Answer to Question #139076 in Macroeconomics for Suraj Rai

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

An increase in government spending will increase the both the general price level and actual gross domestic product beyond the full employment national income.

Government expenditure (G) is a component of aggregate demand, its increase will thus, increase aggregate demand. Given that the economy is at full employment, and assuming that the increase in government expenditure is not derived from an increase in tax revenue, there will be an upward thrust on prices as the economy lacks capacity to expand aggregate supply in order to meet an increase in demand. Eventually, actual national output exceeds potential output, creating an inflationary gap. The graph below illustrates.

As shown on the graph above, the economy was initially in full employment equilibrium where aggregate demand AD1 interact with the long-run aggregate supply LRAS and the short run aggregate supply SRAS. An increase in government spending increases AD from AD1 to AD2 as indicated. Consequently, the actual real GDP increases from the full employment income Yf to Ye, and the general price level increases from P1 to P2 as indicated.