Answer to Question #192222 in Macroeconomics for Abiah Kalim

Question

Evaluate, with the use of an appropriate diagram(s), whether fiscal policy will always be successful at reducing an output gap. (25 marks)

Answer 1

Fiscal policy are measures put across by the government to grow the economy by manipulating the level and allocation of taxes and government spending whereas output Gap is an economic measure of the difference between the actual output of an economy and it's potential output. Reducing the output Gap means that the economy is producing less than potential. This will lead to unemployment, low growth or fall in output. Lowering output Gap might make a central bank to adopt a monetary policy set aside to stimulate economic growth by lowering taxes to boost demand and prevent inflation from falling below the central banks' inflation rate target. When there is a negative output Gap, loose fiscal policy is adopted which results to increased government spending with lower taxes.

Fiscal policy can close recession gaps by decreasing taxes or increasing spending. Fiscal policy analyses a large indicator in assessing the position of the economy but frequently depend on the output Gap to conclude their assessment of economy wide spare capacity. During recession, the economy drops below potential level and the output Gap grows to negative. Changes in government budget on the economy affect the aggregate level of output by changing the incentives that firms and individuals face. Fiscal policy is tight when revenue is higher than spending and loose when spending is higher than revenue.