Consider the hypothetical information in the following table for potential GDP, real GDP and the price level in 2017 and in 2018 if the government does not use fiscal policy.

If the government wants to keep real GDP at its potential level in 2014, it should:
A)decrease income taxes.
B)decrease government purchases.
C)decrease interest rates.
D)increase interest rates.

Question

Consider the hypothetical information in the following table for potential GDP, real GDP and the price level in 2017 and in 2018 if the government does not use fiscal policy.

If the government wants to keep real GDP at its potential level in 2014, it should:
A)decrease income taxes. 
B)decrease government purchases. 
C)decrease interest rates. 
D)increase interest rates.

Quizplus · Accepted Answer

According to the table, potential GDP for both 2017 and 2018 is $20,000 billion. However, in 2018, real GDP falls below potential GDP at $19,000 billion. This indicates that the economy is experiencing a recessionary gap, and output is below its potential level. To close this gap and bring real GDP back to its potential level, the government should use expansionary fiscal policy, such as decreasing income taxes. This would increase disposable income and boost aggregate demand, leading to an increase in output and potentially closing the gap. Decreasing government purchases would have the opposite effect and further decrease output, while changing interest rates may have an impact on investment, but not necessarily on consumption and overall output.

Consider the Hypothetical Information in the Following Table for Potential