Question

Assume the government significantly increases spending for infrastructure, and taxes and interest rates do not change as a result of the spending. How will that change in government spending affect aggregate demand, short-run aggregate supply, the price level, and real GDP?

Answer 1

Answer:

Explanation: There is a high possibility that the rise in taxes will negate the impact of rising government spending which would leave Aggregate Demand (AD) unchanged. However, it is possible that increased spending and rise in tax could lead to an increase in GDP.

In a recession, consumers may reduce spending leading to an increase in private sector saving. Therefore a rise in taxes may not reduce spending as much as usual.

The increased government spending may create a multiplier effect. If the government spending causes the unemployed to gain jobs then they will have more income to spend leading to a further increase in aggregate demand. In these situations of spare capacity in the economy, the government spending may cause a bigger final increase in GDP than the initial injection.

However, if the economy is at full capacity, the increase in government spending would tend to crowd out the private sector leading to no net increase in Aggregate demand from switching from private sector spending to government sector spending.