Final answer:
An expectation of higher inflation due to large budget deficits is likely to cause a leftward shift of the short-run aggregate supply curve, leading to inflationary pressure without affecting long-run real GDP or unemployment levels.
Step-by-step explanation:
If large budget deficits cause the public to think there will be higher inflation in the future, it is likely that the short-run aggregate supply curve (SRAS) will shift to the left. This shift reflects that producers expect higher costs in the future, which decreases the quantity of goods and services that businesses are willing to supply at a given price level. The anticipation of higher inflation can lead to higher wage demands by workers and higher prices for raw materials as businesses try to cover expected increases in costs.
An increase in aggregate demand due to large budget deficits, as shown in economic models like Figure 30.12, can lead to an overheating economy if the level of demand exceeds potential GDP. The intersection of aggregate demand (AD) and short-run aggregate supply (SRAS) at a high level of output results in upward pressure on wages and prices, causing inflation. This scenario can be moderated with contractionary fiscal policy that shifts AD to the left, aiming to bring the economy back to potential GDP.
Alternatively, if budget deficits increase AD when the economy is below its potential GDP, then inflation is less of a concern, and expansionary monetary policy might be more appropriate. In this situation, the central bank's actions can mitigate the effects of higher interest rates from government borrowing, thus sustaining private investment and fostering growth.
However, in the long run, if aggregate demand rises rapidly, it leads to inflationary pressures without affecting real GDP or the natural rate of unemployment, as illustrated by a vertical long-run aggregate supply (LRAS) curve in neoclassical models.