Question

If the circular-flow model is in equilibrium (the sum of money flowing into each box is equal to the sum of the money flowing out of it) and there is an increase in government spending, holding everything else constant, which outcome is likely to occur?

Answer 1

Answer:

increase in nominal GDP due to an increase in the general level of prices (inflation).

Explanation:

In the circular flow model, households represent the primary demand of goods and services, which are mostly supplied by businesses. The money flows in opposite as goods and services flow towards households, while factors of production flow towards businesses. Households purchase goods and services from businesses, while they sell factors of production to businesses. Household's savings = investments, inject money into the circular flow.

When governments increase spending, and everything else remains constant, the inflation rte will increase, resulting in an increase in the nominal GDP, but the real GDP will not be affected.