And in this module, we are also going to briefly address the age old fiscal
policy question as to whether it's better to use tax cuts or
increase government expenditures to fight recessions.
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Suppose then that this time around India is facing an inflationary gap
as illustrated in this figure.
You can see here that the economy is in equilibrium at point A where aggregate
expenditures crosses the 45 degree line of aggregate production and
income is at 960 billion rupees.
But this is 60 billion rupees above the full employment
output of 900 billion rupees.
In such a case, we know that there will be strong upward pressure on prices,
even though such pressures are not visible in the Keynesian model.
Remember, in the Keynesian model, we assume that prices are fixed.
Now in light of these inflationary pressures,
how might fiscal policy be used to close the inflationary gap?
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Of course, to close the inflationary gap depicted in the figure,
we must use contractionary fiscal policy.
The goal is to rein in aggregate demand and thereby rein in demand-pull inflation.
Now as we already know, contractionary fiscal policy means either
cutting government expenditures or raising taxes, or
adopting some combination of the two to cool inflationary pressures.
So take a minute now to calculate how much the Indian government should either
decrease government expenditures or
increase taxes to close the 60 billion rupee gap.