Question

Using the AD-AS model, show and briefly explain the short and long-run effects on the economy of a massive increase in government-sponsored infrastructure spending.?

Answer 1

An expansionary fiscal policy of increasing government infrastructure spending will increase aggregate demand, shifting the AD curve rightward, which increases both price level and real GDP in short run, giving rise to an inflationary gap. In the long run, higher price level will increase the cost of inputs, so firms will lower production and output. Aggregate supply decreases, shifting the short run aggregate supply curve leftward until long run equilibrium is restored at a further higher price level, restoring real GDP to the potential GDP 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 shifts AD0 rightward and economy moves to point B where AD1 intersects SRAS0 with higher price level P1 and higher real GDP Y1, creating an inflationary gap equal to (Y1 - Y0). In the long run, aggregate supply falls, shifting SRAS0 leftward to SRAS1 until it intersects AD1 at point C with further higher price level P1 and real GDP being restored at potential GDP of Y0, eliminating the inflationary gap.