Question

Suppose the government undertakes an expansionary fiscal policy measure that raises aggregate demand but individuals incorrectly anticipate the measure, bias upward. What will the short-and long-run changes be in the price level and Real GDP?

Short answer

In the short run, expansionary fiscal policy results in an increase in both the price level and the Real GDP, especially when individuals anticipate more growth, causing an upward bias. However, in the long run, while the price levels might continue to increase (inflation), Real GDP will likely return to potential GDP as resources become fully employed.

Step-by-step solution

Understand Key Concepts

Expansionary fiscal policy refers to actions by the government, like increasing government spending or reducing taxes, aimed at stimulating the economy. This will generally lead to an increase in aggregate demand, which is the total quantity of goods and services the households, businesses, government, and foreign countries want to buy at any given level. Real GDP denotes the value of all goods and services produced in an economy, adjusted for inflation. An upward bias means people expect more growth than what is actually happening.

Analyze the Short-run Impact

In the short run, the expansionary fiscal policy will increase aggregate demand which will shift the aggregate demand (AD) curve to the right. Consequently, this will lead to an increase in both the price level and Real GDP. The prices rise (inflation) because more money chases after the same quantity of goods and services, while the Real GDP increases because more goods and services are demanded and therefore produced. Furthermore, due to the upward bias, individuals might spend more expecting growth in the economy, further increasing both Real GDP and the price level.

Analyze the Long-run Impact

In the long run, if the aggregate supply remains constant and the increase in aggregate demand is persistent, inflation will continue to rise. As for Real GDP, in the long term, it will return to potential GDP (also called full employment GDP) as resources in the economy are fully employed. The deviation from the potential GDP due to incorrect anticipation by individuals will also correct itself in the long run as the economy adjusts to its potential level.

Key concepts

Aggregate Demand

Aggregate demand represents the total demand for goods and services within an economy at a specific time and price level. It encompasses consumption by households, business investments, government spending, and net exports (exports minus imports).

Understanding aggregate demand helps us grasp how an economy's resources are utilized. In periods when aggregate demand is high, economies tend to produce more, leading to increased employment and output. Conversely, low aggregate demand can slow down economic activity.

• Government and personal consumption constitute a large part of aggregate demand.
• Investment from businesses influences demand through infrastructure development and new projects.
• Net exports can fluctuate based on foreign exchange rates and global economic conditions.

Expansionary fiscal policy aims to boost aggregate demand by increasing government spending or cutting taxes, encouraging more spending by consumers and businesses.

Real GDP

Real Gross Domestic Product (Real GDP) measures the value of all final goods and services produced within a country, adjusted for inflation. This adjustment makes Real GDP a reliable indicator of an economy's true performance over time.

Real GDP focuses on economic output without the distortion of price changes, providing a clear picture of growth or contraction. It is often used to compare economic performance against past years or between different economies.

• Adjusting for inflation ensures that the GDP figure represents actual productivity rather than changes in price level.
• An increase in Real GDP signifies economic growth, often leading to higher employment and wage levels.
• In contrast, a decline in Real GDP indicates an economic downturn or recession.

When the government employs expansionary fiscal policy, Real GDP can see a short-term rise due to increased economic activity and production.

Price Level

The price level refers to the average of current prices across the entire spectrum of goods and services produced in an economy. It is an indicator of inflation or deflation in an economy.

Changes in the price level can have far-reaching effects on both individual purchasing power and macroeconomic stability.

• Rising prices indicate inflation, which can erode consumer purchasing power if wages do not keep pace.
• Stable price levels tend to promote economic certainty and consistent growth as consumers and businesses can plan their finances effectively.
• Deflation, or a decrease in price levels, may lead to increased consumer saving and reduced production, as businesses lower output in response to declining demand.

Expansionary fiscal policy can lead to a higher price level in the short term, resulting in inflation as demand increases faster than supply.

Inflation

Inflation signifies the rate at which the general level of prices for goods and services rises, subsequently eroding purchasing power. It is often measured by the Consumer Price Index (CPI) or the Producer Price Index (PPI).

Inflation can be influenced by varying economic and monetary factors, including fiscal policies, supply chain disruptions, and market demand changes.

• Moderate inflation is generally seen as a sign of a growing economy, as it encourages spending and investment.
• Hyperinflation, however, can destabilize an economy and deter investment due to unpredictable spending power.
• Central banks often aim to keep inflation at a stable level to maintain economic confidence.

In the context of expansionary fiscal policy, higher aggregate demand can push prices upward, thus contributing to inflation, particularly if supply does not increase correspondingly.