Answer to Question #279906 in Macroeconomics for Tenn

Question

5. Suppose an economy has an inflationary gap. How does the government’s actual budget deficit or surplus compare to the deficit or surplus it would have at potential output? 6. Suppose the president was given the authority to increase or decrease federal spending by as much as $100 billion in order to stabilize economic activity. Do you think this would tend to make the economy more or less stable? 7. Suppose the government increases purchases in an economy with a recessionary gap. How would this policy affect bond prices, interest rates, investment, net exports, real GDP, and the price level? Show your results graphically. 

Answer 1

At the potential output, the government will have a balanced budget that is there would be no surplus or deficit. A potential output is an ideal but rare situation. The government will have a surplus budget at the time of the inflationary gap, and it will absorb the additional income generated by the market and reduce the excess demand, thus eliminating the inflation.

6. If the president was given the authority to increase or decrease federal spending by as much as $100 billion in order to stabilize the economic activity, it would all depend on how the money which is spent is acquired and on which products is it spent on, on which products has the federal spending decreased. The economy will be more stable if the money is disinvested in creating jobs for the economy, thus increasing the multiplier effect of the $100 billion. The economy would be less stable if the money was obtained by increasing the level of government debt, which is already near 100%. The US debt to GDP ratio was 106.9% in 2019. This would increase debt repayments, and any future revenue would be used to pay interest. And if the money is spent on unproductive assets that have no multiplier effect, the economy will be even more unstable. The economy would be more stable if the government had to borrow more and there was no multiplier effect.

Thus, spending $100 billion on job creation will help stabilize the economy. However, a large increase in debt could have a negative impact on the economy, necessitating a reduction in federal spending funded by borrowing.

7. From the graph below, an increase in government purchases raises GDP and output, causing the IS curve to shift from IS0 to IS1, thereby raising the interest rate and output.

Bond prices fall as interest rates rise.

Investing is inversely related to interest rates. Savings-Investment gap (S-I) equals Net Exports (X - M), so lower investment equals higher NX.

As a result, real GDP will rise.

In summery, higher aggregate demand shifts AD to the right, from AD0 to AD1, intersecting SRAS0 at point B, with higher price P1 (>P0) and output Y1>Y0.