Questions: ADDITIONAL REVIEW QUESTIONS FOR EXAM # 2 These questions are based on Topic 4 (Fiscal Policy) sections I and II. Question #1 Explain what is meant by the "natural level of output"? Question #2 (A) Draw a diagram that shows the macro-economy in an inflationary gap. What is meant by an "inflationary gap"? Indicate the inflationary gap on the diagram. (B) What is the basic cause of an inflationary gap? (C) What are the characteristics of an inflationary gap in terms of output, employment and prices? Question #3 (A) Draw a diagram that shows the macro-economy in a recessionary gap. What is meant by a "recessionary gap"? Indicate the recessionary gap on the diagram. (B) What is the basic cause of a recessionary gap? (C) What are the characteristics of a recessionary gap in terms of output, employment and prices? Question #4 (A) Explain two ways in which the government can implement restrictive fiscal policy. (B) Draw a diagram that shows the economy in an inflationary gap. Should the government pursue expansionary fiscal policy or should it pursue restrictive fiscal policy to correct this gap? Use the diagram to explain the impact of fiscal policy.

Let's address the first three questions as per the guidelines.

Explain what is meant by the "natural level of output"?

The natural level of output, also known as potential output or full-employment output, is the level of production that an economy can sustain over the long term without generating inflationary pressures. It represents the maximum amount of goods and services an economy can produce when it is operating at full capacity, with all resources (labor, capital, etc.) being used efficiently. At this level, unemployment is at its natural rate, meaning there is no cyclical unemployment, only frictional and structural unemployment.

(A) Draw a diagram that shows the macro-economy in an inflationary gap. What is meant by an "inflationary gap"? Indicate the inflationary gap on the diagram.

An inflationary gap occurs when the actual level of output in an economy exceeds the natural level of output. This situation typically leads to upward pressure on prices, resulting in inflation.

_Diagram Description:_

• The vertical axis represents the price level.
• The horizontal axis represents real GDP (output).
• The Long-Run Aggregate Supply (LRAS) curve is vertical at the natural level of output.
• The Short-Run Aggregate Supply (SRAS) curve is upward sloping.
• The Aggregate Demand (AD) curve is downward sloping.
• The point where AD intersects SRAS to the right of LRAS indicates an inflationary gap.

(B) What is the basic cause of an inflationary gap?

The basic cause of an inflationary gap is an increase in aggregate demand that exceeds the economy's capacity to produce at the natural level of output. This can be due to various factors such as increased consumer spending, higher government spending, lower taxes, or increased investment.

(C) What are the characteristics of an inflationary gap in terms of output, employment, and prices?

• Output: Actual output is higher than the natural level of output.
• Employment: Employment levels are above the natural rate, often leading to labor shortages and increased wages.
• Prices: There is upward pressure on prices, leading to inflation.

(A) Draw a diagram that shows the macro-economy in a recessionary gap. What is meant by a "recessionary gap"? Indicate the recessionary gap on the diagram.

A recessionary gap occurs when the actual level of output in an economy is below the natural level of output. This situation typically leads to downward pressure on prices, resulting in deflation or disinflation.

_Diagram Description:_

• The vertical axis represents the price level.
• The horizontal axis represents real GDP (output).
• The Long-Run Aggregate Supply (LRAS) curve is vertical at the natural level of output.
• The Short-Run Aggregate Supply (SRAS) curve is upward sloping.
• The Aggregate Demand (AD) curve is downward sloping.
• The point where AD intersects SRAS to the left of LRAS indicates a recessionary gap.

(B) What is the basic cause of a recessionary gap?

The basic cause of a recessionary gap is a decrease in aggregate demand that falls short of the economy's capacity to produce at the natural level of output. This can be due to various factors such as decreased consumer spending, lower government spending, higher taxes, or reduced investment.

(C) What are the characteristics of a recessionary gap in terms of output, employment, and prices?

• Output: Actual output is lower than the natural level of output.
• Employment: Employment levels are below the natural rate, leading to higher unemployment.
• Prices: There is downward pressure on prices, leading to deflation or disinflation.

In summary, the natural level of output is the sustainable level of production without inflationary pressures. An inflationary gap occurs when actual output exceeds this level, leading to inflation, while a recessionary gap occurs when actual output is below this level, leading to unemployment and deflationary pressures.