Question

On the graphs below, show the impact of an increase in government spending in the short and long run. Assume that the central bank does not change their inflation target. Consider both the impacts on real GDP and also on the long run real rate of interest (r*).

Real Interest Rate (r) AE Aggregate Expenditure

Answer 1

An increase in government tending will shift the aggregate expenditure curve rightwards to ae� the shout impact is depicted in diagram below the aggregate expenditure curve will shift rightwards to ae� with increase in government spending this increase in government spending will increase real interest rate which will increases inflation in economy the aggregate demand curve will shift rightwards and thus price level and output will increase since target inflation rate is some in the long run, the control bank will reduce money supply which will fall and this reduces inflation in the third band ad� will shaft back the ad and initial pi* will be restored