Question

You are a member of parliament in Iran. Iran is suffering from rising prices and a recession. The government is debating whether the government should undertake a stimulus bill (increase government spending) or austerity (decrease government spending).

a.     Explain what will happen to aggregate demand, inflation and unemployment in the short run if government spending increases (3 points).

b.     Explain what will happen to aggregate demand, inflation and unemployment in the short run if government spending decreases (3 points).

Answer 1

In each graph, initial equilibrium is at point A where AD0 (initial aggregate demand) and SRAS0 (initial short-run aggregate supply) curves intersect, with initial equilibrium price level P0 and real GDP Y0.

(a) An increase in government spending increases aggregate demand, which will shift the AD curve to right, which increases both price level (increasing inflation) and real GDP in short run. Higher real GDP will reduce unemployment in short run.

In following graph, increase in aggregate demand shifts AD0 to right to AD1, intersecting SRAS0 at point B with higher price level P1 and higher real GDP Y1.

(b) A decrease in government spending decreases aggregate demand, which will shift the AD curve to left, which decreases both price level (decreasing inflation) and real GDP in short run. Lower real GDP will increase unemployment in short run.

In following graph, decrease in aggregate demand shifts AD0 to left to AD1, intersecting SRAS0 at point B with lower price level P1 and lower real GDP Y1.