Suppose the economy is in long-run equilibrium. Parliament passes regulations that make it more costly to conduct business, so the long-run aggregate supply curve shifts $80 billion to the left. At the same time, government purchases increase by $60 billion. If the MPC equals 0.75 and the crowding-out effect is $70 billion, what would we expect to happen in the long run to real GDP and the price level?

Question

Quizplus · Accepted Answer

The regulations increase costs, so the LRAS curve shifts left by $80 billion, leading to a decrease in real GDP. Government purchases increase by $60 billion, which will shift the AD curve right by $60 billion * (1/0.75) = $80 billion, exactly offsetting the leftward shift in the LRAS curve. Therefore, in the short run, real GDP will remain unchanged. However, the increase in government spending will increase interest rates and reduce investment spending by $70 billion, leading to a decrease in AD in the long run. Since the leftward shift in the LRAS curve is not offset by the decrease in AD, real GDP will decrease. The increase in government spending will also increase aggregate demand, leading to an increase in the price level. Therefore, real GDP would be lower, but the price level would be higher.

Suppose the Economy Is in Long-Run Equilibrium