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Changes in Government Purchases

25 April, 2016 - 09:12

One policy through which the government could seek to shift the aggregate demand curve is a change in government purchases. We learned that the aggregate demand curve shifts to the right by an amount equal to the initial change in government purchases times the multiplier. This multiplied effect of a change in government purchases occurs because the increase in government purchases increases income, which in turn increases consumption. Then, part of the impact of the increase in aggregate demand is absorbed by higher prices, preventing the full increase in real GDP that would have occurred if the price level did not rise.

Figure 27.8 shows the effect of an increase in government purchases of $200 billion. The initial price level is P1 and the initial equilibrium real GDP is $12,000 billion. Suppose the multiplier is 2. The$200 billion increase in government purchases increases the total quantity of goods and services demanded, at a price level of P, by $400 billion (the $200 billion increase in government purchases times the multiplier) to $12,400 billion. The aggregate demand thus shifts to the right by that amount to AD2. The equilibrium level of real GDP rises to $12,300 billion, and the price level rises to P2.

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Figure 27.8 An Increase in Government Purchases

The economy shown here is initially in equilibrium at a real GDP of $12,000 billion and a price level of P1. An increase of $200 billion in the level of government purchases (ΔG) shifts the aggregate demand curve to the right by $400 billion to AD2. The equilibrium level of real GDP rises to $12,300 billion, while the price level rises to P2.

A reduction in government purchases would have the opposite effect. The aggregate demand curve would shift to the left by an amount equal to the initial change in government purchases times the multiplier. Real GDP and the price level would fall.