Question

The economy is experiencing a short-run recession (low levels of output and high rates of unemployment). You are the chief economic advisor of the federal government. In each of the following two cases, propose a concrete example of policy that the government can implement to boost the economy. Be specific on how each policy would affect output, unemployment, and price level using the AD-AS model.

1. Assume that you are from the Keynesian (mainstream) school of thought.

2. Assume that you adhere to the real business cycle view

Answer 1

Answer 1:

If the economy is in the recessionary gap, then from the perspective of Keynesian school of thought, the government should follow expansionary fiscal policy which involves increase in the level of government expenditure and decrease in the tax rate which will increase consumption and government expenditure in the economy and thus increase aggregate demand which will shift the AD curve rightwards leasing to increase in price level and output in the economy. As the level of output increases, demand for labor will increase in the labor market and this will lead to reduction in the level of unemployment in the economy. This can be depicted as:

Answer 2:

In the case of Classical/ real Business Cycle view, it is assumed that the economy self adjusts itself to the full employment level of output. During the recessionary gap, real wages fall because of increased unemployment in the economy which reduces cost of production in the economy. This reduction in cost will increase the level of aggregate supply in the economy shifting AS curve rightwards to AS' and at new equilibrium point E2, prices have decreased and economy is at the full employment level.