Question

In this chapter, we have been told that the economy, if left alone, will self-correct (classical economics) from a shock even without an explicit government intervention (Keynesian economics). So if someone were to say, "Using monetary or fiscal policy to pump up the economy is counterproductive -you get a brief high, but then you have the pain of inflation," would you say this is a valid argument against stabilization policy? Why or why not? Explain your answer using the terms from the AS/AD model in this chapter. As a bonus, provide a link to a respectable news article that backs your answer. In addition to sharing your own stance on this issue, please respond to at least one other classmate's answer with a constructive comment or question! Your response will be graded according to the following rubric: DISCUSSION Rubric (1) Pts Ratings Criteria 1 pts 2 pts Addresses all 3 pts Attempted Somewhat accurate and/or 3 nts Direct, accurate, and discussion er

Answer 1

PADAS LR.A.S. SR.A.S, S. RASO Po "A,DI A.DO

Initially, the economy is in both short-run (S.R.) and long-run (L.R.) equilibrium at A, corresponding to (Y₀, P₀).

Now, suppose there is an exogenous shock to AS (say oil price rises). This results in decrease in AS for every level of output. Thus, S.R.A.S. shifts from (S.R.A.S.)₀ to (S.R.A.S.)_1.

After this shift, the automatic mechanism works and the new S.R. equilibrium is at B, with new output and price being (Y₁, P₁). Thus, the exogenous shock results in an increase in the price level and decrease in output.

Policy makers now take an expansionary policy measure, to boost demand in the economy, such that output is back at its original level. After the expansionary policy, A.D. shifts from (A.D.)₀ to (A.D.)_1.

After this shift, the automatic mechanism works and both the new S.R. and L.R. equilibrium is at C, with new output and price being (Y₀, P₂). Thus, the exogenous shock results in a further increase in the price level with output being at its original level.

It is worth noting that after undertaking the policy, the price increase becomes even higher (as P₂ > P₁ > P₀), resulting in the pain of inflation. Thus, the given statement is definitely true.