The graph below shows the aggregate demand (AD) and short-run aggregate supply (

Question

The graph below shows the aggregate demand (AD) and short-run aggregate supply (SRAS) curves for an economy. Assume that the economy is initially in short-run and long-run equilibrium at $6 trillion. That is, the economy potential output is $6 trillion per year. Assume that the economy is not experiencing long-run growth and that workers and firms expect the initial price level (150) to remain the same. What is the IONG-RUN effect of an increase in government spending at full employment. First, shift one of the curves to show the short-run response to the increased government spending. Then, shift one of the curves to show the long-run response to higher government spending.

Explanation / Answer

Assuming we are at full employment, initially an increase in government spending will move the AD curve to the right, increasing real GDP and the price level. The increase in the price level will increase resource prices, causing an eventual shift of the SRAS curve to the left and a return to prior full employment GDP at the higher price level.

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