Question

Suppose output exceeds potential output and contractionary fiscal policy is enacted. according to the as/ad model, in the long run, this fiscal policy will produce:

Answer 1

The price level would be lower than would otherwise have occurred.

Since the economy is a inflation gap input prices will eventually increase in the absence of any fiscal policy, causing the price level to rise and output to fall back to potential output. The contractionary fiscal policy will reduce aggregate demand and lower output to potential output while at the same time lowering the price level. Thus the only difference between the two is a lower price level with the contractionary fiscal policy.