Run Equilibrium the Aggregate Supply

¶ … Run Equilibrium The aggregate supply -- aggregate demand (as-AD) framework can be used to explain the impact of fiscal expansion on the economy. The as-AD framework shows that when government spending increases, the level of aggregate demand increases in the short run. This results in a higher GDP as aggregate demand moves upwards on the aggregate supply line. The increase in demand spurs an increase in supply (Moffatt, 2010). How this works depends on the type of stimulus.

If the government creates jobs directly (such as hiring 500,000 workers to take a census) then the bulk of this increased demand comes from the wages that these formerly unemployed workers can now spend. If the government increases purchases (for example increasing DOD spending) then the increase in supply is the result of firms increasing production in order to meet government orders. In either case, aggregate supply is increased.

It can be argued that an increase in government job creation will be diluted since consumption increase may include both domestic and imported goods. Increasingly, that is also the case with government purchases as well, as even domestic companies outsource. It is also worth considering the side impacts that the models does not address, such as the source of the government spending.

If government spending comes from debt, the increase in government spending must have a multiplier effect that will increase tax receipts by a large enough amount to cover the additional interest. The multiplier effect would occur when, for example, government purchases lead to an increase in hiring and investment. The hiring would then lead to an increase in consumer spending, which could encourage other businesses to increase their hiring as well.

The increased business investment could allow companies to develop processes, technology and capacities that will allow them to not only increase their presence in domestic markets but to increase their exports as well. The Keynesian as-AD model assumes that this multiplier will result in an increase in aggregate demand and aggregate supply, if governments increase spending.

For the government, the multiplier is expected to decrease with the size of the investment, so the ideal amount of spending is not infinite, but is constrained by a declining multiplier, which would lead to an equilibrium level of government spending. The as-AD model illustrates another reason by government spending cannot.