Question

Queston 45 Not yet answered Points out of 6.00 Y Flag In October, the US faced a government shutdown as a result of the political stalemate in Washington associated with the funding of the Affordable Care Act. The result of the situation in October was to pass a temporary increase in government spending and revisit the discussion in February of this year Suppose this past February that the debt ceiling negotiations were unsuccessful resulting in another govemment shutdown that resulted in a decrease in government spending (this is not what happened, but work with me herel). Beginning in the long-run equilibrium in the AD/AS Model (no need to focus on the money market here), explain and demonstrate the impact of this decrease in the short run Assuming that the Govemment and Federal Reserve do NOT respond to this shock, how does the economy return to its long-run equilibrium (graph and explain)?

Answer 1

A decrease in government spending will decrease aggregate demand, shifting the AD curve to left, which decreases both price level and real GDP in short run, creating a recessionary gap. In the long run, lower price level will lower the cost of inputs for firms, so firms will increase output. Aggregate supply will increase, shifting the short run aggregate supply curve to right until long run equilibrium is reached at original level but at a further lower price level, restoring real GDP to the initial potential GDP level.

In following graph, a fall in aggregate demand shifts AD0 to left to AD1, intersecting SRAS0 at point B with lower price level P1 and lower real GDP Y1, leading to recessionary gap equal to (Y0 - Y1). In the long run, aggregate supply increases, shifting SRAS0 to right to SRAS1 until it intersects AD1 at point C with further lower price level P2 and real GDP being restored at potential GDP of Y0, eliminating the recessionary gap.