Multiple Choice
The wealth effect along an aggregate-demand curve stems from the idea that a higher price level:
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1. Introduction to Macroeconomics
Introduction to Economics
Multiple Choice
Suppose the government increases its spending while the economy is currently operating below potential output. How will this change affect the output gap?
A
The output gap will remain unchanged.
B
The output gap will become negative as actual output exceeds potential output.
C
The output gap will decrease as actual output moves closer to potential output.
D
The output gap will increase as actual output moves further below potential output.
Verified step by step guidance1
Step 1: Understand the concept of the output gap, which is defined as the difference between actual output (Y) and potential output (Y*), often expressed as Output Gap = Y - Y*. A positive output gap means the economy is producing above potential, while a negative gap means it is below potential.
Step 2: Recognize that when the economy is operating below potential output, the output gap is negative (Y < Y*). This indicates underutilized resources and economic slack.
Step 3: Analyze the effect of an increase in government spending, which is a component of aggregate demand (AD). An increase in government spending shifts the aggregate demand curve to the right, increasing total demand in the economy.
Step 4: Understand that as aggregate demand increases, actual output (Y) rises, moving closer to potential output (Y*). This reduces the negative output gap because the economy is producing more and utilizing resources more fully.
Step 5: Conclude that the output gap decreases (becomes less negative) as actual output moves closer to potential output due to the fiscal stimulus from increased government spending.
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