Suppose the economy is initially in equilibrium, and real and potential GDP are equal. Now, suppose export orders increase. Under these circumstances, which of the following statements is true?
A)If the countercyclical fiscal policy response is made correctly, the new equilibrium will in the long run have a higher rate of inflation than if no response had been made.
B)If the countercyclical fiscal policy response is made correctly, the new equilibrium will in the long run have a lower rate of inflation than if no response had been made.
C)The inflation rate in the new long-run equilibrium will be the same, whether or not countercyclical fiscal policy is used.
D)If the countercyclical fiscal policy response is implemented too late, the new long-run equilibrium will have a higher rate of inflation than if no response had been made.
E)Countercyclical fiscal policy is unable to counter the effect of changes in export orders on real GDP.

Question

Quizplus · Accepted Answer

An increase in export orders will lead to an increase in aggregate demand in the short run, which will cause real GDP to rise above potential GDP and create a positive output gap. To close this output gap, countercyclical fiscal policy can be used to decrease government spending or increase taxes, which will decrease aggregate demand and bring the economy back to the long-run equilibrium. If this response is made correctly, it will result in a lower rate of inflation in the long run than if no response had been made. Therefore, option B is the correct answer. The other options are either incorrect or incomplete in their statements.

Suppose the Economy Is Initially in Equilibrium, and Real and Potential