Question

1. Assume the U.S. economy is initially in a long-run equilibrium. Suppose the President submits a budget to Congress which includes 30% funding cuts to every government program except defense. The largest cuts will be felt by the State Department, the EPA, NASA, and aid to foreign lands. Use the AD/AS model to describe the effect this policy will have on inflation and real GDP in the short run and the long run. Also, cite one externality which should result from cuts to the State Department and the EPA (two externalities total).

Answer 1

It appears from the discussion that there is reduction in the federal budget and it is reflection of reduced government spending G. In AD-AS graph, this implies a leftward shift in the AD that consequently results in lower inflation and lower equilibrium GDP. Now that in the short run nominal wages are sticky, AS does not shift. But during the transition to long run, nominal wages are revised so that lower inflation helps firms to hire more labor (as they are willing to work to get out of unemployment). This shifts AS to the right and real GDP returns to its full employment. This process is long and painfull, resulting in further reduced inflation level

A cut in the budget of EPA would have negative spillovers as it is a regulatory body to protect the environment.It is expected that with lower budget, regulation will somehow result in gradual but palpable environmental degradation. This is a negative externality that can take the shape of increased pollution, exploitation of a common resource etc.