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The graph below depicts the aggregate demand and aggregate supply curves for the economy We can see that this economy is currently experiencing an output gap We will identify and quantify that output gap and analyze some possible fiscal policy responses Identify whether the economy is currently experiencing a recessionary or an expansionary gap Also identify the size of that output gap Suppose that the tax multiplier is 2 5 and that the government wishes to change taxes to eliminate the existing output gap In your essay you should identify whether the government should increase or reduce taxes and by how much You should also include a graph that depicts this change in taxes in the figure above You should clearly identify the new equilibrium level of Real GDP and the new equilibrium price level The intersection of the short run aggregate demand AD curve long run aggregate supply LRAS and long run AD curve determines an economy s long term equilibrium Fiscal policies are responses to economic fluctuations like inflation or recession imposed by the government The government manipulates taxes or government spending to influence aggregate demand and achieve long term equilibrium Depending on the current state of the economy fiscal policies can be either expansionary or contractionary The economy is producing more than it could resulting in an expansionary gap as shown in the graph Exponential growth occurs when the economy produces more than it can handle resulting in either an expansionary or inflationary gap Therefore the government will implement a contractionary policy to close the gap by lowering AD as the economy heats up The current output is 24 trillion whereas the potential output is 21 trillion Output Gap Current Output PotentialOuput 24 21 3Trillion The output gap is 3 trillion The given assessment multiplier is 2 5 In this case the government will have to raise taxes to reduce the current output to achieve the potential output This is because raising taxes will reduce disposable income discouraging spending Therefore government spending is reduced or tax rates are raised under the contractionary fiscal policy Leading to fiscal surplus growth and the economy s money flow declining causing the AD curve to shift to the left until the potential level is reached Hence the result will be reduced and the void will be shut In this case the 3 trillion expansionary gap necessitates a 3 reduction in government output Change Taxes Change GDP Tax Multiplier 3 2 5 1 20 The government must raise taxes by 1 2 trillion to close the gap The situation is depicted in the graph below Since taxes and GDP are related inversely the tax multiplier is negative Therefore an expansionary gap in the economy will be covered by increasing taxes The tax will be raised by 1 2 trillion

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UF ECO 2013 - Notes

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