Question

In the AS-AD model, short run stabilization policy does not affect long run employment and output. Discuss theoretical arguments why this may or may not be plausible.

Answer 1

In this model, long run values of real GDP rate of unemployment and real rate of interest are presumed to be unchanged. This indicates that whenever there is a short run disequilibrium, the economy will always return to its original long run equilibrium values.

This presumption is based on the fact that economy has a given amount of resources available and a given technology. This fixes the productivity of resources and due to this reason, the economy is expected to produce a certain amount of goods and services at a maximum. This is called the long run potential GDP or long run potential output level and it remains unchanged unless there is an increase in the resources for an updation in the technology. this also calls for the rate of unemployment to always return to its natural rate which is the sum of rate of frictional unemployment and rate of structural unemployment. The rate of inflation or the price level need not to remain unchanged but can vary according to the condition of the economy. But the real interest rate returns to its original value due to changes in the nominal interest rate being made in the long run.