Question

a) Using the AS-AD model, graphically illustrate and describe in words what happens to the long-run and short-run equilibrium level of aggregate output and inflation, when the economy is hit by a negative demand shock and the fiscal policy responds to the shock. Make sure you properly label all the axes and curves. Be specific to describe how the fiscal policy can act in this case.

b) Describe the government spending multiplier and how it would affect the fiscal policy response above in part (a).

c) Now, suppose the economy is at the zero lower bound and output is below potential due to a negative demand shock. Explain in words and using the AS-AD model why in this case the fiscal policy impact would be likely bigger and more helpful for the economy?

Answer 1

a)

When economy hit by demand shock ,AD curve shift left .

At initial equilibrium price,there is excess supply. Which lead to increase in inventory ofbl firms and firm will reduce Production to maintain same level of inventory and thus output and price Decreases.

After fiscal expansionary policy implement( Increase in G or tax cuts) ,AD curve shift to right and reach it's initial position and economy again reach its initial long run equilibrium.

b) Goverment spending multiplier refers to pheonomenon that Increase in government spending will lead higher Increase in income than goverment spending Increase.for example, If 200 million Increase in G lead to 400 million Increase in GDP ,so multiplier is 2.

So multiplier Increases the affect of fiscal policy on gdp and economy.

C)zero bound refers to situation when nominal interest is almost Equal to zero.In this there is no way to effect economy through Monetary policy.In this case due to deflation,real interest rate is negitive ,so banks don't lend credits.

When in Normal situation when we increase goverment spending,it lead to increase in gdp and interest rate. Increase in interest rate lewd to decrease in Investment.this is called crowding out.

But in zero bound situation, Increase in government spending lead to increase in output, and turn deflation into inflation and thus Increase nominal interest above zero. So real interest rate become again positive and which lead to start lending credit from banks and thus Increase in Investment.