Answer to Question #289101 in Macroeconomics for Snow

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 and a decrease in the cash rate. Explain your assumptions with respect to the range of aggregate supply of your analysis

Answer 1

On the AS-AD diagram, the fiscal expansion that is, an increase in government spending, causes the AD curve to shift to the right from AD0 to AD1. This causes a new equilibrium that has a higher output level and price (P1). This higher price level slightly offsets the increase in output level as it decreases the real money supply and so shifts the LM curve upwards from LM0 to LM1. The new equilibrium has a higher output level, higher price level, and higher interest rate.

 A decrease in cash rate reduces investment which in turn causes a higher interest rate. This discourages borrowing                        

This can be explained in the diagram below.

The assumption here is that the economy is in the short run.