4. Using fiscal policy to fight inflation Consider the hypothetical economy depi

Question

4. Using fiscal policy to fight inflation Consider the hypothetical economy depicted on the graph. Initially, the economy operates below full-employment output at a price level of 105 and real GDP of $480 billion. Then aggregate demand (AD) increases from AD1 to AD2, moving the economy up along the intermediate and classical ranges of the aggregate supply (AS) curve. Real GDP increases to the full-employment output level of $540 billion, and the price level increases to 120. 130 AS 125 120 115 AD O 110 105 O 100 95 90 85 AD 80 400 420 44040 480 5 520 540 50 580 600 REAL GDP (Billions of dollars)

Explanation / Answer

Solution: Clearly, with the rightward shift in the AD curve, there has been a sustained increase in price level. This might be because full employment is reached at price level of $110 itself, but the demand continues to increase, and since the economy is already operating at full employment, this high demand cannot be met by higher supply, resulting in increase in price level.

So, the increase in aggregate demand from AD1 to AD2 causes rise in inflation.

Now, in order to decrease the aggregate demand by $40, government carries out fiscal contraction, which means either reduces government expenditure, or increases taxes.

Aggregate demand function is given by: C + I + G + NX

Where C is consumption function: C = C(bar) + MPC(Y - T), C(bar) is autonomous spending, and T is lumps taxes, both components independent of Y

Rest are all autonomous for our model : I=I(bar), G =G(bar), NX = NX(bar). So all investment, government expenditure and net exports are independent of Y.

Then, Y = C(bar) + MPC*Y - MPC*T +I(bar) + G(bar) + NX(bar)

All the autonomous spending can be clubbed together as A(bar), where then

A(bar) = C(bar) + I(bar) + G(bar) + NX(bar) - MPC*T

So, Y = A(bar) +MPC*Y

Or Y = (1/(1-MPC))*A(bar)

This derivation will help us eveluate both types of fiscal contractions

Using the above derivation for real GDP, Y, we can also say that change in Y = (1/(1-MPC))*(change in A(bar))

Given the information in the question, MPC=0.9, we require change in Y to be - $40

So, - $40 = (1/(1-0.9))*(change in A(bar))

Change in A(bar) = - $4

So, the government needs to decrease the autonomous spending by $4 to bring about the desired change.

Government expenditure has a direct impact on this autonomous spending (as can be seen by it's formula above). So, keeping all other components of A(bar) constant, G(bar) can change by -$4 (for A(bar) to change by - $4).

So,the government can reduce government expenditure by $4.

Or one of the components of A(bar) involving tax policy (lumpsum tax) is - MPC*T

Thus, keeping other components of A(bar) constant

Change in A(bar) = - MPC*change in T

-4 = - 0.9*change in T

So, change in lumpsum tax = 4/0.9 = 4.444(approx)

Hence, if the government wants to change the tax policy, it should increase taxes by $4.44.

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