Impact of the government’s fiscal package on the economy

An economy is performing at just under potential GDP with an output gap of -0.2%. Unemployment is low, at 4.5%, and firms are beginning to report difficulties in filling vacancies. Wage inflation is currently at 2.2%; inflation is at 1.8%. The central bank is operating a neutral monetary policy. This economy depends heavily on exports to fuel growth. Trading partners’ real GDP growth is forecast to increase strongly over the next three years. Next year is an election year. The current government has announced a fiscal package based around increases in current spending. This is a high income economy and it is not in a monetary union.

1. Use a business cycle diagram and an AD/AS diagram to show the current position of the economy. Use arrows on your diagrams to show the movement of the economy.

2. Explain the likely impact of the government’s fiscal package on the economy, using relevant diagrams and equations. How do you think the central bank is likely to react? Explain your answer. In your answer to question two, you should refer to the policy mix.

Requirements: 2000 words