Answer to Question #97923 in Macroeconomics for Tiffany

Question

The economy is at full employment and an election is coming up. Officials decide to increase government spending by $100 billion. Graham says the money should be spent on improving education and transport systems. Dole proposes building several large Coast Guard training facilities in states that have none. What effect would Graham’s proposal have on the AD/AS model? Describe all shifts and the effects on short and long-run equilibrium change in output and the price level.

Answer 1

The economy is in full employment. This means the Aggregate Demand and Aggregate Supply curve matches each other . At the full employment level, the aggregate demand equals aggegate supply.

Increased government spending is likely to cause a rise in aggregate demand (AD). This can lead to higher growth in the short-term.

Higher government spending will also have an impact on the supply-side of the economy – depending on which area of government spending is increased:

• Education and training – if successfully targetted government spending can increase labour productivity and enable higher long-term economic growth.
• Infrastructure investment – Higher spending on roads and railways can help remove supply bottlenecks and enable greater efficiency. This can also boost long-term economic growth.

Evaluation of higher government spending depends on how the government spending is financed. If government spending is financed by higher taxes, then tax rises may counter-balance the higher spending, and there will be no increase in aggregate demand (AD).

Crowding out. If the economy is close to full capacity, higher government spending can lead to crowding out. This is when the government spends more, but it has the effect of reducing private sector spending. For example, if government borrow from the private sector, the private sector has lower savings for private investment.

The impact of government spending also depends on the state of the economy. If the economy is close to full capacity, then higher government spending may cause inflationary pressures and little increase in real GDP.