Question

. Using AS-AD-LRAS graph, explain the consequences of the budget deficit on output and price level....

. Using AS-AD-LRAS graph, explain the consequences of the budget deficit on output and price level. Assuming the government borrow money from the rest of worlds, and needs to pay it back in the future.

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Answer #1

When there is a budget deficit , it means that government spending is higher than income . So the money supply increases in the economy . This causes the AD curve to shift rightwards or the aggregate demand rises in the eonomy . This is shown in the diagram below . So in the short run , the price level rises and also the real GDP . This causes inflationary pressures in the economy .

Then in the long run , the government has to pay the money back . So it will reduce expenditure and try to increase income by increasing taxes . This causes a contractionary fiscal policy . This leads to reduction in money supply . The AD curve falls back and adjusts to equilibrium in the long run .

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