Question

Explain the effect of an increase in government spending on the on the equilibrium output and inflation in the AD-AS model.

Carefully distinguish between the short-run and the long-run equilibrium.

Would this increase in government spending affect the potential output? Why/Why not? (Brief answer with diagram)

Answer 1

• The aggregate demand/aggregate supply, or AD/AS, model is one of the fundamental tools in economics because it provides an overall framework for bringing economic factors together in one diagram.In addition the AD/AS framework is flexible enough to accommodate both the Keynes’ law approach—focusing on aggregate demand and the short run—while also including the Say’s law approach—focusing on aggregate supply and the long run.

• We can examine long-run economic growth using the AD/AS model, but the factors that determine the speed of this long-term economic growth rate do not appear directly in the AD/AS diagram

Increased government spending is likely to cause a rise in aggregate demand (AD). This can lead to higher growth in the short-term. It can also potentially lead to inflation.

Higher government spending will also have an impact on the supply-side of the economy – depending on which area of government spending is increased. If spending is focused on improving infrastructure, this could lead to increased productivity and a growth in the long-run aggregate supply. If spending is focused on welfare benefits or pensions, it may reduce inequality, but it could crowd out more productive private sector investment.

Estimating Potential GDP :

An inflationary gap exists when the demand for goods and services exceeds production due to factors such as higher levels of overall employment, increased trade activities, or elevated government expenditure. Against this backdrop, the real GDP can exceed the potential GDP, resulting in an inflationary gap.

(Note: It is not easy to tell whether real GDP is below, above, or at potential GDP, so it is not easy tell if discretionary fiscal policy will move real GDP away from potential GDP instead of towards it. Too much fiscal stimulus can cause inflation, while too little can lead to recession.)