Dr Choon-Shan Lai
SSE 104 HW6
Due:
Name of Student:______________
Show all the necessary steps and/or reasoning that lead to you answer.
1. Country ABC is experiencing the following situation. Its current aggregate
demand is illustrated as AD, producing $10 trillion worth of output. Suppose
that the full employment output level/potential output of this country is 12
trillion. Suppose MPS=0.1 and MPI=0.1
P
AS
AD’
AD
10
12
14
Y(in trillions of $)
a) Does this economy have an inflationary output gap or recessionary output
gap? How much? Label the output gap on the above diagram.
The economy is experiencing recessionary output, which is the difference
between current equilibrium output and potential output or full employment
output. Current equilibrium output is equal to $2 trillion. Recessionary output is the
difference between actual output and potential output.
b) If you were the Finance Minister,what would be the fiscal policies that you
might use to restore full employment output level? (There should be at least 3
options. Briefly describe how each option should be implemented)
-
-
-
Increase gov spending- An increase in government spending would
directly contribute to aggregate demand. As a result, the AD curve would
shift to the right, bringing the economy close to full employment.
Increase transfer payments - If transfer payments go up, people will have
more money they can spend. This will lead to more spending, which will
help AD and close the output gap during the recession.
Decrease income tax - When the government cuts income taxes, it gives
consumers more money to spend, which encourages them to spend it.
Dr Choon-Shan Lai
c) If you were to increase the AD, how large should the increase in the AD be
if you were to achieve the full-employment? $2 trillion? $4 trillion? Why?
So far, the AD shortfall has been $4 trillion, and the AD needs to increase $4
trillion to reach full employment. So, as the AD increases, and the AD curve
moves to the right, the economy shifts up the AG curve, causing the price
level to go up. Some of this AD increase is offset by an increase in price level.
So, if the AS curve continues to move up, the AD is going to need to increase
more than $2 trillion of the recession-era output gap to get to full
employment.
d) For each of the 3 fiscal policies in question b), calculate the size of change
in each policy instrument to achieve full employment. Show your steps
carefully.
Government spending – G = -0.8 trillion (government spending must be
increased by .8 trillion)
Income tax – T = -1 trillion (income tax cut must be 1 trillion)
Transfer payment – TP = 1 trillion (transfer payments have to be increased
by 1 trillion)
Dr Choon-Shan Lai