What are government's fiscal policy options for ending severe demand-pull inflation? Use the aggregate demand-aggregate supply model to show the impact of these policies on the price level. Which of these fiscal policy options do you think might be favored by a person who wants to preserve the size of government? A person who thinks the public sector is too large?
Explain why relatively flat as opposite relatively steep labor demand curves are more consistent with the empirical observation that there are relatively minor changes in the real wage rate over the course of the business cycle.
Is sustainable long-run equilibrium always reached when the AD and SAS curves intersect? Why or why not?
If the equilibrium real wage remains constant, what happens to the nominal wage when the actual inflation rate exceeds the expected inflation rate?
"In the steady state, the government benefits from inflation." Explain.
The government has two tools when it wants to influence the macroeconomy: one, it can change taxes, and two, it can change its spending patterns. In case the economy is facing a demand-pull inflation it means AD is rising fast. The four components of AD are household consumption (C), gross private investment (I), government expenditure (G), and net exports (NX). We usually take I, G and X (exports) to be exogenous variables. Thus to curtail a demand-pull inflation the government has to work on somehow curtailing consumption (C) and imports (M), or cut down its own spending. The two options with the government in such a case are:
(a) Cut down government spending: a reduction in G will reduce AD.
(b) Increase taxes: That will bring down the disposable income and will hence bring down both C and M.
This solution shows how a government benefits from inflation.