1. Using AD and AS model, graphically explain the following: Suppose that the Government increases spending...

1. Using AD and AS model, graphically explain the following:

Suppose that the Government increases spending and simultaneously raises taxes.

a) Show the effect of this change on AD schedule.

b) How does this affect output and price level in the Keynesian case.

c) How does this affect output and price level in Classical case.

Expert Solution

Government is increasing its spending and at the same time taxes are also increase

a) Aggregate demand is likely to increase as a result because government spending is increased which will increase aggregate demand directly. At the same time there is an increase in taxes also which will decrease the aggregate demand but if both are increased by the same size then the multiplier effect, even though very small, will be strong enough to shift the aggregate demand curve to the right. Balanced budget multiplier will be 1 in that case

b) In Keynesian case, aggregate supply curve is horizontal and we expect that there will be a rightward shift of the aggregate demand but there is no change in the price level because it is fixed according to the assumption. Output definitely increases

c) In classical case the aggregate supply curve is vertical and we again expect that there will be a rightward shift of the aggregate demand but in this case only price will change there will be no change in the output since the economy is always operating at full employment level

Rahul Sunny answered 2 years ago

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