Chapter 17, Problem 1P

To determine

Concept Introduction:

Expansionary Fiscal policy: This policy is followed by the government to expand the production activities in an economy. This is done by increasing the expenses and cutting the earnings of the government.

Contractionary Fiscal policy: This policy is followed by the government to contract the production activities in an economy. This is done by reducing the expenses and increasing the earnings of the government.

Explanation of Solution

Fig 1

On the Y-axis, aggregate price level is measured and on X-axis, real GDP is measured.

a. Condition of Albernia.

In the given figure 1, the aggregate output that is Y₁is less than the potential output that is Y_P.

Therefore, this gives rise to recessionary gap.

Conclusion:

Thus, Albernia is facing recessionary gap.

b. Effect of fiscal policy.

Albernia uses expansionary fiscal policy, to bring the economy to the position where the economy can produce the desired output.

With the expansionary fiscal policy, the government spending will be increased. These policies include reduction in taxes, increase in purchase of goods and services by government.

Conclusion:

Thus, Albernia uses expansionary fiscal policy.

c. Macroeconomic situation.

Fig 2

On the Y-axis, aggregate price level is measured and on X-axis, real GDP is measured.

After implementation of fiscal policy, the situation of Albernia is reflected in the given figure.

The recessionary gap has been removed and the economy came back to the equilibrium situation that is from E₁to E₂.

Conclusion:

Thus, inflationary gap has been removed.