One of the main roles of the government is stabilizing the economy to attain macroeconomic goals such as price-level stability, full employment, and economic growth. Macroeconomic fluctuations may occur due to shifts in the aggregate demand (AD) or shifts in the short-run aggregate supply curve (SRAS) (See Figure 1). Therefore, policymakers every so often strive to counterbalance these AD and AS curve shifts by using monetary policy and fiscal policy instruments in an attempt to reach long-run equilibrium by closing the recessionary and the inflationary gaps. Figure 1 LAS Recessionary Long-run equilibrium LAS LAS SAS SAS SAS gap P Inflationary gap AD AD AD real GDP Yf real GDP real GDP Yf Y Y1 Above full-employment equilibrium Below full-employment equilibrium Long-run equilibrium Part I: Fiscal Policy The government utilizes fiscal policy instruments (tools) to stabilize the economy and to achieve full employment, control inflation, and encourage economic growth. Fiscal policy is planned adjustments in the government spending and taxes. This part introduces you to the use of fiscal policy instruments to deal with the two major economic problems of recession (unemployment) and inflation. With this background information, answer the following questions on the uses and the effects of the fiscal policy tools to deal with the recessionary and the inflationary gaps. Section 1: Fiscal Policy and the Recessionary Gap Suppose that the U.S. economy is operating below full-employment equilibrium due to the recessionary gap with high rate of unemployment, and the equilibrium point between AD and SRAS occurs below potential real GDP (See Figure 2). Cognizant of the government plan, answer the following questions on the use of fiscal policy tools during the recessionary gap. Figure 2 [BU204M5] Assessment Template LRAS SRAS Aggregate Demand Recessionary gap Real GDP Price Level a) What is the type of fiscal policy the government uses to close the recessionary gap? b) What are the fiscal policy instruments available to the policy makers and how would they be used? Explain c) What are the effects of each of the fiscal policy instruments designed to fight recessions on the Federal Budget and the national debt? Section 2: Fiscal Policy and the Inflationary Gap Suppose the U.S. economy is operating above full-employment equilibrium, which leads to significantly high demand-pull inflationary pressure (see Figure 3). The government plans to use the fiscal policy instruments to close the inflationary gap by shifting the aggregate demand curve. Mindful of this government strategy, answer the following questions on the use of fiscal policy tools during the inflationary gap a) What is the type of fiscal policy the government uses to close the inflationary gap? b) What are the fiscal policy instruments available to the policy makers and how would they be used? Explain c) What are the effects of each of the fiscal policy instruments designed to fight inflation on the Federal Budget and the national debt?

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