Question

Draw an aggregate demand (AD)/aggregate supply (AS) graph to illustrate an economy experiencing a recession. Label all curves and axes.

Also explain,

The monetary policy you would use to eliminate the recession you illustrated above, what are the policy impacts on real GDP, employment, and price level?

Draw an economy in an economic bubble and explain the fiscal policy you would use to get it out.

If the policy you implemented in (c) above succeeds, what is likely to happen to the price level and real GDP?

What is one common difficulty in implementing both fiscal policy and monetary policy?

Answer 1

Below is the aggregate demand (AD)/aggregate supply (AS) graph showing an economy experiencing a recession. The short run equilibrium lies below the long run equilibrium where both prices and output are lower relative to potential levels. The monetary policy required to eliminate the recession would be an expansionary one that raises the money supply and shifts AD to the right. Original equilibrium is restored and real GDP, employment and price level all are increased

Below is the graph of the economy experiencing an economic bubble. The short run equilibrium lies above the long run equilibrium where both prices and output are higher relative to potential levels. A contraction fiscal policy is required which can come along in tax increase or reduction in government spending. This shifts AD to the left. Original equilibrium is restored and real GDP, employment and price level all are decreased

A common difficulty in implementing both fiscal policy and monetary policy is the presence of lags. These are issues related to recognizing an economic problem, deriving a possible policy mix and then implementing the desired response. Both policies have their own inside and outside lags making it difficult for the economy to react in the way it is expected.