Question

Consider an economy that is at potential output. Using the aggregate demand curve and the inflation adjustment line, describe what would happen to real GDP and inflation in the short run, in the medium run, and in the long run if the government cut spending on defense. Be sure to provide an economic explanation for your results.

Answer 1

Short run:  

Rise in aggregate demand in short run will lead to rise in both output and price level. But rise in output level shall be significant. Rise in aggregate demand does not cause equal and proportional rise in output. Some rise in aggregate demand is reflected in price level. If economy is operating at the full employment, the fall in spending would not affect output level if economy operate above the potenial ouput. only price will fall.

Medium run:

Through this period, rise in aggregate demand influences both output and price. But output is influenced marginally. there is larger impact on price level. Production system is not flexible enough to adjust sudden rise in aggregate demand.

Similarly opposite would be true if demand falls.

Long run:

Rise in aggregate demand only reflected on prices only. there is equal and proportional rise in price level. Output does not rise as supply curve becomes vertical. If economy is already operating at above full employment level. Fall in government spending would not cause fall in output level.

Diagram:

in Above diagram, Yn is potential level of output or GDP can not rise after this. Any rise in aggregate demand beyond the point Yn would be translated into the rise in price level only.

Before the point Yn, rise in aggregate demand is translated into partly rise in price level and partly rise in output level.

similarly, if government spending falls, initially there will not be fall in output but price will falls, but government reduces spending again, it would cause negative impacts on output level.