Answer to Question #166410 in Macroeconomics for Abiah Kalim

Question

Evaluate, with the use of an appropriate diagram (s), whether fiscal policy will always reduce a negative output gap. (25 marks)

Answer 1

Solution:

A negative output gap occurs when actual output is less than what an economy could produce at full capacity. Therefore, a negative gap means that there is spare capacity in the economy due to weak demands.

Fiscal policy can be utilized to close the output gaps, by using either government spending or taxes to stabilize the economy. An expansionary fiscal policy that involves raising aggregate demand by increasing government spending or lowering taxes can be used to close a negative output gap.

This is depicted by the below diagram: