Question

a) if Real GDP is more than the long-term growth trend line and Real GDP is rising, explain the appropriate discretionary fiscal policy response that can be used to restore full-employment equilibrium.

b) explain how automatic stabilisers work?

c) briefly discuss 2 reasons why growing government debt may not be a bad thing.

Answer 1

a. Since Real GDP in the economy is more than the long term growth trend line which means that Real GDP in the economy is growing more than the full employment level of GDP of the economy and the economy is in the inflationary gap, thus, contractionary fiscal policy in the form of decreasing government expenditure and increasing tax rate is needed to restore full employment equilibrium in the economy.

b. Automatic Stabilizers adjust automatically to the changes in the level of national income and help economy to bring it back to its full employment level. For instance, income tax increases as national income in the economy increases and unemployment benefits increases when there is recession in the economy and reduce the impact of expansion and recession in the economy.

c. Growing level of government debt is a bad thing for the economy because it reduces the level of private investment because of crowding out impact which reduces aggregate demand. It also reduces the investor sentiment in the economy because confidence in the government is reduced because of rise in the level of government debt.