Question

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

Short answer

In the AD/AS model, an increase in government spending shifts the Aggregate Demand (AD) curve to the right, leading to a new equilibrium point with higher real GDP and price level. The impact on inflation depends on the slope of the Aggregate Supply (AS) curve. If the AS curve is relatively flat, the increased government spending results in a small increase in inflation. Conversely, if the AS curve is steep, the increased government spending leads to a significant increase in inflation.

Step-by-step solution

1. Understand the AD/AS model

The Aggregate Demand (AD) curve represents the total demand for all goods and services in an economy at various price levels. It shows the relationship between the price level (inflation) and the quantity of goods and services demanded, which is measured in real GDP. The Aggregate Supply (AS) curve represents the total supply of goods and services that firms in an economy are willing and able to produce over different price levels. The intersection of the AD and AS curves signifies the equilibrium point, where real GDP and the price level are in balance.

2. Increase in government spending

An increase in government spending directly increases the aggregate demand in an economy. This occurs because government spending is one of the components of aggregate demand, the others being consumption, investment, and net exports. Increased government spending raises total demand for goods and services, thus, shifting the AD curve to the right.

3. Effects on aggregate demand and aggregate supply

When the AD curve shifts to the right due to increased government spending, it intersects the AS curve at a new equilibrium point. This new point represents a higher level of real GDP, indicating an expansion in economic activity. However, the increase in aggregate demand can also lead to a higher price level, which means higher inflation.

4. Analyzing the impact on inflation

The effect of increased government spending on inflation depends on the slope of the AS curve. If the AS curve is relatively flat, the increase in AD will lead to a higher real GDP with only a small increase in the price level. This means that the inflation rate will not rise significantly. On the other hand, if the AS curve is steep, the increase in AD will lead to a much higher price level, indicating a significant increase in inflation. To summarize:

Step 1

: Understand the AD/AS model and how aggregate demand and supply interact to determine the equilibrium price level and real GDP.

Step 2

: Increase government spending, which shifts the AD curve to the right.

Step 3

: Determine the new equilibrium point between the shifted AD curve and the AS curve, which indicates the effect on real GDP and the price level.

Step 4

: Analyze the impact of the increased government spending on inflation, taking into consideration the slope of the AS curve.