Graph of Short Run Aggregate Supply, Long Run Aggregate Supply, and Aggregate Demand:

In a long-run equilibrium with full employment, the economy operates at its potential output (Y*) and experiences a stable price level (PL*). Let’s start by drawing the graph with short-run aggregate supply (SRAS), long-run aggregate supply (LRAS), and aggregate demand (AD).

Long Run Equilibrium (LR)

LRAS curve represents the potential output (Y*), which is the economy’s productive capacity when all resources are fully employed.

AD curve intersects the LRAS curve at point A, indicating the long-run equilibrium.

Equilibrium price level is labeled PL1, and equilibrium output is labeled Y1.

Effect of Increase in Consumer Spending: An increase in consumer spending leads to a short-term increase in aggregate demand. This causes the economy to move away from its long-run equilibrium. Here’s the effect on the graph:

Short Run Equilibrium (SR):

Aggregate demand (AD) curve shifts rightward due to increased consumer spending.

The new equilibrium point is labeled B, where the AD curve intersects the SRAS curve.

Equilibrium price level increases to PL2, and equilibrium output increases to Y2.

 Fiscal Policy Options to Fix Market Imbalance:

The federal government has two main fiscal policy options to address the market imbalance caused by the shift in aggregate demand: expansionary fiscal policy and contractionary fiscal policy.

Expansionary Fiscal Policy: Expansionary fiscal policy involves increasing government spending and/or reducing taxes to stimulate aggregate demand and boost economic activity. This option is suitable when the economy is in a recession or facing a significant downturn.

Effect on the Economy

Increased government spending increases aggregate demand, shifting it to the right.

This shift counteracts the initial decrease in aggregate demand, helping the economy move back toward full employment.

The increased government spending also generates a multiplier effect, as the additional income leads to further increases in consumer spending and investment.

However, expansionary fiscal policy can also lead to higher budget deficits and public debt if not managed carefully.

Contractionary Fiscal Policy: Contractionary fiscal policy involves reducing government spending and/or increasing taxes to decrease aggregate demand and control inflation when the economy is overheating.

Effect on the Economy

Reduced government spending and higher taxes decrease disposable income and aggregate demand, shifting it to the left.

This shift helps to control inflation by reducing demand pressures on resources and preventing the economy from exceeding its potential output.

Contractionary fiscal policy can lead to lower economic growth in the short run, but it can help stabilize the economy and prevent runaway inflation.

In conclusion, fiscal policy is a powerful tool that governments can use to manage economic fluctuations and maintain stability. Expansionary fiscal policy can be employed to address recessions and boost economic growth, while contractionary fiscal policy can be used to control inflation and prevent overheating. The choice between these policies depends on the current state of the economy and the government’s objectives.