Question

Show the effect of expansionary fiscal policy on output and prices in the following cases for an open economy: a. Short run b. Long run

Answer 1

Expansionary fiscal policy raises government spending and reduce tax such that it raise disposable income of consumers and tends to raise aggregate demand in the economy. In short run, it will shift the aggregate demand curve to its right which raise price from P to P1 and raise output from Y to Y1.

In short run, rise in aggregate demand will raise rate of interest. It will raise cost for producers for their new investments which will shift aggregate supply to its left from S to S1 which will also maintain output at its natural level. In long run run price will rise further while output level remains at its natural level.