The interaction of balanced budgets and economic fluctuations Suppose the consti

Question

The interaction of balanced budgets and economic fluctuations Suppose the constitution of the country of Constia requires a balanced budget and that current fiscal policies yield a balanced budget when output is at potential GDP. Suppose now that output in Constia rises above potential GDP. In order to maintain a balanced budget without changing taxes, the government would have to raise expenditures. The following graph shows the aggregate demand (AD) and short-run aggregate supply (AS) curves for the economy of Constia after the rise in output, but before the change in expenditures. The vertical green line shows the economy's potential GDP. Shift one of the curves on the graph to illustrate how the change in expenditures will impact the economy. The constitutional requirement to have a balanced budget has caused output in Constia to fall back toward potential GDP. True False

Explanation / Answer

The real GDP is greater than potential GDP so there is an inflationary gap . So a contractionary fiscal policy must be followed . So the government would have to cut down expenditures .

As there is cut down on government expenditure , the aggregate demand falls in the economy . So the AD curve will shift left .

TRUE .

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