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Given an economy operating in a state of long-run equilibrium
Given an economy operating in a state of long-run equilibrium. This economy suddenly faces unstable security situation that led the government to announce and finalize a deal to buy new fighter planes and missiles.
a. Show the effect of this economic policy on the whole economy in words and graph using AD-AS model.
b. What should governments do to stabilize the economy using the tax fiscal policy instrument, indicate what should be done? Show the effect of your suggested policy in words and graph of the AD-AS model?
Expert Solution
a). Answer:
An economy operating in a state of long-run equilibrium. This economy suddenly faces unstable security situation that led the government to announce and finalize a deal to buy new fighter planes and missiles. Increasing spending on defense will not directly affect the economy of the ecountry.Defence spending affect indirectly through decreasing the risk and provide stability, and its a large amount of government spending so, it will increase income level in the economy. Increasing AD will increase Price level and real GDP or output level.
Graphical Representation:
The economy operating in a state of long-run equilibrium at the point E1. Now you can see how increasing government spending on defense increase AD and AD curve shift right from AD1 to AD2 that increased price and output from P1 to P2 and Q1 to Q2 respectively. The new equilibrium point is E2.
b). Answer:
We have seen above that increasing government spending on defense increase level that increase AD and increasing AD increase price level. So, here the government will increase taxes that will decrease disposable. Decreasing disposable level will decrease AD and decreasing AD will decrease price level and stabilized economy.
Graphical Representation:
The economy operating in a state of long-run equilibrium at the point E1. Now you can see how increasing government spending on defense increase AD and AD curve shift right from AD1 to AD2 that increased price and output from P1 to P2 and Q1 to Q2 respectively. Now increasing taxes decrease AD curve left to AD3. Here prices and GDP both decrease. Over time, wages decrease and as they do, the SRAS shifts to the right due to the increase in firms’ cost of production. The SRAS continues to shift until GDP has returned to potential. Now the economy operating in a state of long-run equilibrium at the point E4.
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