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

Introduction -  In the short run, output fluctuates with shifts in either aggregate supply or aggregate demand; in the long run, only aggregate supply affects output.

High unemployment indicates the economy is operating below full capacity and is inefficient; this will lead to lower output and incomes. The unemployed are also unable to purchase as many goods, so will contribute to lower spending and lower output. A rise in unemployment can cause a negative multiplier effect.

1- Assume that you are form of keynesian school of thought.

Keynesian economics focuses on using active government policy to manage aggregate demand in order to address or prevent economic recessions. Keynes developed his theories in response to the Great Depression, and was highly critical of previous economic theories, which he referred to as “classical economics”.

The AD–AS or aggregate demand–aggregate supply model is a macroeconomic model that explains price level and output through the relationship of aggregate demand and aggregate supply.

Aggregate supply/demand graph.

In a standard AS-AD model, the output (Y) is the x-axis and price (P) is the y-axis. Aggregate supply and aggregate demand are graphed together to determine equilibrium. The equilibrium is the point where supply and demand meet to determine the output of a good or service.

2- Assume that yoy adhere to the real business cycle view. During business cycle contractions the unemployment rate rises and during expansions the unemployment rate falls. The low point in the unemployment rate usually occurs just before the peak. The high point usually occurs just after the trough.

Real business cycle models state that macroeconomic fluctuations in the economy can be largely explained by technological shocks and changes in productivity.

• These changes in technological growth affect the decisions of firms on investment and workers (labour supply). Hence changes in output can be traced to microeconomic and supply-side factors.
• Real business cycle models either completely reject or play down the role of aggregate demand in influencing the economic cycle.
• Real business cycle models suggest that government intervention to influence demand in the economy is generally counterproductive and the optimal policy is to concentrate on supply-side reforms which help the economy to be more efficient and flexible.
• Real business cycle models reject the Keynesian approach to the macroeconomy and also reject monetarism. It tends to be associated with neo-classical economics and the Chicago School of economics.

“RBC theory views cycles as arising in frictionless, perfectly competitive economies with generally complete markets subject to real shocks. RBC models demonstrate that, even in such environments, cycles can arise through the reactions of optimizing agents to real disturbances, such as random changes in technology or productivity.”