Question

15. In 2008 the Chinese government conducted an expansionary fiscal policy. Apply such a policy to the AD-AS model and answer the following questions.
16. 1. What is an expansionary fiscal policy?
    2. How would such a policy affect the aggregate demand curve, the short-run aggregate supply curve, and the long-run aggregate supply curve？
    3. Following the implementation of such a policy, what happens to the real GDP, the price, and the unemployment in the short run? And what happens to them once the price starts to adjust? Use the AS-AD diagram to explain.

Answer 1

a. Expansionary fiscal policy is a tool by which the government tends to increase the aggregate demand in the economy by either increasing its expenditure or by reducing the taxes on the people. It is used at the times of economic slowdowns or recessions or simply when an economy is producing at a level lower than the full employment level.  

b. The expansionary fiscal policy increases the aggregate demand and hence shifts the aggregate demand curve to the right while the short-run and long-run aggregate supply curve remain the same. The short aggregate supply curve is however affected by the aggregate price level in the economy and the structural changes affect the long-run supply curve.

c. As we can see in the following graph, the shift of the AD curve will increase the aggregate price level in the economy which is at the intersection of the aggregate demand curve and the aggregate supply curve. The real GDP measured on the horizontal axis also increases to the right. Now note that the higher GDP would mean more of the production and hence more of the labor will also be needed in the production process, assuming that the production function remains the same, and hence the employment will increase. The higher employment also implies a decline in the unemployment rate in the economy.

Now after the prices begin to adjust at the higher levels, the cost of production will also increase, and hence the aggregate supply in the economy will decline. This will cause the short-run AS curve to shift to the left and the output, in the long run, will bring back to its original level of real GDP leading to an even higher price level.