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3. Consider the Aggregate Demand-Aggregate Supply framework. Suppose government spending is increased when we are not...

3. Consider the Aggregate Demand-Aggregate Supply framework. Suppose government spending is increased when we are not in a liquidity trap, output is at the natural rate of output, and the Fed does not target the interest rate. You can assume for simplicity expected inflation is always zero.

Show what happens over time to output, the price level, and the interest rate.

In the long run, what happens to investment given this expansionary fiscal policy.

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Answer #1

Considering that the output is at potential level and inflation is zero, an increase in the government expenditure will shift the demand curve to the right. It will increase the price and output in the economy. It will increase the investment as the demand is on a rise.

IN the long run, as the price has risen and the real value of wages have fallen it will lead to a higher wage, That will act as a supply shock and the supply curve will shift to the left. It will lead to a even higher price and the interest rate will fall and the investment will fall. The income of the people will fall back to the potential output level.

  

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