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Suppose a government moves to reduce a budget deficit. Using the long-run model of the economy developed in Chapter 3, graphically illustrate the impact of reducing a government's budget deficit by reducing government purchases. Be sure to label: i. the axes, ii. the curves; iii. the initial equilibrium values; iv. the direction curves shift; and v. the terminal equilibrium values
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To graphically illustrate the impact of reducing a government's budget deficit by reducing government purchases, you will need to use the long-run model of the economy. Here are the steps to follow:
Step 1: Set up the axes
On the graph, you will have two axes: the horizontal axis represents the quantity of output (real GDP), while the vertical axis represents the overall price level (price index or inflation rate).
Step 2: Plot the initial equilibrium values
Before any changes are made, identify the initial equilibrium values of real GDP and the price level. Mark this point on the graph as "Equilibrium A", represented by an intersection point between the aggregate demand (AD) curve and the aggregate supply (AS) curve.
Step 3: Label the curves
The AD curve represents the aggregate demand, while the AS curve represents the aggregate supply. Label these curves accordingly on the graph.
Step 4: Indicate the direction of curves' shift
Since the government is reducing its purchases to reduce the budget deficit, this change will impact the aggregate demand curve. Specifically, a reduction in government purchases will cause a leftward shift of the AD curve. Indicate this shift on your graph, with an arrow pointing to the left, labeled as "AD1."
Step 5: Determine the terminal equilibrium values
With the AD curve shifting leftward, the new equilibrium point will be reached where the AD1 curve intersects the AS curve. Mark this point as "Equilibrium B" on the graph, representing the new terminal equilibrium values of real GDP and the price level.
Step 6: Label the terminal equilibrium values
Using labels or annotations, indicate the new real GDP and price level at "Equilibrium B" on the graph.
By following these steps, you will be able to graphically illustrate the impact of reducing a government's budget deficit by reducing government purchases using the long-run model of the economy.