Analyse The Effect Of The AS/AD Model

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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
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(Pan Pylas http://www.3news.co.nz/Survey-finds-Eurozone-recovery-slowing/tabid/417/articleID/322427/Default.aspx)

In conclusion the short run output can be above or below the natural level of production and therefore output is never the same as the natural level, as eventually production goes back to its natural level through changes in the price level in the medium to long term.
Fiscal policy is one of two tools the government use to manage the economy. It involves the use of borrowing, government spending and taxation to affect the growth of jobs, output and aggregate demand. This policy can be used to change people’s spending ways, distribute wealth and lastly a use of intervention to correct failures in the
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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

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