Question

27. Use of discretionary policy to stabilize the economy 

Should the government use monetary and fiscal policy in an effort to stabilize the economy? The following questions address the issue of how monetary and fiscal policies affect the economy and the pros and cons of using these tools to combat economic fluctuations. 

The following graph shows a hypothetical aggregate demand curve (AD), short-run aggregate supply curve (AS), and long-run aggregate supply curve (LRAS) for the U.S. economy in March 2020.

Suppose the government decides to intervene to bring the economy back to the natural level of output by using _______ policy .

Depending on which curve is affected by the government policy, shift either the AS curve or the AD curve to reflect the change that would successfully restore the natural level of output. 

Suppose that in March the government undertakes the type of policy that is necessary to bring the economy back to the natural level of output given in the previous scenario. In July 2020, consumer confidence decreases, leading to a decrease in consumer spending. Because of the _______  associated with implementing monetary and fiscal policy, the impact of the government's new policy will likely _______ once the effects of the policy are fully realized

Answer 1

(1) Government brings back economy to its natural level of output using contractionary fiscal policy (because, AD intersects AS to the right of LRAS curve implying an inflationary gap).

(2) Contractionary fiscal policy will lower aggregate demand, shifting AD curve leftward as shown below.

(3) Because of the time lags associated with monetary and fiscal policy, impact of new policy will likely decrease output below its natural level of output** once the ffects of policy are fully realized.