Using the aggregate supply and demand model, describe every step in the process of adjustment in the short and then long run of an economy when government spending decreases.

Essay by WilldrinkCollege, Undergraduate December 2004

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A decrease in government spending, or a leftward shift in the aggregate demand curve, will initially reduce total spending by the amount of the decrease. Because all spending becomes someone else's income, income will decrease. With less income, people will decrease consumption spending. Thus, the initial reduction in government spending will have a multiplied effect on total spending. Since spending is now less than output, inventories in investment will increase and businesses will have fewer incentives to produce. Aggregate quantity supplied will be greater than aggregate quantity demanded, and output and prices will fall as business try to sell of their excess inventories. These lower prices will cause aggregate quantity demanded to increase and aggregate quantity supplied to decrease. This process continues until the two are once again equal. A new short-term equilibrium will be reached at a lower price and quantity than before the decrease in spending.

The decrease in spending will also affect unemployment. As businesses lower output due to lower prices, the demand for labor will fall, and workers will be laid off. At the same time, lower prices will reduce inflation. In the long-run, the fall in demand for labor will reduce wages as laborers are willing to work for less. This will lower costs of production and aggregate supply will increase. This will lead to a decrease in prices and an increase in aggregate quantity demand. If prices are lower in the U.S., foreign demand for U.S. goods will increase and U.S. demand for foreign goods will decrease. Thus, exports will increase and imports will decrease, causing net export spending to increase. The real value of wealth will have increased for consumers since they can buy more goods and services for lower prices, and consumption spending will increase. Also, lower prices reduce the demand for money which causes interest rates to fall. Lower interest rates will cause investment spending to increase since the opportunity cost is less.

These three effects will increase total spending. Prices will start to rise again, along with aggregate supply. The demand for labor starts to increase and wages increase; however, wages will not increase as fast as they originally fell. Still, the economy will eventually return to the full-employment level of real GDP. Hence, the return to long-run equilibrium is a "natural adjustment."