Question

Suppose the current administration decides to decrease government expenditures as a means of cutting the existing government budget deficit.

1. Using a graph of aggregate demand and supply, show the effects of such a decision on the economy in the short run. Describe the effects on inflation and output.
2. What will be the effect on the real interest rate, the inflation rate, and the output level if the Federal Reserve decides to stabilize the inflation rate?

Short answer

1. The diagram displaying the effect of a decrease in authorities expenditure at the financial system in a brief run is as follows:
2. If the Federal Reserve comes to a decision to stabilize the inflation price, it's going to bring about the lower real interest rate with every and each inflation price.

Step-by-step solution

Part (a) Step 1: Concept Introduction

The total amount spent by the government on investments, consumption, research and development, and switch fees is referred to as government expenditure.

The total demand for goods and services in the financial system at a specific rate stage during a given time period is known as the combination demand.

The sum of the amount of production that all enterprises in the economy are likely to supply at a particular price level at some point in a certain time frame is known as combination deliver.

Part (a) Step 2: Explanation

The diagram displaying the effect of a decrease in authorities expenditure on the financial system in a brief run is as follows:

Where,

- LRAS is the long-run aggregate supply curve

- SRAS is the short-run aggregate supply curve

- AD is the aggregate demand.

- e shows the intersection point.

According to the combined demand and supply analysis, the aggregate demand curve shifts leftwards, from advert to AD1, as the government's expenditure lowers with each fee of inflation because aggregate expenditure decreases with each fee of inflation. Following the leftward shift of the aggregate demand curve, a new intersection factor with the quick-run aggregate deliver curve is generated at e1. This new intersection factor indicates a low output stage and a lower inflation rate. At this new breakpoint, the inflation rate is lower than what was previously targeted, yet the output is also below the expected level.

Part (b) Step 1: Concept Introduction

Inflation is the rate at which prices rise over time, resulting in a decrease in the purchasing power of money.

Actual interest prices refer to the price at which creditors receive interest after adjusting for inflation.

The number of products and services produced in the financial system within a given time period is referred to as output level.

Part (b) Step 2: Explanation

If the Federal Reserve decides to stabilize the inflation rate, it will result in a fall in the actual interest rate with each increase in the rate of inflation. The aggregate demand curve will move to the appropriate to its capacity equilibrium point as a result of the lower real incomes. The inflation rate might be reduced to its targeted factor at this equilibrium point, and output will be restored to its expected level.

Part (b) Step 3: Final answer

If the Federal Reserve decides to keep inflation stable, every inflation price will result in a lower real interest rate.