Question

Graphically show how (a) Expansionary Fiscal Policy eliminates recessionary gap and, (b) Contractionary Fiscal Policy eliminates inflationary gap.

Answer 1

This illustrates the use of fiscal policy to shift aggregate demand in response to a recessionary gap and an inflationary gap. In Panel (a), the economy produces a real GDP of Y1, which is below its potential level of Yp. An expansionary fiscal policy seeks to shift aggregate demand to AD2 in order to close the gap. In Panel (b), the economy initially has an inflationary gap at Y1. A contractionary fiscal policy seeks to reduce aggregate demand to AD2 and close the gap.