Econ-112                            Introduction to Macroeconomics                         Worksheet #4

1.  Suppose Congress believes that the economy is performing below potential GDP (i.e., there is a deflationary gap).

a.)  If the government did not change it’s fiscal policy explain using the appropriate graph how the economy would tend to move back to potential GDP.

b.)  Explain why the government might want to change it’s fiscal policy in this situation.

c.)  What types of specific fiscal policy actions could be undertaken to promote a higher level of real GDP?

d.)  Suppose Congress is mistaken in believing the economy is below potential GDP, and the economy is actually at potential GDP (i.e., a long-run equilibrium).  If Congress undertakes expansionary fiscal policy what effects would you expect this to have on real output and the price level both in the short run (unanticipated) and in the long run (anticipated)?  Explain using the appropriate graph.

2.  Suppose Congress believes that the economy is performing above potential GDP (i.e., there is an inflationary gap).

a.)  If the government did not change it’s fiscal policy explain how the economy would tend to move back to potential GDP.  Use the appropriate graph in your explanation.

b.)  Explain why the government might want to change it’s fiscal policy situation.

c.)  What types of specific policy actions could be undertaken to promote a lower level of real GDP?

d.)  Suppose Congress is correct in believing that the economy is above potential GDP, but uses contractionary fiscal policy that is ‘too restrictive’.  What effect would you expect this to have on real output and the price level if this fiscal policy change is unanticipated?  Explain using the appropriate graph.

3.  Suppose the economy is currently at long-run equilibrium (i.e., at potential GDP).  If the government undertakes an expansionary change in fiscal policy explain (using the appropriate graphs) what difference it makes in terms of its effects on real GDP and the price level whether the change in fiscal policy was unanticipated or completely anticipated.

4.  An increase in government spending has an expansionary effect on AD.  However, an increase in government spending has to be paid for by either taxes or borrowing.

a.)  If taxes are raised to pay for increased spending what effect would this have on expansionary effects of higher government spending?

b.)  If instead of raising taxes the government borrows (i.e., increases the deficit) to pay for increased spending what effect would a larger deficit have on the expansionary effects of higher government spending?

5.  The U.S. government’s system of transfer payments and taxes are described as

‘automatic stabilizers’.  Explain what is meant by this statement.