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Chapter 13: Q2. (page 282)

What are the government鈥檚 fiscal policy options for ending severe demand-pull inflation?

Short Answer

Expert verified

Reduced government spending and amplified taxes are the fiscal options to regulate demand-pull inflation.

Step by step solution

01

Effects of decreased government spending

Fiscal policy has two instruments that are government spending and taxes.A contractionary budgetary policy of the government reduces government spending.Lower government spending will directly shrink the aggregate expenditure of the economy.

As a result, a lower income will pull the demand down to a lower aggregate demand and supply model equilibrium. Hence, prices will fall, and inflation will be controlled or halted.

02

Effects of high taxes

Another part of a contractionary fiscal policy is high taxes.As taxes rise, the disposable income of consumers declines. Consequently, the consumption expenditure and saving in the economy also contracts. Less amount of consumption reduces the aggregate expenditure.

On the other hand, lower saving pulls down the gross investment as the economy is stable when saving matches the investment. Therefore, the consumption and investment expenditure falls, bringing the equilibrium GDP down. A lower GDP will reduce the aggregate demand, and the prices will fall. Hence, higher taxes will regulate demand-pull inflation.

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Most popular questions from this chapter

(For students who were assigned Chapter 11) Assume that, without taxes, the consumption schedule for an economy is as shown below:

GDP, Billions

Consumption, Billions
\(100120
200200
300280
400360
500440
600520
700600

  1. Graph this consumption schedule. What is the size of the MPC?

  2. Assume that a lump-sum (regressive) tax of \)10 billion is imposed at all levels of GDP. Calculate the tax rate at each level of GDP. Graph the resulting consumption schedule and compare the MPC and the multiplier with those of the pretax consumption schedule.

  3. Now suppose a proportional tax with a 10 percent tax rate is imposed instead of the regressive tax. Calculate and graph the new consumption schedule, and calculate the MPC and the multiplier.

  4. Finally, impose a progressive tax such that the tax rate is 0 percent when GDP is \(100, 5 percent at \)200, 10 percent at \(300, 15 percent at \)400, and so forth. Determine and graph the new consumption schedule, noting the effect of this tax system on the MPC and the multiplier.

  5. Use a graph similar to Figure 13.3 to show why proportional and progressive taxes contribute to greater economic stability, while a regressive tax does not.

Refer back to the table in Figure 12.7 in the previous chapter. Suppose that aggregate demand increases such that the amount of real output demanded rises by \(7 billion at each price level. By what percentage will the price level increase? Will this inflation be demand-pull inflation, or will it be cost-push inflation? If potential real GDP (that is, full-employment GDP) is \)510 billion, what will be the size of the positive GDP gap after the change in aggregate demand? If government wants to use fiscal policy to counter the resulting inflation without changing tax rates, would it increase government spending or decrease it?

Real Output Demanded (Billions)
Price Level (Index Number)

Real Output Supplied (Billions)
\(506
108\)513
508104512
510100510
51296507
51492502

Explain how built-in (automatic) stabilizers work. What are the differences between proportional, progressive, and regressive tax systems as they relate to an economy鈥檚 built-in stability?

Some politicians have suggested that the United States enact a constitutional amendment requiring that the federal government balance its budget annually. Explain why such an amendment, if strictly enforced, would force the government to enact a contractionary fiscal policy whenever the economy experiences a severe recession.

Define the cyclically adjusted budget, explain its significance, and state why it may differ from the actual budget. Suppose the full-employment, noninflationary level of real output is GDP3 (not GDP2) in the economy depicted in Figure 13.3. If the economy is operating at GDP2 instead of GDP3, what is the status of its cyclically adjusted budget? The status of its current fiscal policy? What change in fiscal policy would you recommend? How would you accomplish that in terms of the G and T lines in the figure?
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