Question

A temporary government spending shock.

a) Suppose the government very temporarily, and unexpectedly, increases its purchases of goods. (Assume the government finances these temporary purchases by issuing additional debt. Assume the government only purchases goods—it does not produce goods, or employ labor directly.) Explain the impact in both the goods and labor markets today. What happens to consumption demand, investment demand, aggregate demand, and aggregate supply? What happens to the market-clearing real interest rate, output, consumption and investment? Illustrate graphically.

b) Suppose instead that the government financed the temporary spending by an equally very temporary proportional increase in the income tax. (That is, both the average and marginal tax rates increase temporarily.) Discuss how this changes each of your answers to the questions in part (a).

Answer 1

(a) the impact of increase in government spending will be reflected aggregate demand curve because the spending has been financed by issuing debt. Therefore, aggregate supply curve will also get impacted. In this light, the diagramatical impact is reflected in the figure below. However, the impact on goods and labour market will be zero because the government spending is temporary which means production will not get affected.

B) If the government decided to finance its spending by increasing tax the impact will be now reflected on aggregate demand curve only as shown in diagram. Moreover, the liquidity of money will remain unchanged because now the income of the citizens will get affected due to higher tax rate. Therefore, now due to higher tax rate the interest rate and output produced will decrease which was previously higher. The main reason the output has fallen because people do not have much income to spend on goods and services.

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