Quiz 26: Business Cycles
Fiscal Policy: Fiscal policy is made by the government, which includes government purchases, taxes, transfer payments, and borrowings. This policy affects directly or indirectly macroeconomic variables such as real GDP, employment, price level, and growth of the economy. a.Impact of government purchases on real GDP: If the government purchases decrease, then the consumption and investment of the economy also decreases. As a result, the real GDP of the economy will decrease. b.Impact of net taxes on real GDP: An increase in net tax will reduce the disposable income of the tax payers. The fall in disposable income will reduce both the consumption and saving of an economy. As a result, the real GDP of the economy will fall. c.Impact of transfer payment on real GDP: Transfer payment is the payment collected during the time of exchange of goods and services. Hence, reduction of transfer payment will increase the consumption level, thereby the real GDP of an economy will increase. d.Impact of marginal propensity to consume on GDP: Decrease in marginal propensity to consume implies that less proportion of income is spent for consumption. Hence, the demand for goods and services will reduce due to low income. As a result, real GDP of an economy will decrease.
Fiscal policy under steeper supply curve: A steeper supply curve indicates that the quantity supply is less sensitive to the change in price.A steeper short-run aggregate supply curve would be less sensitive to the fiscal policy. It means expansionary fiscal policy (which aims to expand the level of output) will have less effect on output; as a result, price level will increase. Similarly, a contractionary fiscal policy (which is made to reduce the output level) will have less effect on output; as a result, price level will decrease.Therefore, in case of steeper aggregate supply curve, the regulation of fiscal policy will have a less effect on real GDP and more effect on price level.
Classical economists views on self-correcting mechanism: According to classical economists, full employment can be achieved by altering price, wage, and rate of interest in an economy. Therefore, price, wage, and rate of interest should be more flexible to alter the disequilibrium aggregate demand and aggregate supply. Hence, at full employment level, aggregate demand-supply identity holds. Classical theory believes in self-correcting mechanism. If the aggregate demand is less than aggregate supply, then decreasing price or rate of interest or increasing the wage would bring the aggregate demand to equilibrium level. Hence, the recession can be automatically adjusted.On the contrary, Keynes assumed that achieving full employment is not possible because change in price or wage will affect the effective demand. If an economy reduces price or increases wage rate to remove the excess demand, then it would cause a fall in effective demand , which in turn will move the economy to recession. Hence, the disequilibrium in aggregate demand and aggregate supply should be adjusted by change in output level and not through price or wage levels.
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