Question

4. When an economy is already at full employment, what is the outcome of expansionary fiscal policies to employment, inflation, real output, and deficits (assuming no changes in tax rates)?

5. Explain the effects of the following actions on equilibrium income, assuming that the marginal propensity to consume is 0.8

Government purchases rise by $40 billion.

Taxes fall by $40 billion.

Answer 1

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Answer 4.

When economy is already at full employment and expansionary fiscal policy is implemented then an increase in aggregate demand causes slight increase in real output. Since resources are fully employed so firms won't have the option to hire the workers however firms need to meet the growing demand. Anyway there will be significant increase in price level as economy is currently producing beyond full employment level.As a result there will be demand-pull inflation. That means the inflation will rise and there is increase in real output with unemployment reducing. In an expansionary fiscal policy there is increase in government spending or tax breaks . It is assumed here that there are no changes in charge rates , that means there is increase in government spending. With the end goal that when government spending increase there is rise in deficits as well. Hence , expansionary fiscal policy increases deficits.

Impact of expansionary fiscal policy when economy is already at full employment is shown in diagram.