Question

Congress just passed close to a $500 billion increase in government spending:    

C. How will this impact C, AD, Prices and inflation, output, and unemployment? Make sure to include an analysis using the intermediate run AD/AS model with both an intuitive and graphic analysis. (Assume that the AS supply curve is vertical like it is in the Classical Model).

Answer 1

In the long run, the AS curve is vertical indicating that output level is unaffected by the changes in the prices or inflation.

Components of AD include:

AD = C + I + G

where C = consumption

I = investment spending

G = Government spending

An increase in the government spending of $500 billion will increase the G component of AD increasing the aggregate demand. The higher government spending puts money in the pocket of the public. People will feel that their purchasing power has increased. So, they start spending on goods and Consumption will increase.

Below graph shows the impact of an increase in government spending:

The economy is at long-run equilibrium at point E where short-run AD and short-run AS intersect LRAS. A rise in government spending raises aggregate demand. AD curve shifts to the right from AD to AD1. The new equilibrium is at point E1. At this point, Both prices and real GDP are higher than the previous level.

So, the Economy experiences inflation with higher output with lower unemployment.

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