Question

If, rather than being upward sloping, the short-run aggregate supply (SRAS) curve were a horizontal line at the current price level, what would be the effect on the size of the government purchases and tax multipliers? Briefly explain.

Short answer

If the short-run aggregate supply (SRAS) curve were a horizontal line at the current price level, then both the government purchases and tax multipliers would be larger. This is because, when the SRAS curve is horizontal, changes in government purchases and taxes can cause larger changes in aggregate demand without any change in the price level.

Step-by-step solution

Understanding the Concept of Aggregate Supply

The aggregate supply curve shows the total quantity of output—real GDP—that firms will produce and sell at each price level. The short-run aggregate supply (SRAS) curve shows the relationship in the short run between the price level and the quantity of real GDP supplied by firms. When the SRAS curve is upward sloping, it means that when the price level rises, the quantity of real GDP supplied also rises.

Understanding the Concept of SRAS as a Horizontal Line

When the SRAS curve is a horizontal line at the current price level, it means that changes in the price level do not affect the quantity of real GDP supplied by firms. In other words, firms are willing to supply the same amount of real GDP at any price level.

Calculating the effect on the Government Purchases

The government purchases multiplier is the change in aggregate demand that results from a change in government purchases. When the SRAS curve is horizontal, the government purchases multiplier is large because an increase in government purchases will lead to a larger increase in aggregate demand. This is because the level of output can increase without any increase in the price level.

Calculating the effect on the Tax Multipliers

The tax multiplier is the change in aggregate demand that results from a change in taxes. When the SRAS curve is horizontal, the tax multiplier is large in absolute value because a change in taxes will lead to a larger change in aggregate demand. Again, this is because any change in taxes can lead to an increase in output without any increase in price level.

Key concepts

Government Purchases Multiplier

The government purchases multiplier encapsulates how much aggregate demand changes due to a shift in government spending. Imagine a scenario where the government decides to invest more money into infrastructure. This influx of spending, according to the multiplier concept, can lead to a more than proportionate change in aggregate demand.

In an ideal situation where the short-run aggregate supply (SRAS) curve is upward sloping, increases in government purchases spur higher aggregate demand which typically results in a higher price level and more output. However, when the SRAS is horizontal, firms are ready to supply more output without needing to raise prices. Thus, any increase in government spending translates directly to a substantial increase in real GDP.

• This results in a large government purchases multiplier.
• The output can increase significantly with government expenditure.
• No corresponding rise in prices occurs.

This amplified multiplier effect is crucial in understanding how fiscal policy can be used effectively in different economic scenarios.

Tax Multiplier

Similar in concept to the government purchases multiplier, the tax multiplier measures how changes in taxation shift aggregate demand. Unlike government spending, a reduction in taxes increases disposable income, encouraging more consumer spending, which then boosts aggregate demand.

This effect is particularly pronounced when the SRAS curve is horizontal. Since firms can increase output without price hikes, the influence of reduced taxes leads to a much larger change in real GDP. The tax multiplier consequently becomes larger in absolute value.

• A decrease in taxes heavily stimulates aggregate demand.
• More output is produced without affecting price levels.
• Encourages consumption as disposable income rises.

With this backdrop, tax policies can be utilized more effectively to stabilize an economy particularly when the SRAS is horizontal.

Real GDP

Real GDP stands for Real Gross Domestic Product. It is a measurement of a country's economic output adjusted for price changes (inflation or deflation). By focusing on real instead of nominal values, real GDP provides a more accurate reflection of an economy’s output and growth.

In the short run, real GDP can fluctuate due to changes in aggregate demand and aggregate supply. When an SRAS curve is horizontal, any changes in aggregate demand, such as those brought on by government spending or tax adjustments, result in significant changes in real GDP without altering the price level.

• Provides a true measure of economic performance.
• Reflects changes in output adjusted for price levels.
• Sensitive to fiscal policy effects, like those from multipliers in a horizontal SRAS scenario.

Understanding real GDP and its dynamics is essential for grasping how fiscal policy interventions can influence economic conditions effectively.