40. Suppose that aggregate demand increases such that the amount of real output

Question

40.

Suppose that aggregate demand increases such that the amount of real output demanded rises by $15 billion at each price level. Instructions: Enter your answers as whole numbers. By what percentage will the price level increase? Will this inflation be demand-pull inflation or will it be cost-push inflation? If potential real GDP (that is, full-employment GDP) is S510 billion, what will be the size of the positive GDP gap after the change in aggregate demand? If the government wants to use fiscal policy to counter the resulting inflation without changing tax rates, would it increase government spending or decrease it?

Explanation / Answer

(a)

Current equilibrium price = 100 (at which demand = supply = 510)

As per revised demand shedule (see below), new price level = 112 (Demand = supply = 515)

So, price level increased by 12%.

It will be a demand pull inflation.

(b)

Potential GDP = 510

Actual (equilibrium) GDP = 515

GDP Gap = Actual GDP - Potential GDP = $5 billion

(c)

Government has to reduce government spending to lower the actual GDP.

P DEMAND SUPPLY 88 535 500 94 530 507 100 525 510 106 520 512 112 515 515

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