Consider the hypothetical information in the following table for potential GDP, real GDP and the price level in 2013 and in 2014 if the government does not use fiscal policy. Year Potential GDP Real GDP Price Level 2013 $1.5 trillion $1.5 trillion 150 2014 $1.7 trillion $1.6 trillion 152 If the government wants to use fiscal policy to keep real GDP at its potential level in 2014, it should: increase interest rates. decrease transfer payments. decrease interest rates. decrease government purchases. decrease income taxes.
Question
Consider the hypothetical information in the following table for potential GDP, real GDP and the price level in 2013 and in 2014 if the government does not use fiscal policy.
Year Potential GDP Real GDP Price Level 2013 1.5 trillion 150 2014 1.6 trillion 152 If the government wants to use fiscal policy to keep real GDP at its potential level in 2014, it should:
increase interest rates.
decrease transfer payments.
decrease interest rates.
decrease government purchases.
decrease income taxes.
Solution
The government should decrease income taxes.
Here's why:
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In 2014, the real GDP is less than the potential GDP. This indicates that the economy is in a recessionary gap, where the total output is less than the potential output that could be achieved with full employment.
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To close this gap, the government needs to stimulate the economy. One way to do this is by using expansionary fiscal policy, which involves either increasing government spending or decreasing taxes.
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Decreasing income taxes would increase disposable income for households. This would lead to an increase in consumer spending, which would increase the demand for goods and services.
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The increased demand would then lead to an increase in production, which would increase the real GDP.
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Therefore, to keep the real GDP at its potential level in 2014, the government should decrease income taxes.
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