Question

using the IS-LM and the AD-LRAS-SRAS figures what happens to real interest rate, output and prices if there is a temporary increase in government purchases for military purposes. Will it matter whether the temporary increase in military spending is funded by taxes or by borrowing?

Answer 1

When there is an increase in the government spendings on purchases for military purposes, the IS curve and the AD curve will shift to the right while the LM and SRAS will remain the same. As seen in graph 1, this rightward shift of the IS curve will increase the output in the economy from Y to Y' and the interest rates will also increase simultaneously from i to i'. In graph 2, the rightward shift of the AD curve will again increase the output level in the economy but along with the prices from P to P'. Since it is a temporary increase, there will not be any change in the long run AS curve.

Thus, as a result of an increase in government purchases, interest rates, output, and the price level all will increase.

Yes, it will matter if the spending is funded by taxes or borrowings. When the expenditure will be funded by the borrowings, the total pool of the funds in the markets will reduce and thus the interest rates increase which makes it difficult for the private players to borrow and thus this would cause crowding out of the private spending. However, when these expenditures are made by increasing the taxes in the economy, the disposable income will reduce and thus the consumption of the consumption. The reduced consumption will thus not be at an optimal level further causing the loss of the consumer surplus.