Question Two

Consider an economy that is in equilibrium with output equal to potential, Y*. Then the government decreases its level of purchases (G). Assume this increase in G has no effect on long run growth (i.e. potential). a) Draw an ADfAS diagram illustrating the shortrun effects of this scal policy. b) On your diagram illustrate the effects of the automatic 'adjustment process', explaining why any curves shift, and identify the new long-run equilibrium in the economy