Question

Get an article on the United States economy. Relate it to either the AE/AP Keynesian model or the aggregate supply and demand graph. Draw graph to explain the relationship between the article and the model.

Answer 1

Fiscal policy and its direction

The recession of 2008-09 was shock to the economy that resulted from sub-prime crises. The government enacted the American Recovery and Reinvestment Act as an immediate economic stimulus package worth $787 billion (in total $830 billion) on February 2009. The purpose was to end the 2008 recession quickly by stimulating consumer spending and creating or saving around 2 million jobs. It instilled the confidence in the economic agents that was needed to boost economic growth.

However, stimulus failed in its very aim of saving jobs and increasing consumption spending. The failure of the stimulus was a blow to the theory that economies can be brought into action by an injection of government spending. People realized that every dollar injected by the government through spending would eventually be taken out in the form of taxes. It did increased the consumer spending and brought the economy back on the path of growth but the process was only gradual. The scenario is illustrated below.

AS-AD model

The aggregate demand curve AD exhibits a negative relationship between the price level and the output (income) level, which can be drawn using the basic IS-LM model. The Aggregate supply curve AS exhibits a positive relationship between the price level and the output (income) level. Both determine the price level and the output level in the economy.

During the recession, the economy was operating before its full potential and so the operating equilibrium was below the LRAS, shown by E1

When government increased its spending, income increasesd multiple times, precisely by ΔG/1 – MPC. With stimulated Aggregate expenditure AE, AD shifted to the right exhibiting a rise in income. With more income in hand, the quantity of money demanded increased with fixed money supply. Hence the interest rate rose and both money market and goods market achieved a new equilibrium at E2 where both interest rate and income level are higher.

This increase in income, however, came at the cost of rising inflation so the new equilibrium has more inflation and more real output.