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Assume the economy is at a full-employment equilibrium. Now, if due to the pandemic, government increases...

Assume the economy is at a full-employment equilibrium. Now, if due to the pandemic, government increases spending to fight the virus, would this, ceteris paribus, be reflected as a change in aggregate demand or a change in aggregate supply? Explain. Be sure to clearly identify a textbook factor of AD or AS that is causing this change. Would this change be an increase or decrease? Explain.  Would this change result in the economy moving to a short-run below, or above, full-employment equilibrium?  Explain.  What do you predict will happen in the short-run to the equilibrium price level, the level of Real GDP and employment in the economy? Explain.

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Answer #1
  • When Government increases spending to fight the pandemic virus , other things being constant, There will be change In 'Aggregate Demand' or 'AD'.
  • This is so because AD = C+I+G+Xn.

Where C = consumption

I = INVESTMENT

G = Govt Spending

Xn = Net exports.

Now clearly a change in govt spending will affect the 'G' component of AD . Thus,. We see a change in AD.

  • Direction of change -: There will be an Increase in AD (due to increase in govt spending. Graphically this increase in AD is seen as a forward shift in AD curve.The logic is that when govt increases its spending ,there is an increase in money supply in the economy , thereby increasing the purchasing power of people. Further an increase in purchasing power will lead to increased demand by the people .
  • We can see the scenario in the following figure. Initially the economy is in full employment EQUILIBRIIM when Aggregate Demand= Short run Aggregate Supply= Long Run Aggregate Supply or AD = SRAS = LRAS.

-: An increase in Govt Spending will increase the AD from AD to AD1.

-: The new equilibrium point is at E1 and the Equilibrium output is Q1now. The prices have increased from P to P1 due to increase in Aggregate Demand.

-: We can see that the new short run equilibrium surpasses the Potential GDP or Full employment level (LRAS). This change results in Short run - above full employment EQUILIBRIIM.

  • Thus the short run prices will increase(from P to P1) , short run Real GDP will increase (from Q to Q1) and the short run employment will also increase (due to short run increase in output)

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