Question

If wages are indexed to the CPI, what will be the effect of an expansionary fiscal policy on output and prices? Use charts to justify your answer. Please provide detailed explanation for this answer it is 15 marks

Answer 1

An expansionary fiscal policy increases government spending and/or decreases taxes, and thus raises aggregate demand which shifts the AD curve to right. It increases price level and real GDP in short run, giving rise to a positive output gap.

In the long run, since wages are indexed with CPI (signifying that an increase in price level increases wage rate), higher short run wage rate increases the production cost, so firms lower output. Aggregate supply falls, shifting the short run aggregate supply curve to left, and the process continues until long run equilibrium is achieved at potential GDP level but at a further higher price level.

In following graph, long-run equilibrium is at point A where AD0 (aggregate demand), LRAS0 (long-run aggregate supply) and SRAS0 (short-run aggregate supply) curves intersect, with long-run price level P0 and real GDP (= Potential GDP) Y0. An expansionary fiscal policy increases aggregate demand, shifting AD0 to AD1, intersecting SRAS0 at point B with higher price level P1 and higher real GDP Y1, creating a positive output gap equal to (Y1 - Y0). In the long run, aggregate supply decreases, shifting SRAS0 to left to SRAS1 where it intersects AD1 at point C with a still higher price level P1, but real GDP is restored at potential GDP of Y0, eliminating the positive output gap.