Answer to Question #136337 in Macroeconomics for Jimmy

Question

Assume that an economy is initially operating at the natural rate of output (full employment output). Use the AD-AS model to illustrate graphically the effects on price and output of an increase in government spending. Explain your assumptions with respect to the range of aggregate supply of your analysis.

Answer 1

i) Effect on price:

Increased government spending result in a rise in aggregate demand (AD). This potentially lead to demand pull inflation and hence an increase in the price level as shown in the graph below.

ii) Effect on output:

Increase in government spending could lead to increased productivity and a growth in the long-run aggregate supply as shown in the graph below.

When AS increases, the full employment level of output increase from RDO-FE1 to RDO-FE2.

iii) Assumptions include;

1.Availability of land and raw materials.

2. High quantity and productivity of labour.

3. Large quantity and productivity of capital.

4. Technological improvements which lead to increased productivity and output.

5. High level of entrepreneurship in the economy.