Using an AD/ASdiagram, and reference to a real world example, explain how government can
use fiscal policy to close an inflationary gap. [10 marks]
An inflationary gap occurs when an economy's actual output exceeds its potential output,
leading to increased prices and inflation. To close inflationary gaps, contractionary fiscal policies
are often used to reduce aggregate demand by decreasing government spending and increasing
taxes, slowing down economic growth to a more sustainable level. An example of the use of a
contractionary fiscal policy to close an inflationary gap is the case of Argentina in 2018.
Argentina has faced significant economic challenges for decades, characterized by high inflation
and large budget deficits. By 2018, the country was experiencing severe inflationary pressures,
with inflation rates soaring above 40%. The economy was overheating due to excessive
government spending, financed by borrowing (which created large budget deficits), which
exacerbated the inflationary gap.
This inflationary gap can be seen in figure 1, where actual output (y1) is higher than potential
output (yFe). To close the inflationary gap the Argentine government implemented several
measures in 2018.
One measure was decreasing government spending. The government, under President Macri,
started an austerity program to cut public expenditures. This included reducing subsidies for
utilities and transportation, which had previously been a significant drain on the budget. This
will decrease the economy’s aggregate demand, as government spending is a primary
component of AD, shifting AD to the left from AD1 to AD2. As a result, firms would produce less
output to match the lowered demand, thus bringing actual output (y1) towards the economy’s
productive capacity (yFe), closing inflationary gap.
The government also increased personal income and business tax during the inflation. Increase
in personal income tax will decrease disposable income, thus decreasing consumption and
lowering the aggregate demand of the economy. Business taxes increased to 30%, the profit
retained after tax will be reduced, contributing to decrease in investment spending. Since
consumption and investment are primary components of aggregate demand, AD will shift to the
left from AD1 to AD2, thus bringing actual output (y1) towards the economy’s productive
capacity (yFe), closing inflationary gap.
In conclusion, Argentina's experience in 2018 illustrates how reductions in government
spending and increases in taxes can help close inflationary gaps, ensuring sustainable economic
stability.
3 a. Using an AD/AS diagram, and reference to a real world example, explain how government
can use fiscal policy to close a recessionary gap. [10 marks]
A recessionary gap occurs when an economy's actual output falls below its potential output,
leading to high unemployment and negative economic growth. To close recessionary gaps,
expansionary fiscal policies are often used to stimulate consumption and investment through
tax cuts and government spending, which causes an increase in aggregate demand and thus
, raising output levels closer to its potential level. An example of the use of an expansionary fiscal
policy to close a recessionary gap is the American Rescue Plan (ARP) Act by the U.S.
government. After the COVID-19 pandemic hit the U.S., the country’s economy went into a deep
recession, causing widespread business closures and job losses. This recessionary gap can be
seen in figure 1, where actual output (y1) is lower than potential output (yFe). To close this gap,
the U.S. government enacted the ARP Act in March of 2021, which included direct payments to
workers and support for businesses.
A key component of the ARP was direct payments to workers. During the pandemic, many
people were forced out of their jobs due to lockdown and social distancing measures. As a
result, unemployment increased significantly, and the country’s real GDP decreased as well. The
ARP provided direct payments to essential workers like teachers, nurses, and police officers,
providing them with bonus pays on top of their regular wages. This increased the disposable
income for many workers, increasing their consumption on goods and services, and thus,
directly increasing the aggregate demand of the economy. This increased consumption will
boost the sales of businesses, leading them to hire more workers, and thus decreasing
unemployment and increasing real GDP. This will result in AD1 shifting to the right to AD2,
bringing y1 to yfe and thus closing the recessionary gap.
Another component of the ARP was support for small businesses. Since the start of the
pandemic, the US has experienced widespread business closures, leading to increased
unemployment and lowered economic activity. Through providing rent reliefs and grants for
payroll and other business expenses, the ARP allowed businesses to keep their doors open,
their staff employed and continue to meet the costs of running their business. This also
encourages investment, which directly increases aggregate demand of the economy.
In conclusion, the fiscal policy implemented through the ARP helped close the recessionary gap
by increasing AD through direct payments and support for businesses, stabilizing economy and
reducing unemployment.
use fiscal policy to close an inflationary gap. [10 marks]
An inflationary gap occurs when an economy's actual output exceeds its potential output,
leading to increased prices and inflation. To close inflationary gaps, contractionary fiscal policies
are often used to reduce aggregate demand by decreasing government spending and increasing
taxes, slowing down economic growth to a more sustainable level. An example of the use of a
contractionary fiscal policy to close an inflationary gap is the case of Argentina in 2018.
Argentina has faced significant economic challenges for decades, characterized by high inflation
and large budget deficits. By 2018, the country was experiencing severe inflationary pressures,
with inflation rates soaring above 40%. The economy was overheating due to excessive
government spending, financed by borrowing (which created large budget deficits), which
exacerbated the inflationary gap.
This inflationary gap can be seen in figure 1, where actual output (y1) is higher than potential
output (yFe). To close the inflationary gap the Argentine government implemented several
measures in 2018.
One measure was decreasing government spending. The government, under President Macri,
started an austerity program to cut public expenditures. This included reducing subsidies for
utilities and transportation, which had previously been a significant drain on the budget. This
will decrease the economy’s aggregate demand, as government spending is a primary
component of AD, shifting AD to the left from AD1 to AD2. As a result, firms would produce less
output to match the lowered demand, thus bringing actual output (y1) towards the economy’s
productive capacity (yFe), closing inflationary gap.
The government also increased personal income and business tax during the inflation. Increase
in personal income tax will decrease disposable income, thus decreasing consumption and
lowering the aggregate demand of the economy. Business taxes increased to 30%, the profit
retained after tax will be reduced, contributing to decrease in investment spending. Since
consumption and investment are primary components of aggregate demand, AD will shift to the
left from AD1 to AD2, thus bringing actual output (y1) towards the economy’s productive
capacity (yFe), closing inflationary gap.
In conclusion, Argentina's experience in 2018 illustrates how reductions in government
spending and increases in taxes can help close inflationary gaps, ensuring sustainable economic
stability.
3 a. Using an AD/AS diagram, and reference to a real world example, explain how government
can use fiscal policy to close a recessionary gap. [10 marks]
A recessionary gap occurs when an economy's actual output falls below its potential output,
leading to high unemployment and negative economic growth. To close recessionary gaps,
expansionary fiscal policies are often used to stimulate consumption and investment through
tax cuts and government spending, which causes an increase in aggregate demand and thus
, raising output levels closer to its potential level. An example of the use of an expansionary fiscal
policy to close a recessionary gap is the American Rescue Plan (ARP) Act by the U.S.
government. After the COVID-19 pandemic hit the U.S., the country’s economy went into a deep
recession, causing widespread business closures and job losses. This recessionary gap can be
seen in figure 1, where actual output (y1) is lower than potential output (yFe). To close this gap,
the U.S. government enacted the ARP Act in March of 2021, which included direct payments to
workers and support for businesses.
A key component of the ARP was direct payments to workers. During the pandemic, many
people were forced out of their jobs due to lockdown and social distancing measures. As a
result, unemployment increased significantly, and the country’s real GDP decreased as well. The
ARP provided direct payments to essential workers like teachers, nurses, and police officers,
providing them with bonus pays on top of their regular wages. This increased the disposable
income for many workers, increasing their consumption on goods and services, and thus,
directly increasing the aggregate demand of the economy. This increased consumption will
boost the sales of businesses, leading them to hire more workers, and thus decreasing
unemployment and increasing real GDP. This will result in AD1 shifting to the right to AD2,
bringing y1 to yfe and thus closing the recessionary gap.
Another component of the ARP was support for small businesses. Since the start of the
pandemic, the US has experienced widespread business closures, leading to increased
unemployment and lowered economic activity. Through providing rent reliefs and grants for
payroll and other business expenses, the ARP allowed businesses to keep their doors open,
their staff employed and continue to meet the costs of running their business. This also
encourages investment, which directly increases aggregate demand of the economy.
In conclusion, the fiscal policy implemented through the ARP helped close the recessionary gap
by increasing AD through direct payments and support for businesses, stabilizing economy and
reducing unemployment.
