Question

Explain why the length of time for the adjustment process to work in a neo-classical framework lead some economists to believe fiscal or monetary policy is needed.

Answer 1

Neo-classical framework focuses on supply and demand acting as the driving forces in an economy.

Neo-classical economists believe that the economy will correct itself over time when there is high inflation or high unemployment levels, but it takes time and damage when natural forces are put into place without any intervention. For example when timely action is not taken, it could lead to high inflation and high unemployment rates as employees are laid off when wages have to rise in order to meet employees demands.

Thus when fiscal or monetary policy is used, the adjustment process declines drastically and timely intervention leads to fast recovery. For example if monetary policy increases the level of interest rates, without a rise in unemployment levels further exacerbating the economy, the interest rates pull the money back into the banking system, which leads to timely intervention and thus economy is stabilised in as short a time span as possible and inflation is back under control.