If the economy is in a deflationary gap then price expectations of workers are higher than actual prices. Eventually price expectations will be revised downward. This will shift short-run AS to the right and bring the economy back to potential GNP.

Econ-112 Introduction to Macroeconomics Worksheet #5

Answers

1. a.) If the economy is in a deflationary gap then price expectations of workers are higher than actual prices. Eventually price expectations will be revised downward. This will shift short-run AS to the right and bring the economy back to potential GNP.

1. b.) If the government believes that it will take too long for price expectations to be revised then they may see expansionary fiscal policy as a way of avoiding the unemployment and lower incomes associated with a deflationary gap.

1. c.) Increase government spending on the purchase of goods and services or on transfer payments; cut taxes.

1. d.) Short-run effects - higher real GDP and a higher price level

long-run effects - still at potential GDP but at a higher price level

2. a.) If the economy is in an inflationary gap then price expectations are lower than the actual price level. Eventually price expectations will be revised upward. This will shift short-run AS back to the left, resulting in a higher price level as the economy returns to potential GDP.

2. b.) If the government uses contractionary policy to decrease AD then the economy could be brought back to potential GDP without the resulting higher prices.

2. c.) Decrease government spending on goods and services or transfer payments; increase taxes.

2. d.) Contractionary policy that is too restrictive will cause real output to fall below potential GDP and the price level will decrease even more than if the correct policy had been used.

3. If expansionary fiscal policy is not anticipated then real GDP would be increased and the price level would rise. If expansionary policy is fully anticipated then the price level would rise even further but real GDP would remain unchanged.

4. a.) An increase in taxes tends to decrease householdsí disposable income and thus decrease consumption. This would tend to decrease AD or offset the expansionary effects of increasing government spending.

4. b.) An increase in the government deficit will tend to increase the real interest rate and crowd out private investment. In addition, higher interest rates will tend to decrease consumption and net exports also. These effects of a higher interest rate will tend to decrease AD or offset the expansionary effects of increasing government.

5. As the economy starts to expand (i.e., incomes and employment increases) because of the progressive tax system, taxes increase. Also, transfer payments decrease as incomes increase and employment rises. These changes act countercyclically to dampen the expansion. When the economy moves into a recession (i.e., incomes and employment decrease) taxes tend to decrease and transfer payments increase. These changes are expansionary and tend to limit a recession. Thus, government tax and transfer programs act as automatic stabilizers for the economy.

6. a.) Government spending on public goods that make the economy more productive shifts LRAS to the right, increases potential GDP, and puts downward pressure on the price level. Government transfer payments such as unemployment compensation, welfare payments, and Social Security tend to discourage work or saving. This tends to shift LRAS to the left, decreasing potential GDP, and increasing the price level.

6. b.) Government taxes also tends to discourage labor supply and saving and thus decreases LRAS, decreases potential GDP, and raises the price level. Cutting taxes will have the opposite effect.

6. c.) Government borrowing that crowds out private investment would lead to a smaller capital stock in the economy. This will shift LRAS to the left, decreasing potential GDP, and increasing the price level.