model answers fiscal policy

Question 1

expansionary fiscal policy

Answer 1

EXPANSIONARY FISCAL POLICY (1)

1) Assume the government would like to stimulate economic growth
2) It may decide to cut taxation, which will boost AD to AD1, as consumption rises.
3) This has the effect of increasing real national output from Y to Y1.

4) There will also be the added benefit of creating employment.
5) However, this has come at the expense of an increase in the price level to P1, which may hamper the inflation target.
Y Y1 FE
6) In addition, if additional consumption is spent on imports, then this will worsen the balance of payments on current account.

Question 2

expansionary policy 2

Answer 2

1) Imagine the government would like to stimulate the supply-side of the economy
2) They may cut corporation tax in order to boost firms’ profits, which can then be reinvested in capital projects.
3) LRAS will shift to the right to LRAS1.
4) Productive capacity has now increased to FE1 and there has been a fall in the price level from P to P1, helping to soften inflationary pressure.
5) However, if AD remains unchanged, spare capacity has now increased in size from Y-FE to Y1-FE1, indicating a waste of

Question 3

CONTRACTIONARY FISCAL POLICY

Answer 3

1) Assume the government would like to use fiscal policy to maintain its inflationary target of 2%, because the economy is running up against capacity constraints.

2) It may decide to increase taxation, which will cut AD to AD1, as consumption falls.
3) This has the effect of reducing inflationary pressure as the price level falls from P to P1.
4) There will also be the added benefit of improving the balance of payments on current account as less income is spent on imports.
CONTRACTIONARY FISCAL POLICY

   5) However, this has come at the expense of a reduction in real national output from Y to Y1, which damages economic growth. 6) In addition, falling consumption and lower aggregate demand is likely to increase cyclical unemployment.