Question

You are a fiscal policy advisor:

Explain the policy recommendations you would make.

Illustrate the effect of your policy recommendation using AD/AS analysis.

Include the size of proposed changes in either government spending, taxes, or transfer payments.

Relate your answer to our macroeconomic goals of full employment, price level stability, and economic growth.

Be sure to analyze each event independently.

Circumstances:

a. Potential GDP is $17.5 trillion. Actual GDP is $16 trillion. MPC = .5.

b. Potential GDP is $17.5 trillion. Actual GDP is $19 trillion. MPC = .75.

c. Potential GDP is $17.5 trillion. Actual GDP is $17.5 trillion. MPC = .80.

d. Potential GDP is $17.5 trillion. Actual GDP is $14.5 trillion. MPC = .9

Answer 1

Macroeconomics takes an overall view of the economy, which means that it needs to juggle many different concepts including the three macroeconomic goals of growth, low inflation, and low unemployment; the elements of aggregate demand; aggregate supply; and a wide array of economic events and policy decisions.

The aggregate demand/aggregate supply, or AD/AS, model is one of the fundamental tools in economics because it provides an overall framework for bringing these factors together in one diagram. In addition, the AD/AS framework is flexible enough to accommodate both the Keynes’ law approach—focusing on aggregate demand and the short run—while also including the Say’s law approach—focusing on aggregate supply and the long run.

Growth and recession in the AD/AS model

We can examine both long-term and short-term changes in gross domestic product, or GDP, using the AD/AS model. In an AD/AS diagram, long-run economic growth due to productivity increases over time is represented by a gradual rightward shift of aggregate supply. The vertical line representing potential GDP—the full-employment level of gross domestic product—gradually shifts to the right over time as well. You can see this effect in AD/AS diagram A below, which shows a pattern of economic growth over three years.

However, the factors that determine the speed of this long-term economic growth rate—like investment in physical and human capital, technology, and whether an economy can take advantage of catch-up growth—do not appear directly in an AD/AS diagram.

AD/AS diagram A, on the left, shows how productivity increases will shift aggregate supply to the right.

Figure 1 in "Shifts in Aggregate Supply"

In the short run, GDP, falls and rises in every economy as the economy dips into recession or expands out of recession. When an AD/AS diagram shows an equilibrium level of real GDP substantially below potential GDP—as is shown in the diagram below at equilibrium point E0—it indicates a recession. On the other hand, in years of resurgent economic growth the equilibrium will typically be close to potential GDP—as it is at equilibrium point E1

The higher of the two aggregate demand curves in this AD/AS diagram is closer to the vertical potential GDP line and hence represents an economy with a low unemployment. In contrast, the lower aggregate demand curve is much farther from the potential GDP line and hence represents an economy that may be struggling with a recession.

Figure 2 in "Shifts in Aggregate Demand"

Unemployment in the AD/AS diagram

We can examine two different types of unemployment using an AD/AS diagram—cyclical unemployment and the natural rate of unemployment. Cyclical unemployment bounces up and down according to the short-run movements of GDP. The long-term, baseline level of unemployment that occurs year in and year out, however, is called the natural rate of unemployment.

The natural rate of unemployment is determined by how well the structures of market and government institutions in the economy lead to a matching of workers and employers in the labor market. Potential GDP can imply different unemployment rates in different economies, depending on the natural rate of unemployment for that economy.

In an AD/AS diagram, cyclical unemployment is shown by how close the economy is to the potential or full-employment level of GDP. Take another look at the AD/AS diagram above. Relatively low cyclical unemployment for an economy occurs when the level of output is close to potential GDP, as at the equilibrium point E1.On the other hand, high cyclical unemployment arises when the output is substantially to the left of potential GDP on the AD/AS diagram, as at the equilibrium point E0.

The factors that determine the natural rate of unemployment are not shown separately in the AD/AS model, although they are implicitly part of what determines potential GDP, or full-employment GDP, in a given economy.

Inflationary pressures in the AD/AS diagram.

Inflation fluctuates in the short run, and higher inflation rates typically occur either during or just after economic booms. For example, the biggest spurts of inflation in the US economy during the 20th century followed the wartime booms of World War I and World War II. On the other hand, rates of inflation generally decline during recessions.

The AD/AS framework implies two ways that inflationary pressures may arise. One possible trigger is if aggregate demand continues to shift to the right when the economy is already at or near potential GDP and full employment, thus pushing the macroeconomic equilibrium into the steep portion of the aggregate supply curve. Let's look at diagram A, on the left below. In this diagram, you'll see a shift of aggregate demand to the right. The new equilibrium E1 is at a higher price level than the original equilibrium E0. In this situation, the aggregate demand in the economy has soared so high that firms in the economy are not capable of producing additional goods because labor and physical capital are fully employed, and so additional increases in aggregate demand can only result in a rise in the price level.

The two graphs show how a shift in aggregate demand or supply can cause inflationary pressure. The graph on the left shows two aggregate demand curves to represent a shift to the right. The graph on the right shows two aggregate supply curves to represent a shift to the left.

Figure 1 in "How the AD/AS Model Incorporates Growth, Unemployment, and Inflation"

Another source of inflationary pressures is a rise in input prices that affects many or most firms across the economy—perhaps an important input to production like oil or labor. This situation can cause the aggregate supply curve to shift back to the left. In diagram B above, the shift of the SRAS curve to the left also increases the price level from P0 at the original equilibrium E0 to a higher price level of P1 at the new equilibrium E1. In effect, the rise in input prices ends up—after the final output is produced and sold—being passed along in the form of a higher price level for outputs.

An AD/AS diagram shows only a one-time shift in the price level. It does not address the question of what would cause inflation either to vanish after a year, or to sustain itself for several years.

The aggregate demand/aggregate supply, or AD/AS, model is one of the fundamental tools in economics because it provides an overall framework for bringing economic factors together in one diagram.

• We can examine long-run economic growth using the AD/AS model, but the factors that determine the speed of this long-term economic growth rate do not appear directly in the AD/AS diagram.

• Cyclical unemployment is relatively large in the AD/AS framework when the equilibrium is substantially below potential GDP and relatively small when the equilibrium is near potential GDP.

• The natural rate of unemployment—as determined by the labor market institutions of the economy—is built into potential GDP, but does not otherwise appear in an AD/AS diagram.

• Pressures for inflation to rise or fall are shown in the AD/AS framework when the movement from one equilibrium to another causes the price level to rise or to fall.

(b)when potential GDP is $17.5 trillion and actual GDP is $19 trillion.

In economics, potential output (also referred to as "natural gross domestic product") refers to the highest level of real gross domestic product (potential output) that can be sustained over the long term.

Limits to output[edit]

Natural (physical, etc) and institutional constraints impose limits to growth.

If actual GDP rises and stays above potential output, then, in a free market economy (i.e. in the absence of wage and price controls), inflation tends to increase as demand for factors of production exceeds supply. This is because of the finite supply of workers and their time, of capital equipment, and of natural resources, along with the limits of our technology and our management skills. Graphically, the expansion of output beyond the natural limit can be seen as a shift of production volume above the optimum quantity on the average cost curve. Likewise, if GDP persists below natural GDP, inflation might decelerate as suppliers lower prices in order to sell more product, utilizing their excess production-capacity.

Potential output in macroeconomics corresponds to one point on the production–possibility curve for a society as a whole, reflecting its natural, technological, and institutional constraints.

What impact would a decrease in the size of the labor force have on GDP and the price level according to the AD/AS model?

Any economy running in Inflationary phase is not sustainable(As people are made to work beyond their capacity and many such reasons).

Also, note that in the long run, any increase in the AD will not impact GDP much and only increase the price levels thus causing the Inflation.So to bring back the economy to the levels of potential GDP govt employs the Fiscal policy tools i.e Tax cuts and reduced govt spending.Instead, G is diverted towards administration and civil… (readm

Algebraically derive the equation for aggregate Demand which also incorporates marginal propensity to consume and tax rate .here i am explaining how fiscal policy can influence the level of aggregate demand .

So, we know that the AD Curve represents all the pairs of price/income that guarantee the equilibrium in both the Money Market and the Goods and Services Market. Let's think about Expanding Fiscal Policy. In the model, the Government decides to increase Public Spending. This leads to a bigger Planned Expenditure. A bigger PE, after the multiplier effect ends, ends up increase the income. Higher income leads to a bigger transaction volume. A higher transaction volume leads to a greater liquidity… (readmoreof this comment)

A positive occurs when actual output is greater than potential output. This will occur when economic growth is above the long run trend rate (e.g. during an economic boom). It will involve firms asking workers to overtime.

With a positive output gap, there will be inflationary pressures. It will also tend to cause a bigger current account deficit as consumers buy more imports due to domestic supply constraints.

This shows a positive output gap with the monetarist view of LRAS. In this case, the economy is already at full employment, but there is an increase in the money supply and a further rise in AD. In the short-term firms can meet demand by paying higher wages and encouraging over-time. However, this short-term economic growth is unsustainable and leads to inflationary pressures. Output invariably returns to Yf – the level of full employment.

(d)when potential GDPis $17.5 trillion and actual GDP is $14.5trillion.

The long-run trend rate of economic growth is the average sustainable rate of economic growth over a period of time. The long-run trend rate is determined by the growth of productivity and growth of long-run aggregate supply. (LRAS). If actual growth is higher than the long-run trend rate, then we get inflationary pressures. If growth is below the long-run trend rate, we get a negative output gap and inflation.

Negative Output Gap

This occurs when actual output is less than potential output gap. This is also called a deflationary (or recessionary) gap. In this situation, the economy is producing less than potential. There will be unemployment, low growth and/or a fall in output. A negative output gap will typically cause low inflation or even deflation. A negative output gap may imply a recession (fall in GDP) or just very low economic growth.