[Joseph_E._Stiglitz,_Carl_E._Walsh]_Economics(Bookos.org) (1)

Fiscal Policy A change in government purchases or taxes alters
the level of aggregate expenditures, and therefore output, for a given
rate of inflation. An increase in government purchases, for example,
raises aggregate expenditures at each level of the inflation rate; for
every value of inflation, total expenditures (and therefore equilibrium
GDP) are higher. This effect of a rise in government purchases is shown
in Figure 31.4. The increase causes a rightward shift in the ADI curve.
If the initial level of inflation was π 0 , the initial level of output was Y 0 .
After the increase in government purchases, equilibrium output
increases from Y 0 to Y 1 . At the inflation rate π 0 , output is now Y 1 . 1
Changes in taxes also shift the ADI curve. An increase in taxes
reduces disposable income and leads to a fall in consumption. At each
rate of inflation, aggregate spending will be lower. The ADI curve will
shift to the left.
INFLATION (π)
π 0
Initial
ADI curve
Y 0
Y 1
OUTPUT (Y )
ADI curve
with higher
government
purchases
Changes in the Monetary Policy Rule The position of the
ADI curve also depends on monetary policy. We have already learned
how the slope of the ADI curve is affected by the policy rule that describes
how the central bank adjusts the real interest rate in response to changes
in inflation and how aggregate spending reacts to changes in the real
interest rate. The slope has this automatic reaction to changes in inflation
built into it. But we can also investigate what would happen if, at
each rate of inflation, the central bank changed interest rates—that is,
if the policy rule were to shift. For example, suppose the Fed decides to
cut interest rates for a given rate of inflation. The Fed did just this in
1998 when it was concerned that the financial crisis in Asia would harm
the United States. How will such an interest rate cut affect the ADI curve?
Figure 31.4
To answer this question, we need to work out the effects of the policy change on
the real interest rate and then determine the impact on aggregate expenditures.
That will tell us whether equilibrium GDP has increased or decreased. Since we are
holding the rate of inflation constant, an increase in GDP will cause the ADI curve
to shift to the right; a decrease in GDP will cause a shift to the left.
The Fed’s decision to cut interest rates at a given rate of inflation first lowers
the real rate of interest. We know that this reduction, in turn, will boost aggregate
expenditures by lowering the cost of credit to households and firms. The rise in
aggregate expenditures leads to an increase in equilibrium GDP. Hence, we can conclude
that the ADI curve shifts to the right when, at each rate of inflation, the Fed
cuts nominal interest rates.
We could run through the same steps to determine that the reverse happens to
the ADI curve when the Fed raises interest rates at each rate of inflation. Since monetary
policy ensures that each rate of inflation now leads to a higher real interest
rate, aggregate expenditures will be lower. The fall in aggregate expenditures at
each value of inflation lowers equilibrium GDP, shifting the ADI curve to the left.
THE EFFECT OF GOVERNMENT PURCHASES
ON AGGREGATE EXPENDITURES AND THE
ADI CURVE
An increase in government purchases raises aggregate
expenditures at each value of the rate. This increase in
aggregate expenditures increases equilibrium output. At
the initial inflation rate π 0 , this change represents an
increase in output from Y 0 to Y 1 . The rise in government
purchases causes the ADI curve to shift to the right,
as shown.
1 The size of the increase in output is determined by the magnitude of the initial increase in spending and the
multiplier, as explained in Chapter 30.
THE AGGREGATE DEMAND–INFLATION CURVE ∂ 695