In what macroeconomic circumstances will an expansionary fiscal policy lead to inflation?What is the answer for question 1.

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pohnpei397 | College Teacher | (Level 3) Distinguished Educator

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An expansionary fiscal policy (reduction in taxes and/or increase in government spending) is likely to result in inflation if the economy is in the intermediate or the classical range of the aggregate supply curve.

Beginning economics texts portray the aggregate supply curve as having three portions.  In the Keynesian portion, it is flat.  This means that an increase in aggregate demand (AD) such as would be caused by expansionary fiscal policy, would lead to GDP growth without inflation.  The next portion of the curve, the intermediate range, is upward sloping.  An increase in AD in this range would lead to an increase in real GDP, but also to inflation.  Finally, the classical range of the curve is vertical.  An increase in AD there would lead only to inflation and to no GDP growth.

Thus, an expansionary fiscal policy will lead to inflation if the equilibrium at the present time (the intersection of the AD and AS curves) is in the intermediate or classical ranges of the AS curve.


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