Question

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
508	104	512
510	100	510
512	96	507
514	92	502

Short answer

The price level increased by 8%.

It is demand-pull inflation.

The positive GDP gap is $3 billion.

The government spending will decrease.

Step-by-step solution

Increase in price level and type of inflation caused by the increase in the price level

The real output demanded and supplied equate with each other at $510 billion. So, the equilibrium GDP is $510 billion, and the equilibrium price level is 100.

An increase of $7 billion in real output demanded at each level will shift the real output demand schedule in the following manner:

Real Output Demanded (Billions)	New Real Output Demanded (Billions)	Price Level (Index Number)	Real Output Supplied (Billions)
$506	$513	108	$513
508	515	104	512
510	517	100	510
512	519	96	507
514	521	92	502

Since the new real output demanded equals the real output supplied at $513 billion, the new equilibrium real GDP is $513 billion. The new equilibrium price level is 108.

The percentage increase in price level is as follows:

$$\begin{gathered} Increaseinpricelevel=\frac{\left(108-100\right)}{100}\times 100 \\ =8\% \end{gathered}$$

Therefore, the price level increased by 8%.

The price level increased due to an increase in real output demanded, which results from demand-pull inflation.

Positive GDP gap

The GDP gap is the result of deviation in actual GDP from potential GDP and can be calculated in the following manner:

GDP gap = Actual GDP – Potential GDP

Since actual GDP is $513 billion, and potential GDP is $510 billion, the GDP gap is as follows:

GDP gap = ($513 - $510) billion

GDP gap = $3 billion

Therefore, the positive GDP gap resulting from the increase in aggregate demand is $3 billion.

Change in government spending to control the inflation

Contractionary fiscal policy is most effective in controlling demand-pull inflation as it reduces the aggregate expenditure of the economy.A tightened aggregate expenditure reduces the economy’s income, ultimately contracting the aggregate demand. As aggregate demand comes down, the price level falls.

Therefore, demand-pull inflation can be reduced through a contractionary fiscal policy. Since taxes are held constantly, only government spending can be used to apply the contractionary fiscal policy.

Hence, the government will decrease its spending to reduce the demand-pull inflation.