantity demanded. There occurs inflationary gap in the economy and the size of the gap is 513 billion - 510 billion = 3 billion

4) If government wants to use fiscal policy, they have two options which is to change government spending or change tax but change in tax is permissible here. Thus, to counter inflation, government spending should be decreased which will result in fall in aggregate demand which will eventually reduce price level.