Question

Suppose the economy is in a recessionary gap. Show the impact of the appropriate fiscal policy response on the following graph.

a) Increase in government spending
b) Decrease in taxes
c) Combination of both
d) No fiscal policy response

Answer 1

In response to a recessionary gap, the appropriate fiscal policy response would be to reduce taxes or increase government spending. This will shift the aggregate expenditure function up and result in a new equilibrium at potential GDP.

Step-by-step explanation:

The appropriate response to a recessionary gap is for the government to reduce taxes or increase spending so that the aggregate expenditure function shifts up from AEo to AE₁. When this shift occurs, the new equilibrium E₁ now occurs at potential GDP as shown in Figure D9 (a).