Answer to Question #112276 in Macroeconomics for Kgothatso

Question

2.2Assuming 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 increase taxes such as income tax and VAT and cut spending.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 can pressures without causing a recession. fiscal policy involving governments spending cuts or tax increases can help to reduce the upward pressure on the price level by shifting aggregate demand to the left, to AD1, and causing the new equilibrium E1 to be at potential GDP, where aggregate demand intersects the LRAS curve.

In the graph below, the economy starts at the equilibrium quantity of output Y0, which is above potential GDP.In oder to reduce this,a contractionary fiscal policy should be used to shift aggregate demand down from AD0 to AD1, leading to a new equilibrium output E1, which occurs at potential GDP, where AD1 intersects the LRAS curve.