The diagram below is for a closed economy which begins in long-run equilibrium at Y* and . FIGURE 31-3 Refer to Figure 31-3.Suppose the government implements an expansionary fiscal policy,which increases the budget deficit.The economy's adjustment process returns real GDP to Y* in the long run.Since real GDP is not affected in the long run,how are future generations likely to be harmed by this government policy?

Question

The diagram below is for a closed economy which begins in long-run equilibrium at Y* and  .  FIGURE 31-3 Refer to Figure 31-3.Suppose the government implements an expansionary fiscal policy,which increases the budget deficit.The economy's adjustment process returns real GDP to Y* in the long run.Since real GDP is not affected in the long run,how are future generations likely to be harmed by this government policy?

Quizplus · Accepted Answer

An expansionary fiscal policy leads to an increase in aggregate demand, causing a short-run increase in output and prices. However, in the long run, prices and wages adjust, and the economy returns to its potential output level, represented by Y*. If the increase in government spending is not accompanied by an increase in taxes or a reduction in government spending elsewhere, it will lead to an increase in the budget deficit. This may lead to an increase in interest rates, which will lead to a decrease in private investment. Therefore, the increase in government spending may lead to a crowding out effect on private investment, which may harm future generations by reducing the future growth rate of potential GDP.

The Diagram Below Is for a Closed Economy Which Begins