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Fiscal Policy: Recessionary Gap

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2. Explain how fiscal policy can be used to close the (a) recessionary gap and(b) inflationary gap.

Purchases will rise shifting the AD curve to the right if the government purchases more, cutting taxes and increasing transfer payment while the other things stay constant. This increase depends on the position of macroeconomic equilibrium before the government starts spending. The government stimulus increases the size of the budget deficit, and also leads to an increase in AD, resulting in an increase of price level and RGDP. If we have a change of policy of right magnitude and well timed, then the fiscal policy might stimulate the economy, pulling it out of contraction and/or recession and this would result in full employment at RGDPnr. …show more content…

This actions made by the government will also reduce households’ disposable incomes. As a consequence, we will have a reduction of purchases of consumption goods and services, and the high taxes will reduce investment purchases. The AD curve will shift leftward by the reduction in consumption, investment, and government purchase. So, by lowering the price level, and bringing the RGDP back to full employment level, will result in a new short and long run equilibrium, closing the inflationary gap.

3. Why does a larger government budget deficit increase the magnitude of the crowding-out effect?

What the crowding out effect implies is that if the government borrows money to pay deficit, it would drive the interest rates up in the market place for all of the other borrowers. Consequently, this will discourage consumers and also businesses from borrowing.

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)?

Well, assuming no changes in tax rates, the economy will no decrease more the unemployment but at the same time will not increase; however, inflation will grow while the real output will stay the same and deficits will start to

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