Assume the Island Nation of Somberio is in the midst of an expansionary period of high...

Assume the Island Nation of Somberio is in the midst of an expansionary period of high GDP growth. Up for re-election, their Prime Minister directs their budgetary office to increase government spending and decrease the taxation rate.

Illustrate the effects of this action on the macro economy by drawing an AD-AS model, keeping in mind the determinants of aggregate demand.
Describe what the economic danger is when implementing such expansionary fiscal policy given the current state of their economy.

Solutions

Expert Solution

It is given that the economy is in the midst of an expansionary period of high GDP growth. This indicates that there must be an inflationary gap in the beginning because the GDP growth rate is high and therefore actual GDP must be greater than potential GDP in the beginning.

Now the government has decided to increase its spending and decrease taxes which is an expansionary fiscal policy. This policy is likely to increase disposable income and therefore consumption. As a result there will be an increase in the aggregate demand and aggregate demand curve shifts further to the right.

The economic danger of this policy is the creation of an even larger inflationary gap and a very high demand pull inflation which implies that the economy is currently highly unstable because it is operating beyond its full capacity. In the long run the effect of such policy will be an even higher inflation when the economy attempt to self correct itself by shifting the aggregate supply curve to the left.

Rahul Sunny answered 11 months ago

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