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Chapter 13: Q2. (page 282)

What are the government’s fiscal policy options for ending severe demand-pull inflation?

Short Answer

Expert verified

Reduced government spending and amplified taxes are the fiscal options to regulate demand-pull inflation.

Step by step solution

01

Effects of decreased government spending

Fiscal policy has two instruments that are government spending and taxes.A contractionary budgetary policy of the government reduces government spending.Lower government spending will directly shrink the aggregate expenditure of the economy.

As a result, a lower income will pull the demand down to a lower aggregate demand and supply model equilibrium. Hence, prices will fall, and inflation will be controlled or halted.

02

Effects of high taxes

Another part of a contractionary fiscal policy is high taxes.As taxes rise, the disposable income of consumers declines. Consequently, the consumption expenditure and saving in the economy also contracts. Less amount of consumption reduces the aggregate expenditure.

On the other hand, lower saving pulls down the gross investment as the economy is stable when saving matches the investment. Therefore, the consumption and investment expenditure falls, bringing the equilibrium GDP down. A lower GDP will reduce the aggregate demand, and the prices will fall. Hence, higher taxes will regulate demand-pull inflation.

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Most popular questions from this chapter

What do economists mean when they say Social Security and Medicare are “pay-as-you-go” plans? What are the Social Security and Medicare trust funds, and how long will they have money left in them? What is the key long-run problem of both Social Security and Medicare? To fix the problem, do you favor increasing taxes or do you prefer reducing benefits?

How are supply-side policies implemented and what types of supply-side policies are used?

Refer back to the table in Figure 12.7 in the previous chapter. Suppose that aggregate demand increases such that the amount of real output demanded rises by \(7 billion at each price level. By what percentage will the price level increase? Will this inflation be demand-pull inflation, or will it be cost-push inflation? If potential real GDP (that is, full-employment GDP) is \)510 billion, what will be the size of the positive GDP gap after the change in aggregate demand? If government wants to use fiscal policy to counter the resulting inflation without changing tax rates, would it increase government spending or decrease it?

Real Output Demanded (Billions)
Price Level (Index Number)

Real Output Supplied (Billions)
\(506
108\)513
508104512
510100510
51296507
51492502

Which of the following would help a government reduce an inflationary output gap?

  1. Raising taxes

  2. Lowering taxes

  3. Increasing government spending

  4. Decreasing government spending

Some politicians have suggested that the United States enact a constitutional amendment requiring that the federal government balance its budget annually. Explain why such an amendment, if strictly enforced, would force the government to enact a contractionary fiscal policy whenever the economy experiences a severe recession.
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