CH 13 - Changes in Government Purchases Figure 1...

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Unformatted text preview: Changes in Government Purchases Figure 1 illustrates the shortrun effects of a reduction in government purchases. The IA line does not shift, so the decrease in government purchases will result in a shift in the AD curve to the left. The intersection between the new AD line and the IA line determines the shortrun GDP level, which is now below potential GDP. ShortRun Effects of a Reduction in Government Purchases Changes in Government Purchases Over time, the inflation rate will decrease and the IA line will shift downward because the economy is producing below the potential GDP. The next graph illustrates the dynamic adjustment in real GDP after a reduction in government purchases. In the figure, the IA line in the medium run (MR) is lower than that in the short run, while the IA line in the long run (LR) is lower than that in the medium run. Dynamic Adjustment After a Reduction in Government Purchases Dynamic Adjustment After a Reduction in Government Purchases Changes in Government Purchases The bottom graph of Figure 2 illustrates the effects of the same change in government purchases to real GDP over time. Note: The return to potential GDP on the bottom graph corresponds to the return to the longrun GDP on the top graph. Details of the Components of Spending The following table provides details on the change in each component of the real GDP in the short run and in the long run, when there is a reduction in government purchases. The arrows in the figure indicate what happens compared with what would have happened in the absence of a change in government purchases. More Detailed Analysis of a Reduction in Government Purchases Details of the Components of Spending In the short run, the decrease in government purchases has the following effects: A decrease in real GDP No change to investments, because real interest rates are unchanged in the short run A decrease in consumption, because consumption spending is positively related to real GDP An increase in net exports, because imports are negatively related to real GDP Details of the Components of Spending In the long run, the decrease in government purchases has the following effects: A return of the real GDP level to the potential GDP level Higher consumption, investment, and net exports than before the drop in government spending, because interest rates decreased to bring the economy back to potential GDP Details of the Components of Spending The decrease in government spending that results in higher investment spending can also encourage faster growth in the potential GDP in the long run. This situation is illustrated by the steeper potential GDP curve in the long run shown in Figure 4. Figure 4: Increase in the LongTerm Growth After a Recession Caused by a Decrease in Government Purchases er ep ste e op sl Changes in Monetary Policy Disinflation: a reduction in the inflation rate. Example: The interest rate decreases from 10 percent to 3 percent. Deflation: a decrease in the overall price level (or a negative interest rate). Example: The CPI (or any other measure for the general price level) decreases from 140 to 130. Changes in Monetary Policy A change in the monetary policy toward inflation will shift the AD curve to the right. A change in the monetary policy toward disinflation will shift the AD curve to the left. Changes in Monetary Policy Figure 5 illustrates the effects on the economy in the short run, medium run, and long run of a change in the monetary policy toward disinflation. In the short run, the AD curve will shift to the left. The intersection between the IA curve and the new AD curve will determine the equilibrium GDP. Figure 5: Disinflation: A Transition to Lower Inflation Changes in Monetary Policy If the disinflation is small and gradual, then the decline in real GDP could result in a temporary growth slowdown. In a temporary growth slowdown, the real GDP growth does not turn negative. Changes in Monetary Policy In the medium run, the IA curve will shift downward and inflation will decline as the real GDP falls below the potential GDP. This situation is illustrated in Figure 5 as a drop in the IA line (MR). In the long run, the intersection between the IA (LR) run and the new AD curve is at the potential GDP, and the economy has fully recovered. Figure 5: Disinflation: A Transition to Lower Inflation The Volcker Disinflation The scenario illustrated in Figure 5 is very similar to the disinflation that occurred in the United States in the early 1980s, when Paul Volcker was Fed Chairman. The real GDP fell below potential GDP, and the unemployment rate rose to 10.8 percent. By 1982, recovery was on its way. By 1985, the economy was near its potential. Reinflation and the Great Reinflation Reinflation: an increase in the inflation rate caused by a change in monetary policy. Great Reinflation: a period in the 1960s and 1970s when the Fed and other central banks around the world allowed inflation rates to increase. Price shocks Demand shock: a shift of the components of the aggregate demand curve that leads to a shift in the aggregate demand curve. Price shock: a change in the price of a key commodity such as oil, usually because of a shortage, that causes a shift in the inflation adjustment line. The Effects of Price Shocks Figure 6 illustrates the effect of a price shock that results in an upward shift in the IA line. The price shock can be caused by an increase in the price of oil or other commodities. A Price Shock The Effects of Price Shocks Short run: The upward shift in the IA line results in a real GDP lower than the potential GDP. Because the GDP is below its potential, the inflation rate decreases. Medium run: The lower inflation rate causes the economy to grow. Long run: The economy returns to potential GDP. Stagflation Stagflation: a situation in which both high inflation and high unemployment occur simultaneously. Figure 6: A Price Shock Key Terms disinflation deflation reinflation demand shock price shock stagflation ...
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This note was uploaded on 06/01/2010 for the course ECONOMICS STA2012 taught by Professor Fan during the Spring '10 term at A.T. Still University.

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