Principles of Macroeconomics / Unit 14 MAC 1316 worked example, 60 to 90 seconds
Which Action, and Which Way
The idea
From a description of the economy, name an appropriate fiscal action and the direction aggregate demand moves. Two steps, in order: locate output against potential, then choose the direction. Only after that does the choice of instrument arise, and the model is silent on it.
In practice
Output sits below potential with high unemployment, so this is a recessionary gap and the action is expansionary: raise purchases, cut taxes, or raise transfers, and aggregate demand shifts right. Output sits above potential with inflation rising, so this is an inflationary gap and the action is contractionary: cut purchases, raise taxes, or cut transfers, and aggregate demand shifts left. Now a harder case: output is below potential and inflation is also rising, which unit eight identified as a supply shock. Expanding demand raises output and worsens inflation; contracting does the reverse. Fiscal policy cannot fix both.
Where people slip
That third case is the one worth carrying. Fiscal policy moves aggregate demand, so it can address a problem caused by aggregate demand. When the trouble came from the supply side, every available move improves one half of the problem and worsens the other, and no choice of instrument escapes that.
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