In the AS/AD model, consider an economy where the level of production is below the natural level. Would the economy stay forever in this position? Explain the adjustment process in the economy. Suggest a fiscal policy to increase output. Analyse the effect of this macro‐policy on the price level, employment and fiscal deficit. (1500 words)
The natural level of production is determined by an economy’s supply potential. In the short run an economy is usually above or below the natural rate of production. This is because the natural level of output doesn’t come into play as we are in the short run and this means that we have one factor of production; be it labour or capital that is fixed. See figure 1.1.
(Figure 1.1 taken from Page …show more content…
However there are now ideas used by fiscal policy other than demand management such as the distribution of wealth and fixing free market failures such as externalities.
There are a few ways in which an expansionary fiscal policy method can increase the output of the economy. These can be done simultaneously or one at a time depending on the impact the government would like to have.
A method of what the government can do is increase government spending. This can be done with money being spent on infrastructure and schools. An increase in government spending leads to an increase in demand for goods and service leading to an increase in output. We know that private consumption is a function of the level of output and therefore if there is an increase in output consumption increases through people getting paid more for the increase of output. As well as this, investment is also determined by the level of output, for example if a firm realises that they are consistently having to put people on overtime to keep up with output they will then start to invest more into more workers or machinery to keep up with this increase in …show more content…
At an output of Y1, i1, to a new equilibrium at Y2,i2.
The extent of the increase of spending affecting the deficit depends on the current budget of the government. As an increase in spending on a budget surplus would have less consequences compared to an increase of budget deficit. As a deficit leads to fiscal crowding out; where the government borrows from the private sector leading the private sector to have less to spend and invest; leading to higher interest rates leading to a further reduction in investment spending.
When government spending occurs employment tends to increase. This is because as producers respond to government demand production from firms increase; leading to a requirement of more labour. This effect is multiplied as those newly employed start spending money their wages and therefore more demand is created and therefore producers respond by providing more goods and services leading to a multiplying cycle.
Regarding the price level of the macroeconomic policy we can determine that due to the government spending an increase in the aggregate demand occurs which increases the price of the goods and services sold. See Figure
The natural level of production is determined by an economy’s supply potential. In the short run an economy is usually above or below the natural rate of production. This is because the natural level of output doesn’t come into play as we are in the short run and this means that we have one factor of production; be it labour or capital that is fixed. See figure 1.1.
(Figure 1.1 taken from Page …show more content…
However there are now ideas used by fiscal policy other than demand management such as the distribution of wealth and fixing free market failures such as externalities.
There are a few ways in which an expansionary fiscal policy method can increase the output of the economy. These can be done simultaneously or one at a time depending on the impact the government would like to have.
A method of what the government can do is increase government spending. This can be done with money being spent on infrastructure and schools. An increase in government spending leads to an increase in demand for goods and service leading to an increase in output. We know that private consumption is a function of the level of output and therefore if there is an increase in output consumption increases through people getting paid more for the increase of output. As well as this, investment is also determined by the level of output, for example if a firm realises that they are consistently having to put people on overtime to keep up with output they will then start to invest more into more workers or machinery to keep up with this increase in …show more content…
At an output of Y1, i1, to a new equilibrium at Y2,i2.
The extent of the increase of spending affecting the deficit depends on the current budget of the government. As an increase in spending on a budget surplus would have less consequences compared to an increase of budget deficit. As a deficit leads to fiscal crowding out; where the government borrows from the private sector leading the private sector to have less to spend and invest; leading to higher interest rates leading to a further reduction in investment spending.
When government spending occurs employment tends to increase. This is because as producers respond to government demand production from firms increase; leading to a requirement of more labour. This effect is multiplied as those newly employed start spending money their wages and therefore more demand is created and therefore producers respond by providing more goods and services leading to a multiplying cycle.
Regarding the price level of the macroeconomic policy we can determine that due to the government spending an increase in the aggregate demand occurs which increases the price of the goods and services sold. See Figure