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Explain the effect of an increase in government spending on the on the equilibrium output and...

Explain the effect of an increase in government spending on the on the equilibrium output and inflation in the AD-AS model. Carefully distinguish between the short-run and the long-run equilibrium. Would this increase in government spending affect the potential output? Why/Why not?

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Answer #1

With increase in government spending, aggregate demand rises. As a result, aggregate demand curve shifts to the right. This increases both equilibrium output level and general price level. With increase in general price level over a period of time, it would lead to demand pull inflation.

However, in the long run if output increases above its potential level, aggregate supply will fall and bring back the output to its potential level.

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