National Income and AD/AS Analysis: Question 5

Worked solution

Part (a): Effect of the rise in G on the AD curve and on equilibrium

Aggregate Demand is $AD = C + I + G + (X-M)$, so government spending (G) is one of AD’s four components. A permanent increase in G, with C, I and $(X-M)$ unchanged, directly raises the amount of planned spending at every price level, so Meridia’s AD curve shifts to the right.

Holding the aggregate supply curve constant, a rightward shift of AD moves the equilibrium to a new point further up and to the right along the AS curve. In general, this raises both the equilibrium price level (there is upward pressure on prices as demand for output increases) and the equilibrium level of real output (firms respond to the extra demand by producing more).

Part (b): Discussing the extent to which the outcome depends on which LRAS section applies

The size of the price-level effect relative to the real-output effect of this same rightward AD shift depends heavily on how much spare capacity exists in Meridia’s economy beforehand - that is, which section of the three-part LRAS curve is currently relevant.

If Meridia is on the highly elastic (near-horizontal) section of LRAS - meaning there is considerable spare capacity, with unemployed labour and idle machinery - firms can respond to the extra government spending by putting these idle resources back to work without needing to bid up scarce inputs. In this case, the rise in AD mainly raises real output, with little or no rise in the price level: the infrastructure spending is close to “pure” extra growth.

If Meridia is on the upward-sloping middle section of LRAS - some spare capacity remains, but resources are becoming scarcer as the economy approaches full employment - firms can still expand output somewhat, but they increasingly compete for limited labour, materials and equipment. Here, the same rise in AD raises both real output and the price level together, with the balance between the two depending on exactly how tight the labour and resource markets have become.

If Meridia is already on the vertical section of LRAS - the economy is already at full employment and maximum productive capacity - no further real output can be produced no matter how much AD rises, since all resources are already fully employed. In this case, the entire effect of the extra government spending falls on the price level: Meridia experiences pure demand-pull inflation, with real output completely unchanged.

Overall, the extent to which this infrastructure programme raises Meridia’s real output rather than simply inflating its price level depends critically on how much spare capacity existed before the rise in spending, not on the size of the rise in G itself. The very same increase in government spending could be close to costless in terms of inflation if Meridia currently has significant spare capacity, or could be entirely inflationary with no growth benefit at all if Meridia is already producing at its productive limit - which is why identifying the economy’s starting position on the LRAS curve matters so much for judging the wisdom of demand-side stimulus policies such as this one.

Final answers

• (a) The rise in G shifts Meridia’s AD curve rightward; holding AS constant, this raises both the equilibrium price level and the equilibrium level of real output.
• (b) The balance between the price-level effect and the real-output effect depends on which LRAS section applies: mostly output, little price rise on the highly elastic section; both output and price level rise on the upward-sloping section; only the price level rises (pure inflation) on the vertical, full-employment section.