Hello everyone,
I have some trouble understanding the solution for the following question (provided by investopedia.com):
Which of the following statements with respect to budget deficits and its effects on inflation and real interest rates is true? (a) Keynesian models stipulate that when governments run a deficit when the economy is below full employment, there will be no effect on inflation. (b) New Classical models stipulate that an increase in government spending will result in an excess demand for loanable funds and therefore the real rate of interest will increase. © Empirical research has shown that even for countries that consistently spend more than they tax, there is no direct link between a budget deficit and inflation or real interest rates. Answer by Investopedia: a) is correct.The Keynes model stipulates that an expansionary fiscal policy will not result in escalating inflation if the economy is operating below full employment levels. However, expansion beyond a level indicated by the long-run aggregate supply curve will indeed cause excessive inflation. In either case, expansion will translate into increased government borrowing, which will lead to increasing levels of real interest rates. My interpretation: An expansionary fiscal policcy will always cause an increase an inflation, since the shift in the AD-curve moves the economy along the upward shifting SRAS curve (no matter where in relation to the LRAS curve we are). As illustrated below:
Could someone explain why answer a) is supposed to be correct? Do they mean, that only to the right of the LRAS we have escalating inflation and to left it is moderate? If so, answer a) sitll says no effect on inflation.
I appreciate your help.
Thanks,
Tartaglia