Question

(0, 5, or 10) Describe the effect (increase or decrease) on GDP, unemployment, and inflation of each of the following: (a) war, (b) elimination of environmental regulations, and (c) cuts in welfare benefits. Explain your answers.

Answer 1

In all the following graphs, initial equilibrium is at point A where AD0 (aggregate demand) and SRAS0 (short-run aggregate supply) curves intersect with initial equilibrium price level P0 and initial equilibrium real GDP Y0.

(a)

During wars, government massively increases its (military) spending, which increases aggregate demand, shifting AD curve rightward and increasing both inflation and real GDP. Unemployment decreases.

In following graph, AD0 shifts rightward to AD1, intersecting SRAS0 at point B with higher price level P1 and higher real GDP Y1.

(b)

More relaxed environmental regulation increases business activity, which increases aggregate supply. SRAS shifts right, decreasing inflation and increasing real GDP. Unemployment increases.

In following graph, SRAS0 shifts right to SRAS1, intersecting AD0 at point B with lower price level P1 and higher real GDP Y1.

(c)

Lower welfare benefits decreases government spending, which decreases aggregate demand, shifting AD curve leftward and decreasing both inflation and real GDP. Unemployment increases.

In following graph, AD0 shifts leftward to AD1, intersecting SRAS0 at point B with lower price level P1 and lower real GDP Y1.