Answer to Question #279670 in Macroeconomics for Kaju

Question

using appropriate diagrams show the impact of a fiscal contraction on output, interest rate and price level under classical and keynesian supply conditions.

Answer 1

Under fiscal contractionary policy, the government will decrease its spending and thus decrease its borrowing. This will make the supply of available funds in the credit market to raise and therefore the rate of interest will fall.

The contractionary fiscal policy is aimed at lowering the aggregate demand in order to prevent the aggregate demand curve from shifting from $AD$ to $AD_2$ , as shown below:

In order to cut down aggregate demand and the level of money supply, contractionary fiscal policy when employed, will cut down the cut down the level of output and it will also lower the price levels. This is as illustrated in the diagram below: