G: Refer to the figure below. Suppose the economy is in a short-run equilibrium

Question

G: Refer to the figure below. Suppose the economy is in a short-run equilibrium at output Y3 and inflation rate 2. The economy is currently experiencing ______, and the correct fiscal policy response to this situation, to return the economy to potential GDP, is to ______.

1: a recessionary gap; increase government spending

2: an expansionary gap; decrease government spending

3: a recessionary gap; increase taxes

4: an expansionary gap; decrease taxes

H: The AS curve slopes upward because:

1: firms generally sell their products at preset prices.

2: relaxing the assumptions of the Keynesian model allows us to develop a more realistic model where firms no longer care about prices.

3: many firms raise their prices when aggregate demand has increased.

4: inflation is higher in goods-producing industries than service-producing industries.

Explanation / Answer

An inflationary gap is the condition in which the Real GDP that the economy is producing is greater than the Natural Real GDP and the unemployment rate is less than the natural unemployment rate. In inflationary gap the short run equilibrium real GDP is greater than the natural real GDP. Thus in figure above; Y2 is the short run equilibrium output where real GDP that the economy is producing is more than the long run natural real GDP.

To combat or off set the inflationary gap the economy needs to produce less than what it is producing in the short run. Thus it needs to decrease its aggregate expenditure and real GDP. Hence the government took a contractionary fiscal policy of either increasing taxes or decreasing government spending to stabilize the economy.

An appropriate fiscal policy of decreased government spending decreases the aggregate expenditure and thus shifts the aggregate demand curve downward until the economy reaches the long run equilibrium at Y2 given in the figure above.

Then the correct option is

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The supply side of the economy is represented by the aggregate supply of the economy. The aggregate supply is the quantity supplied of the real GDP at various price levels, ceteris paribus. The graphical representation of the aggregate supply in the short run in the economy is given by the SRAS curve. This is an upward rising curve showing the direct relationship between price level and quantity supplied of real GDP. The change in price level changes the quantity supplied. The change in the other factors other than price level shifts the supply curve upwards or downwards.

There are two explanations for the upward rising short run aggregate supply:

Therefore, the correct option is

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