7 . Economic fluctuations I

The following graph shows a hypothetical economy in long-run equilibrium at an expected price level of 120 and a natural output level of $600 billion. Suppose the government increases spending on building and repairing highways, bridges, and ports.

Using the graph, shift the short-run aggregate supply (AS) curve or the aggregate demand (AD) curve to show the short-runimpact of the increase in government spending.

ADAS02004006008001000120024020016012080400PRICE LEVELOUTPUT (Billions of dollars)ADAS

In the short run, the increase in government spending on infrastructure causes the price level to the price level people expected and the quantity of output to the natural level of output. The increase in government spending will cause the unemployment rate to the natural rate of unemployment in the short run.

Again, the following graph shows a hypothetical economy experiencing long-run equilibrium at the expected price level of 120 and natural output level of $600 billion, prior to the increase in government spending on infrastructure.

Along the transition from the short run to the long run, price-level expectations will and the curve will shift to the .

Using the graph, illustrate the long-runimpact of the increase in government spending by shifting both the aggregate demand (AD) curve and the short-run aggregate supply (AS) curve in the appropriate directions.

ADAS02004006008001000120024020016012080400PRICE LEVELOUTPUT (Billions of dollars)ADAS

In the long run, due to the increase in government spending, the price level , the quantity of output the natural level of output, and the unemployment rate the natural rate.