Question

Qno.2 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

An increase in government spending will cause AD to increase, and a decrease in the cash rate will cause AS to decrease. As a result the price level will definitely increase, and the equilibrium output may either increase or decrease.