1. Fiscal policy during a recession Aa Aa The following graph shows the model fo

Question

1. Fiscal policy during a recession Aa Aa The following graph shows the model for a hypothetical economy. The economy is currently at equilibrium at point A, where the current aggregate demand curve (AD1), the short-run aggregate supply curve (SRAS), and the long-run aggregate supply (LRAS) curve intersect. INFLATION RATE [Percent) LRAS 10 AD1 D2 10 REAL GDP GROWTH RATE (Percent] Suppose consumers fear that an economic recession is under way and, thus, consumption growth decreases sharply As a result, the aggregate demand curve shifts down and to the left. Point B is the new equilibrium What fiscal policy action may the government take to move the economy back to point A? Eliminate tax cuts Increase government spending Increase the money supply Which of the following statements best describes the multiplier effect? An initial increase in government spending may cause an even greater increase in aggregate demand An initial increase in government spending may cause an even greater decrease in aggregate demand An initial increase in consumer spending is always a multiple of an increase in aggregate demand

Explanation / Answer

Economy has moved from point A to point B due to decrease in aggregate demand.

So, in order to bring the economy back to point A, aggregate demand has to be increased.

Government generally administers expansionary fiscal policy in order to increase the aggregate demand.

Expansionary fiscal policy includes increasing government spending or tax cuts or both.

So,

The government must increase government spending to move the economy back to point A.

Hence, the correct answer is the option (2) [Increase government spending].

Multiplier effect is best described by following statement -

An initial increase in government spending may cause an even greater increase in aggregate demand.

Hence, the correct answer is the option (1).

Following statement illustrates differences between government spending and tax cuts -

A tax cut puts more spending in the hands of the private sector, whereas an increase in government spending does not.

Hence, the correct answer is the option (3).

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