Intermediate Macroeconomics

Fiscal Contraction
Effect of reduction in budget deficit through a fall in G in the short and medium
run.
• Initial equilibrium is at point A = Yn , Pe
• Now government reduces G → AD shifts to AD’
New equilibrium is at A’ = Y’P’ implying output and prices both falls.
There is a recession in the short run
Adjustment process to medium run equilibrium.
• At A’ P < Pe
Workers revise Pe downwards so that wages fall, prices fall and AS shifts
down.
• We move down along AD’ towards Yn.
• The process continues till AS shifts to AS’’ and equilibrium is at A’’. Here
Y = Yn and P = P’’ = Pe
Conclusion – Fiscal contraction only gives us a temporary recession but otput
returns to Yn in the medium run.
Dynamic Effects of decrease in G on output and interest rate
We examine the same process in terms of IS – LM curves to see how interest
rate changes.
• The figure has two parts :
1. The upper panel is the same AS – AD diagram without AS’’ curve.
2. This lower panel shows the same process in terms of IS – LM
curves
▪ Initial equilibrium is at A which is equal to Yn, i.
▪ Fall in G shifts to IS’ and the new equilibrium is at A’ which
is equal to Y’, i’.
▪ Note that at A’ the LM has shifted to LM’ because in the
short run the price has fallen so that M/P has fallen. So,
M/P has risen shifting LM right to LM’.
▪ IS’ and LM’ intersect at A’
This is the short run equilibrium which is the same as the A’ in upper figure.
Note that output and interest rate have both fallen.
In case P had remained constant, the IS’, LM intersection would have been at
B. But the AD has shifted down and the price change moving us to LM’ and A’.

From Short Run to Medium Run

• At A’, Y’ < Yn and P < Pe so that Pe declines and prices fall
• Real money supply increases and the LM shifts rightwards until reaches
LM’’
• IS’ and LM’’ give us A’’ which is final equilibrium where Y = Yn and
interest rate is i’’
• Increase in M/P reduces small interest rate i → AD and Y increases to Yn
Conclusion – A fall in G reduces interest rate but leaves output unaffected
in the medium run.

Effect on investment
a) Short Run → A fall in G reduces Y and also reduces interest rate i
A fall in Y incereases investnemt
 A fall in i reduces investment
Net effect on investment uncertain

b) Medium Run →
Yn = C (Yn – T) + I (Yn, i) + G
Y is constant at Yn so C is constant
Interest rate has fallen so, that investment I will rise, given
Y = Yn.
G has fallen by policy
Conclusion – A fall in G increases investment by the same amount in medium
run.