Question

From a position of potential GDP and zero inflation, the government increases defense spending (an increase in G). Describe qualitatively, using words and graphs but no algebra, what happens to GDP, the price level, interest rates, consumption, investment, and net exports. Assume at first that expectations of inflation remain at zero. Then describe how your answers change if expectations of inflation depend on last year’s inflation.

Answer 1

An increase in G increases aggregate demand. AD curve shifts rightward, increasing price level and real GDP, causing an inflationary gap in short run. Higher real GDP and output increases consumption, investment and net exports, and increases interest rate in short run. In long run, higher price level increases production cost, so firms decrease output. Aggregate supply decreases, and SRAS curve shifts leftward, further increasing price level but restoring real GDP to potential GDP level.

In following graph, when money supply increases, AD curve will shift rightward from AD1 to AD2, intersecting SRAS1 at point E2 with higher price level P2 and higher real GDP Y2, with inflationary gap being equal to (Y2 - Y1) in short run. In long run, SRAS1 shifts left to SRAS2, intersecting AD2 at point E3 with further higher price level P3 and restoring real GDP to potential GDP level Y1, removing the short-run inflationary gap.