Question

Using SRAS-AD-LRAS framework and beginning at long run equilibrium, explain the impact of an expansionary fiscal policy in an economy. Discuss the impact on Price level, real GD, unemployment and interest rate both in short and long run.

Answer 1

At the long run equilibrium, there is potential GDP achieved and natural level of  unemployment. At this stage, if expansionary fiscal policy takes place, then:

1. AD will shift to the right and Price level will increase at the short run, unemployment level will be lower than the natural rate of unemployment in the short run. there will be expansionary gap (real GDP will be more than potential GDP) in the short run.

2. Due to inflation set in the economy, SRAS curve will shift to the left and long run GDP will be achieved in the long run. At this level, price level will be higher in the long run. Unemployment will increase and become equal to the natural rate of unemployment in the long run.

Interest rate is majorly affected by the monetary policy, rather fiscal policy.