Chapter 32: Problem 8

Use the AD/AS model to show how increases in government spending can lead to more inflation.

Short Answer

Expert verified

In the AD/AS model, an increase in government spending shifts the AD curve to the right, resulting in a new equilibrium with a higher price level (\(P_2\)) and output level (\(Y_2\)). This increase in the price level represents inflation, as the demand for goods and services exceeds the initial output level, leading to higher prices.

Step by step solution

Draw the initial AD/AS diagram

Consider an economy in equilibrium, represented by the intersection of the AD and AS curves. Label the initial equilibrium price level as \(P_1\) and the initial equilibrium output level as \(Y_1\).

Identify the effect of increased government spending

An increase in government spending will lead to higher aggregate demand for goods and services in the economy. This will cause the AD curve to shift to the right, as there is now a higher quantity of goods and services demanded at each given price level.

Draw the new AD curve

Shift the AD curve to the right to represent the increase in government spending. Label the new AD curve as AD\(^\prime\).

Find the new equilibrium

Locate the new intersection point between the AS curve and the new AD\(^\prime\) curve. This is the new equilibrium resulting from the increased government spending. Label the new equilibrium price level as \(P_2\) and the new equilibrium output level as \(Y_2\).

Compare the initial and new equilibrium

The new equilibrium price level, \(P_2\), is higher than the initial equilibrium price level, \(P_1\). This increase in the price level is inflation. Additionally, the new equilibrium output level, \(Y_2\), is higher than the initial equilibrium output level, \(Y_1\), indicating an expansion in the economy. In conclusion, using the AD/AS model, we have shown that an increase in government spending can lead to more inflation as the increase in aggregate demand shifts the AD curve to the right, resulting in a higher equilibrium price level and output level.