Question

Suppose the economy is at potential GDP (i.e. full employment), and the government increases the amount of government purchases to increase aggregate demand. What can be one potential drawback of this fiscal approach? Use graphs to explain where relevant.

Answer 1

If the economy is already at potential GDP, no further policy changes need to be made.

However, if the government decides to increase purchases, and hence increase AD, the following changes take place:

• AD curve shifts to the right.
• LRAS and SRAS don't change
• At the new intersection of AD and SRAS, price level is higher, short run GDP is higher, employment level is higher

Thus, the main drawback is that there will be inflation in the economy, which will have to be controlled.

In the diagram, LRAS denotes the long run AS, with GDP level Y*. Due to the government policy, AD shifts to AD".

This raises the price level from P to P", and GDP level from Y* to Y".

In the long run, GDP will return to Y*.

In the short run, there will be higher inflation.