Use an AD-AS model to depict the following scenarios in the short-run: The government cuts taxes...

Use an AD-AS model to depict the following scenarios in the short-run:
1. The government cuts taxes
2. There is a reduction in government spending
3. The government increases transfer payments

Which of the above three scenarios above would be fiscal policy?

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Expert Solution

Use an AD-AS model to depict the following scenarios in the short-run:
1. The government cuts taxes
2. There is a reduction in government spending
3. The government increases transfer payments

Which of the above three scenarios above would be fiscal policy?

Answer : During an deflationary level, govt. can adopt expansionary fiscal policy(lowering tax rates and increasing govt. spending) and central bank can have expansionary monetary policy ( lowering interest rates and increasing money supply ).

During an inflationary level, govt. can adopt contractionary fiscal policy(Raising tax rates and decreasing govt. spending) and central bank can have contractionary monetary policy ( raising interest rates and lowering money supply ).

Hence, all options a, b and c are fiscal policy tools.

Tool a and c is used in deflationary levels. b is used in inflationary level.

a has following impact : Govt. tax reduction will make sure that people are left with more income and they spend more.

Aggregate demand (AD1) shifts to right to AD2. Real GDP goes up from Yf to Ye. More jobs are generated and price levels also go up from Pf to Pe encouraging more suppliers to come in the market.

option b is used in inflationary gap.Reduced spending will shift AD1 To AD2. Real GDP will go down from Yf to Ye. Price levels will also go down from Pf to Pe.

Option c acts as automatic stabilizer. When govt. is increasing transfer payments then it would mean that people will be left with more income and aggregate demand will shift to right and create inflationary gap as discussed for option a.

Rahul Sunny answered 1 year ago

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