Question 1 Report
Fig. 1 shows aggregate demand curves for an economy. The government has announced a temporary increase in spending on rail construction. Price level is shown on the vertical axis and real output on the horizontal axis.
(a) Which curve, AD1 or AD2, is most likely to show the effect of the higher government spending? [1]
(b) Explain the likely effect on real output, assuming spare capacity exists. [2]
(c) Analyse one reason why this policy could cause inflation instead. [3]
(a) The higher government spending shifts aggregate demand to the right, shown by AD2. [1]
(b) Rail construction is government expenditure, so the temporary spending increase raises aggregate demand. If spare capacity exists, firms can employ unused workers and other resources to produce more. Therefore real output rises. [2]
(c) The spending raises aggregate demand. However, if workers, raw materials and machinery are already fully used, firms cannot increase output much further. Excess demand and rising production costs then lead firms to raise prices. This is demand-pull inflation. [3]
Key distinction: With spare capacity, higher demand mainly raises output. Close to full capacity, higher demand is more likely to raise the price level.
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