Chapter 13, Problem 13.1LO

To determine

:

The effects of discretionary fiscal policy as per Keynesian model.

Concept Introduction:

Gross Domestic Product: It is the final value of all the final goods and services produced within the territorial boundaries of a nation in a given period of time.

Discretionary Fiscal Policy: It is a tool used by the government to achieve equilibrium level of GDP during different economic situations. The policy mainly focuses on government spending and its taxation tools.

A tax cut or an increase in government spending is an expansionary fiscal policy. A decrease in government spending and an increase in tax rates is a contractionary fiscal policy. These policies are used to achieve objectives of low unemployment rates, price stability, and economic growth.

Explanation of Solution

Keynesian economists argue that the intervention of government is necessary to correct the output gap. They assume that the private expenditure and government expenditure are not a substitute of each other.

An expansionary fiscal policy implies that the government has either increased their spending or reduced taxes to give a boost to the economy.

A higher spending will increase the aggregate demand directly and a tax cut would increase the disposable income (after tax income) of the consumers, which would in turn lead to an increase in the aggregate demand.

As a result, the aggregate demand will shift rightwards leading to an increase in the value of real GDP and price levels.

This policy is used to correct a recessionary gap or a negative output gap (actual GDP lower than the potential; GDP).

A contractionary fiscal policy implies that the government has either decreased their spending or increased taxes.

Reduced government spending will decrease the aggregate demand directly and a tax increase would decrease the disposable income (after tax income) of the consumers, which would in turn lead to a decrease in the aggregate demand.

As a result, the aggregate demand will shift leftwards leading to a decrease in the value of real GDP and price levels.

This policy is used to correct an inflationary gap or a positive output gap (actual GDP higher than the potential; GDP).