Chapter 27, Problem 3P

To determine

(a)

To indicate:

The movement that represents an unanticipated expansionary government policy in the short run.

Answer to Problem 3P

The movement of the equilibrium from point A to point F is due to an unanticipated expansionary government policy in the short run.

Explanation of Solution

The economy was in the initial equilibrium at point A with the intersection of AD₀ and SARS₀. At point A, the expected price level and the realized price level are same at PL₀. The equilibrium output RGDP_NR is the also on the long-run aggregate supply curve LRAS, which makes the company stable at the long-run equilibrium.

Now, suppose the government wants to lower the unemployment level and pursues an expansionary fiscal policy. However, this move of the government was unanticipated by the public. This means, they do not expect a price rise in the near future. As a result, the short-run aggregate supply curve stays unchanged.

As the expansionary fiscal policy is implemented, the aggregate demand curve shifts from AD₀ to AD₁with no corresponding shift in the short run aggregate supply curve due to unanticipated nature of the fiscal policy. A new equilibrium is established at point F in the short run.

Economics Concept Introduction

Expansionary government policy:

The government policies that cause the aggregate demand of the economy to rise and thereby induce production and income along with the generation of employment is referred as the expansionary government policy. The tools used by the government for this purpose taxation and government expenditure. For the expansionary purpose, the government may either lower the tax rate or increase its expenditure or both. Expansionary government policy, also called expansionary fiscal policy, can help the economy move out of a recessionary situation.

To determine

(b)

To indicate:

The movement that represents an unanticipated contractionary government policy in the short run.

Answer to Problem 3P

The movement from equilibrium point F to equilibrium point A represents the unanticipated contractionary government policy.

Explanation of Solution

The economy is in the long run equilibrium at point A with real GDP, RGDP_NR and price level PL₀. The economy is described by the aggregate demand curve AD₀ and short-run aggregate supply curve SRAS₀. For some reason, the aggregate demand curve shifts to AD₁ and the economy shifts to a new short run equilibrium at point F. However, at point F, the equilibrium real GDP is greater than the natural rate of real GDP represented by the long-run equilibrium at point A. The new equilibrium with output level more than the natural rate of real GDP of the economy represents a short-run situation which is not stable.

To bring back stability to the economy, government takes measures that shifts the aggregate demand curve to the left to its original position, which is only possible when the government pursues a contractionary fiscal policy. However, if the contractionary fiscal policy is unanticipated, the public will maintain its expectation about the price level and therefore, the short run aggregate supply curve will remain unaffected. A contractionary fiscal policy affects the aggregate demand by lowering it from its current level for all prices and thereby shifting the aggregate demand curve back from AD₁to AD0. With no change in the position of the short run aggregate supply curve due to the unanticipated nature of the policy, the shift in the aggregate demand curve will being the economy back to the old equilibrium at point A from point F.

Economics Concept Introduction

Contractionary government policy:

The government policies that cause the aggregate demand of the economy to fall and thereby discourages production and generation of income along with employment is referred as contractionary government policy. The tools used by the government for this purpose are taxation and government expenditure. For the contractionary purpose, the government may either raise the tax rate or lower its expenditure or both. Contractionary government policy, also called contractionary fiscal policy, help the economy control inflation by lowering the circulation of money in the economy.

To determine

(c)

To indicate:

The movement that represents an anticipated expansionary government policy under the rational expectations.

Answer to Problem 3P

The movement from point A to point E represents completely anticipated expansionary government policy under rational expectations.

Explanation of Solution

When an expansionary fiscal policy is completely anticipated, public by virtue of rational expectation will know from before that there will be a rise in the price level due to the policy. They immediately revise their activities and thereby changes the position of the short-run aggregate supply curve. Labor will revise their wages upwards; household will revise its spending; producers will lower production due to rising cost and so on which will shift SRAS₀to SRAS₁ even before the policy comes into effect creating a new short run equilibrium point at R. As the expansionary policy is implemented, the shift in the aggregate demand curve from AD₀to AD₁ generates the long run equilibrium at point F, where the economy is in the long run potential level of output with a higher price level.

Economics Concept Introduction

Expansionary government policy:

The government policies that cause the aggregate demand of the economy to rise and thereby induce production and income along with the generation of employment is referred as the expansionary government policy. The tools used by the government for this purpose taxation and government expenditure. For the expansionary purpose, the government may either lower the tax rate or increase its expenditure or both. Expansionary government policy, also called expansionary fiscal policy, can help the economy move out of a recessionary situation.

Rational expectations:

People make decisions based on three primary factors, namely human rationality, available information, and experiences. The theory of rational expectation suggests that the current expectation of people can influence the future state of the economy.

To determine

(d)

To indicate:

The movement that represents an anticipated contractionary government policy in the short-run.

Answer to Problem 3P

The movement from point E to point F represents completely anticipated contractionary government policy in the short run.

Explanation of Solution

Suppose the economy is in long-run equilibrium at point E. At this point, the government plans a contractionary fiscal policy. If the move is completely anticipated, public will know from before that a contractionary fiscal policy will lower the price level. They will immediately revise their activities and that will cause the short run supply curve to shift rightwards from SRAS₁ to SRAS₀ even before the policy is implemented. Thus, the economy will move to a new short run equilibrium at point F.

Economics Concept Introduction

Contractionary government policy:

The government policies that cause the aggregate demand of the economy to fall and thereby discourages production and generation of income along with employment is referred as contractionary government policy. The tools used by the government for this purpose are taxation and government expenditure. For the contractionary purpose, the government may either raise the tax rate or lower its expenditure or both. Contractionary government policy, also called contractionary fiscal policy, help the economy control inflation by lowering the circulation of money in the economy.

To determine

(e)

To explain:

The result of a situation where an expansionary government policy is made, but the inflationary effects of this policy is less than expected.

Answer to Problem 3P

If the expansionary fiscal policy results in the less than expected inflation, it will inhibit the growth in output and employment.

Explanation of Solution

The expansionary fiscal policy boosts the aggregate demand which in turn puts an upward pressure on the price level. The rising price level encourages businesses to expand production level and generate income and employment. However, in case the fiscal policy fails to create the desired level of inflation, it will generate less impetus for the businesses to produce more and thereby inhibit the growth of output and employment.

Economics Concept Introduction

Expansionary government policy:

The government policies that cause the aggregate demand of the economy to rise and thereby induce production and income along with the generation of employment is referred as the expansionary government policy. The tools used by the government for this purpose taxation and government expenditure. For the expansionary purpose, the government may either lower the tax rate or increase its expenditure or both. Expansionary government policy, also called expansionary fiscal policy, can help the economy move out of a recessionary situation.