Using the aggregate supply and demand model, describe every step in the process of adjustment in the short and then long run of an economy when government spending decreases.
Date Submitted: 09/09/2006 23:00:17
Category: / Social Sciences / Economics
Length: 1 pages (386 words)
Category: / Social Sciences / Economics
Length: 1 pages (386 words)
A decrease in government spending, or a leftward shift in the aggregate demand curve, will initially reduce total spending by the amount of the decrease. Because all spending becomes someone else's income, income will decrease. With less income, people will decrease consumption spending. Thus, the initial reduction in government spending will have a multiplied effect on total spending. Since spending is now less than output, inventories in investment will increase and businesses will have fewer …
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…interest rates will cause investment spending to increase since the opportunity cost is less.
These three effects will increase total spending. Prices will start to rise again, along with aggregate supply. The demand for labor starts to increase and wages increase; however, wages will not increase as fast as they originally fell. Still, the economy will eventually return to the full-employment level of real GDP. Hence, the return to long-run equilibrium is a "natural adjustment."
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