Question

Congress decides to increase government spending and taxes by equal amounts. Use the IS-LM AD-SRAS-LRAS model to illustrate graphically the short run impact of the increase in government spending and taxes on output and interest rates, prices, consumption, unemployment rate and investment in short run. Explain clearly which curve would shift and why. What will be the long run impact of this increase in government spending and taxes on output and interest rates, prices, consumption, unemployment rate and investment. Show the appropriate movement of curves both for the short run and the long run. Be sure to label: i. the axes; ii. the curves; iii. The initial equilibrium values; iv. The direction the curves shift; and v. the short run equilibrium values and vi. The long run equilibrium values.

Answer 1

Ans. Suppose initially the economy is in longrun equilibrium with output Y, price level P and interest rate r. When government spending increases, consumption increases shifting the IS curve to the right to IS’ due to which transaction demand for money also rises causing interest rate to shift up to i’ from i. This increase in interest rate increases the cost of borrowing and thus, leads to fall in the level of investment. The combined effect of increased spending and reduced private investment causes aggregate demand to increase shifting the AD curve to the right from AD to AD’ increasing output level from Y to Y’ and increase in price level due to excess demand in the market from P to P’. This increase in output level above the long run equilibrium level leads to a decrease in unemployment rate below the natural rate of unemployment.

In long run, increase in prices leads to a decrease in real wages of the workers who now demand higher wages, increasing the cost of production and leading to decrease in short run aggregate supply shifting it to left from SRAS to SRAS’. This increase in wages leads to increase in unemployment back to the natural rate decreasing consumption spending which leads to fall in output from Y’ to Y which is long run output and due to decrease in aggregate supply price level rises further to P”. In IS-LM framework, increase in price level leads to a decrease in real money supply causing the LM curve to shift to left from LM to LM’. This leads to increase in interest rate and thus, reduces private investment causing output to fall back to full employment level Y from Y’

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