Question

Contractionary Fiscal Policy Exercise 3 

The graph below depicts the full-employment level of output and the actual level of real GDP. 

a. At which time period is an economic expansion occurring? 

 Year 1 

 Year 9 

 Year 3 

b. What is the best policy action by the federal government during an economic expansion? 

 Expansionary fiscal policy 

 Full-employment fiscal policy 

 Contractionary fiscal policy 

c. True or false: In order to smooth out the business cycle, fiscal policy should adjust government spending and taxes to reflect the exact difference between actual GDP and full-employment GDP. 

 True 

 False

Answer 1

Part a) Economic expansion means increase in the level of economic activities in the economy leading to increase in the real GDP. From the graph one can see that economic expansion is occurring at Year 1. During the year 3 and 9, the economy is witnessing recession signified by decline in the real GDP.

Part b) During the period of economic expansion the best policy action that the federal government can take is contractionary fiscal policy to ensure that the economy does not overheat leading to inflation. Expansionary fiscal policy is used during the recession stage.

Part c) The statement that “In order to smooth out the business cycle, fiscal policy should adjust government spending and taxes to reflect the exact difference between actual GDP and full-employment GDP,” is True. The government can fill the gap between actual and full employment GDP during recession through expansionary fiscal policy.