Question

The government should never use fiscal policy to combat business cycle fluctuations coming from changes in money demand if it also wishes to keep longer term movements in the price level to a minimum. Is this claim true, false or uncertain? Explain by using words and a single AS/AD diagram.

Answer 1

It is false because in order to control/combat business cycle fluctuations due to changes in money demand government takes many measues like increasing or decreasing expenditure, increasing or decreasing taxes because if government does not do that then increase in money demand/increase in money supply can cause inflation and this can cause less demand for goods and services and due to this production will get decreased and any country's economy's GDP, GNP can also get decreased and when in any country there is less money in the hands of people due to high taxes and less income level, low GDP and low employment level then its government can increase the public expenditure and decrease the taxes on the people and firms and industry and this will have postive effect on its economy and due to this money supply/money demand will get incresed due to increased public expenditure, due to low level of taxes people will have more money to spend on goods and services and due to increased demand for goods and services production will also gets increased and this will put postive effect on its ecomony and adverse business fluctuations can be controlled.

So any government's fiscal policy measures are a good tool to combat business fluctuations.

we can explain the same with the simple AD-AS model.

Above graph shows under expansionary fiscal policies aggregate demand(AD) curve shifts towards right to AD1 and to what extent it will affect money demand, national output and price levels depends upon the elasticity of aggregate supply curve.