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Exercise: short and long run effects of a fiscal policy

 

You are in charge of the government budget for the year 2021. You are told that schools and public roads need to be updated, and you estimate an appropriate budget in order to carry out the task. Describe what will happen in the short run to the economy, and what type of inflation do we see? Describe the supply side effect from this policy, explain what happens in the long run. Assume that there is no crowding out effect.

  • First, note that updating public infractures, assuming taxes stay the same, will require an increase in government spending, which will also have an impact on the investment and consumption level in the economy (remember the spending multiplier?). Therefore, the aggregate demand curve will shift to the right. This will cause inflation (i.e positive change in the price level) and a higher output in the short-run. 
  • Note that if we were to assume a large crowding out effect, the short run aggregate supply curve would shift to the left (increase in production cost). However we can ignore this for now.
    • Since inflation is caused by an increase in the aggregate demand, this must be a demand-pull inflation.
  • This policy will have a supply side effect, better roads imply quicker transportation, trucks and cars will require less maintenance, and a better educated public force can be thought as being more productive workers (i.e they have more human capital). Therefore, we should expect the LRAS to shift to the right.
    • Note that the SRAS would also shift to the right, though it would be after the rightward shift in the AD curve. We can focus on the LRAS for the long run effect.

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Location: Boston, MA, USA

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