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The federal government wants to cool down the overheated economy by cutting its spending. Describe how this policy may affect the unemployment rate.
Next, consider the following three scenarios, and USE APPROPRIATE DIAGRAMS to show the likely effects of an activist policy in both the short and long run.
A. The economy is above potential output.

B. The economy is at potential output.

C. The economy is below potential output.

*Please answer the questions with their corresponding letters (A,B, and C) for easier understanding.

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Solution Summary

Total output in the short run is determined.

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1) The federal government wants to cool down the overheated economy by cutting its spending. Describe how this policy may affect the unemployment rate. (5 marks)
Solution:
When the federal government reduces its government expenditure, it refers to a contractionary fiscal policy. This will have an impact on the aggregate demand curve as government spending is one of the important components of the AD curve. The AD curve will shift leftward causing a decline in both real output & the price level. Decline in the price level represents a decline in the inflation rate in the economy.
By considering the short run Phillips curve, decline in the inflation rate will lead to an increase in the unemployment rate along the Phillips curve.

In the figure above, AD decreases from AD1 to AD2. As a result, the equilibrium real output decreased from Y1 to Y2. While, the price level in the economy has decreased from P1 to P2 - therefore, the rate of inflation has fallen. When the level of output decreases, the number of people employed also decreases, indicating that the ...

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