Question

Suppose the federal government unexpectedly decreases its spending. With the aid of an aggregate demand-aggregate supply diagram, explain how this contractionary fiscal policy affects the price level, P, and total output, Y, in the short-run.

How does the economy adjust to this policy in the long-run?

What is the effect of this policy on P and Y in the long-run?

[Note: Assume that the economy is in a long-run equilibrium prior to the increase in government spending. Also assume that the short-run aggregate supply curve slopes up.]

Answer 1

A decrease in government spending will decrease aggregate demand (AD), shifting AD curve toward left which will decrease price level, income and real GDP in the short run, thereby causing a short run recessionary gap. In the long run, lower price level will decrease the cost of inputs and firms will increase their output, increasing aggregate supply. This will shift the short-run aggregate supply curve toward right and new long run equilibrium will be at a further lower price level, but restoring real GDP to potential GDP level, thereby eliminating the recessionary gap.

In the graph, initial long run equilibrium is at point A where aggregate demand (AD0), short-run aggregate supply curve (SRAS0) and long-run aggregate supply curve (LRAS0) intersect with initial price level P0 and real GDP (= full-employment/potential GDP) Y0. Lower government spending will decrease aggregate demand, shifting AD curve toward left to AD1, intersecting SRAS0 at point B with lower price level P1 and lower real GDP Y1, giving rise to a short-run recessionary gap of (Y0 - Y1). In the long run, SRAS0 curve shifts toward right to SRAS1, intersecting AD1 at point C with further lower price level P2 and real GDP will be restored to potential GDP level of Y0, eliminating the short run recessionary gap.