Problem 1 (15%) Government plans to apply fiscal policy in 2017

1. The fiscal applied will be taxes. Government should increase taxes in year 2017 inorder to reach the equilibrium. Because actual GDP in 2017 is higher than the potential GDP. To reach the equilibrium GDP, the total GDP should decrease. This happens when taxes are increased.

Tax multiplier is -2. That is a KD 1 change in taxes will result in -KD 2 change in the GDP. That is a KD 1 increase in taxes will decrease GDP by KD 2.

Actual GDP in 2017 is KD 16.4 billion and potential GDP is KD 16.0 billion.

So, the GDP has to decrease by KD 0.4 billion.

We have seen that a KD 1 increase in taxes will decrease GDP by KD 2.

So, to decrease GDP by KD 0.4 billion, the taxes has to increase by KD 0.2 billion.

??????Therefore, government should increase taxes by KD 0.2 billion.

2. No. Increase in government purcahses will not be a good decision.

The actual GDP is already higher than the potential real GDP. This happens when over full employment of resources happens. This cannot continue further. After this level, if we increase government purchases, the output won't increase. Only prices will increase and nominal GDP will increase. Because there are no extra resources to produce more real output.

So, at this level, any increase in government purcahses will lead to an increase in price level but no increase in real output.

Therefore, government purchases is not a good idea.