Life has become yet more complicated. Government spending works with a distribut

Question

Life has become yet more complicated. Government spending works with a distributed lag. Now when $1 billion is spent today, GDP increases by $1 billion this period and $1.5 billion next period.

a. What happens to the path of GDP if government spending rises enough this period to put GDP back to its potential level this period?

b. Suppose fiscal policy actions are taken to put GDP at its potential level this period. What fiscal policy will be needed to put GDP on target next period?

c. Explain why the government has to be so active in keeping GDP on target in this case.

Explanation / Answer

a) Now as GDP reaches to potential its potential this year then in the next period the GDP will be more than its potential GDP because of lag. There will be inflationary gap in GDP.

b) As there will be inflationary gap then they will use contractionary fiscal policy to close the gap i.e. they will reduce spending, increase taxes or reduce transfer payments,

c) Government has to be very active in keeping GDP on target in this case because of the lag, a policy which grows GDP up to potential level will increase GDP more than potential in next period so policy used in next period will be contractionary fiscal policy, and in next period after that due to lag the GDP will fall below potential so expansionary fiscal policy will be needed then and so on.

Related Questions

Navigate

• Browse (All)
• Browse L
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.