Question

Question 4)

Assume an economy that can be described by the following Table 1.

Table 1

Year	Potential GDP	Real GDP	Price Level
1	$1 020 billion	$1 020 billion	100
2	$1 080 billion	$1 060 billion	103

1. Draw a dynamic aggregate demand and aggregate supply diagram to illustrate the state of the economy in Year 1. How can we characterize this position in Year 1?

Answer: this position can be characterized

2. Assume in Year 2 that no policy is pursued. Using information contained in Table 1, show in your diagram which you used for part a) where the economy would now be in Year 2. What can you say about the situation this economy is in.

3. Illustrate and explain the appropriate fiscal policy to use in this situation in order for the economy to produce at potential GDP in Year 2.

Answer 1

a) In year 1, demand curve is D and supply curve is S. The economy is equilibrium at point A where actual GDP = potentail GDP. Economy is equal to long run production level.

b) In year 2, a rise in demand cause price to rise to 103 and output to rise to 1,060 and shifts demand curve to D1 from D. In year 2, potential GDP is 1,080 while actual GDP is 1,060 which cause recessionary gap in the economy equals to 1,080 - 1,060 = 20

c) Government can adopt expansionary fiscal policy which will raise government spending and reduce taxes such that it raise disposable income which tends to raise aggregate demand in the economy. It will shift aggregate demand curve to D2 where price level is higher than 103 and output reaches to its potential GDP. Economy reaches to its long run equilibrium level of point C.