Macroeconomic as/Ad Framework Essay

1695 Words Sep 9th, 2012 7 Pages
1) Use the AS/AD framework to show the separate effects on GDP, inflation and public sector borrowing on any single national economy of: a) cut in public spending b) an increase in the rate of VAT (sales tax) c) a slowdown in the GDP growth of less developed economies. (Make sure that you include clear and appropriate diagrams for this question) According to Begg and Ward (2009) fiscal policy is the government’s decisions regarding taxation and spending to influence level of demand for goods and services. Cut in public spending and increase in the rate of VAT are instruments of contractionary fiscal policy in order to slow down economy, reduce inflation and deficit. a) Cut in public spending …show more content…
Y2

Y1

National output

Cut in public spenting (G↓) Increase of rate of VAT (T↑)

GDP decrease decrease

Inflation decrease decrease

Public sector borrowing decrease decrease

Table 1 Separate effects on GDP, inflation and public sector borrowing

Since it’s quite common to me I will be using Croatia as an example ‐ In August 2009 Croatian government has increased VAT from 22% to 23% and introduced additional tax, so called “crisis tax” of 3% on salaries. In my opinion government wanted to “save” the budget and in short term collect additional income from higher taxes. Secondly, since Croatian economy is heavily import oriented with effects of contractionary fiscal policy balance of trade has been improved because of decreased import, so domestic goods and services are becoming more attractive and in mid term export could become driver for growth. In that way it has created foundation for private sector to start investing since interest rates has fallen, but we still do not see positive effects which will cause aggregate demand to be increased and start shifting to the right. Moreover without foreign investment Croatian economy can’t increase itself aggregate demand (because of it size) and current situation in Eurozone is extremely toughs so investors will still wait to see its outcome.

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