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Chapter 27: Problem 2

What are the key differences between how we illustrate a contractionary fiscal policy in the basic aggregate demand and aggregate supply model and in the dynamic aggregate demand and aggregate supply model?

Short Answer

Expert verified
Contractionary fiscal policy is represented in both the basic and dynamic AD-AS models by a leftward shift of the AD curve. On the other hand, the dynamic AD-AS model, unlike the basic one, allows for ongoing rightward shifts, mimicking continual economic growth and inflation. Thus, in the dynamic model, contractionary fiscal policy would be seen as a slower rightward shift or possibly even as a leftward shift, depending on the degree of fiscal changes.

Step by step solution

01

Discuss Contractionary Fiscal Policy

Contractionary fiscal policy refers to the actions of the government to slow down an economy's growth, probably to combat inflation. This policy usually entails increased taxation and/or decreased government spending.
02

Depicting Contractionary Fiscal Policy in the Basic AD-AS Model

In this model, an introduction of contractionary fiscal policy results in a reduction in aggregate demand. This is shown by a leftward shift of the AD curve on a graph where the vertical axis is 'Price Level' and the horizontal axis is 'Real GDP'. Less government spending or higher taxes reduces consumers' disposable incomes, lowering their consumption levels and leading to a decrease in overall demand.
03

Depicting Contractionary Fiscal Policy in the Dynamic AD-AS Model

In contrast to the basic model, the dynamic model incorporates changes over time, including inflation and growth. A contractionary fiscal policy, in this case, would still lead to a leftward shift of the AD curve. However, due to inflation and growth, both AS and AD curves shift to the right over time. Therefore, contractionary policy in this case would be depicted as a slower rightward shift or a possible leftward shift of the AD curve, depending on the degree of policy change.
04

Highlight the Differences

The key difference lies in how each model illustrates the changes over time. The basic model portrays a static snapshot of the economy, with shifts in AD because of policy changes being instantaneous and isolated. The dynamic model, however, illustrates ongoing rightward shifts in AD and AS due to the economy's continuing inflation and growth. Here, changes in fiscal policy are relative to this ongoing trend rather than being isolated shifts.

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