Question

Assume the economy is initially in a long run equilibrium.

a. Use AD-AS and Phillips curve diagrams to show the short run effects in prices (inflation) and output (employment) if firms are pessimistic about economy in the future

b. In order to maintain output what would government do with fiscal policy in response to event in part a

Answer 1

Philips curve shows inverse relationship between Inflation and unemployment. If aggregate demand shifts right then it shows peoples confidence in an economy. Price levels go up and also number of jobs are higher.

a. Less confidence in firms will produce less number of goods.

Aggregate supply shifts from AS1 to AS2 and hence inflation-unemployment in Philips curve which was 2% and 5 % respectively will shift outwards from Short run Philips curve (SRPC) to new SRP with more inflation and unemployment- say 4% and 8% respectively. In short from point a to point b in Philips curve diagram.This has happened as price levels went from P1 to P2 and real GDP shifted from Y1 to Y2 causing unemployment to go up.

This shows stagflation in the short run.

b. Policies should focus on supply side.

Supply side policies: This policy focuses on aggregate supply. It has two types- market based and interventionist based. market based policy focuses on incentives for businesses, labor market reforms and encouraging competition. Interventionist based policy focuses on human and physical capital.

Tax concessions can be given in short term.

All these factors will aim at shifting aggregate supply back to AS1 . This needs a longer time.This will bring AS2 back to AS1 and Long run Philips curve is regained with Short run Philips curve shifting back from point b to point a.