Explain how an expansionary government budget (higher expenditure and lower taxes) can affect aggregate demand and price level in the short run. Discuss any two possible side‑effects.
Answer
An expansionary budget raises aggregate demand through higher government spending and increased disposable income, shifting the AD curve rightward and raising output and price level in the short run; side‑effects may include crowding out of private investment and rising inflationary pressures.
Step-by-step solution
- State the components of an expansionary budget: increase in G and/or decrease in T.
- Explain the direct effect on aggregate demand: higher G raises AD; lower T raises consumption, further raising AD.
- Show the AD curve shifting rightward, leading to higher equilibrium output (Y) and price level (P) in the short run.
- Identify side‑effect 1 – crowding out: higher government borrowing can raise interest rates, reducing private investment.
- Identify side‑effect 2 – demand‑pull inflation: increased AD can push the price level up if the economy is near full capacity.
- Conclude that while short‑run output rises, the side‑effects may offset some benefits.
Common mistake: Ignoring possible crowding‑out or assuming price level remains unchanged.
Concept tested: Impact of expansionary fiscal policy
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