Answer to Question #109961 in Macroeconomics for kgothatso

Question

Assuming that South Africa economy is over heated (a period of very high level of inflation and production). The government decides to slow down the economy by decreasing public expenditures.
Explain by the use of graphs, the impact of such fiscal policy on aggregate output. In your explanation, describe the interaction between the Money market, IS-LM and AD-AS Model.

Answer 1

The government can slow down the economy by increase taxes charged on commodities such as income tax and VAT and cut spending. This reduces the government’s expenditure situation and helps to reduce demand in the economy.

Both these policies reduce inflation by reducing the growth of aggregate demand. If economic growth is rapid, reducing the growth of AD can reduce inflationary pressures without causing a recession.

If south africa has high inflation and negative growth, then reducing aggregate demand would be more unpalatable as reducing inflation would lead to lower output and higher unemployment. They could still reduce inflation, but, it would be much more damaging to the economy.