Assume that the economy reaches natural unemployment, but demand keeps increasing and we experience inflation in...

Assume that the economy reaches natural unemployment, but demand keeps increasing and we experience inflation in the 7%-10% annual range.

Explain, how Keynesian economists would address this situation in general
Identify the 2 major tools of discretionary fiscal policy, and explain how each of these tools could be used to correct this situation.

Expert Solution

The situation mentioned in this case is known as an "inflationary gap", or in other words, a period of heightened economic activity, caused by excess aggregate demand.

To correct this situation, AD has to be shifted to the left. This will bring back the economy to equilibrium.

Keynesian economists focus upon corrections in AD through fiscal policy tools.

The two main tools of discretionary fiscal policy are:

government expenditures
government taxes

Government expenditures are on purchases of goods and services, and transfer payments.

Taxation policy includes direct and indirect taxes, which cover households and firms.

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In this situation, contractionary fiscal policy is required.

Government expenditures need to be decreased. The government has to cut down on purchases, and to reduce transfer payments (like subsidies). This will slow down the flow of funds in the economy, and AD will shift to the left.

Another option is to increase the taxes, either direct, indirect or both. The extent of increase depends on the nature of the problem. An increase in taxes reduces consumption and investment levels in the economy, and this shifts AD to the left.

Rahul Sunny answered 2 years ago

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