Question

Consider a closed economy which is in a long-run equilibrium, with Y = Y*. There is then a permanent increase in the annual flow of government purchases of goods and services, G. Explain what happens in the short run (no factor-price adjustment). Show in an AD/AS diagram. 2. Explain what happens in the long run (full factor-price adjustment). Show in an AD/AS diagram. (Assume that the current value of Y* is constant.) 3. In our simple model, consumption is a function of disposable income, C =C(Y-T). If the increase in G leads to no long-run increase in Y, explain what component of aggregate expenditure must get “crowded out” by the increase in G. Remember your national-income accounting for a closed economy that says: Y = Ca + Ia + Ga where the “a” subscript denotes “actual” expenditure. What are the future implications for the path of Y* from this reduction in a specific type of expenditure? 4. Explain, in words, why an increase in government purchases may be desirable in the short run, but possibly undesirable for the economy in the long run. 5. Does it matter what the increase in government spending is for? For example, are the long-run costs of an increase in government spending on education likely to be the same as an increase in government spending on the construction of buildings? Explain.