Question

If a government expands its fiscal policy to raise equilibrium output, what will happen in the long term, according to the neoclassical view of the economy?

It will not work because it will disincentivize production.

It will not work because the flexible prices will eventually choke off any increase in aggregate demand.

It will not work because it will raise the level of unemployment.

In adaptive expectations, agents ________ to make their forecasts of economic conditions.

use both current and past information

ignore current information and consider only the past

ignore the past and consider only current information

Answer 1

1. In the long run according to neoclassical, economy produces at full employment level of output. If government expands it's fiscal policy to raise equilibrium output, then in long run it will not work because the flexible prices (note: Neoclassical assumes flexible price and wages) will eventually choke off any increase in aggregate demand.

It means increase in government spending leads to increase in aggregate demand in economy with a long run aggregate supply curve (I e, full employment level output). The increase in aggregate demand beyond the full employment level output will cause inflation in economy.

As a result labor start demanding a rise in wage, which result a fall in short run aggregate supply and cause economy to back to the full employment level output .

Thus, flexible price and wage choke off the increase in aggregate demand.

So, the correct answer is an option (b)

2. In adaptive expectations agents ignore current information and consider only the past to make their forecast of economic condition.

So, the correct answer is an option (b).