Question

Stabilization Policy: Suppose the economy is initially above potential output. If policymakers prefer price stability and do not desire higher interest rates, what type of stabilization policy should it use and then briefly explain how that policy will impact the economy? Use an IS/LM graph and an aggregate demand graph to support your answer.

Answer 1

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Question:

Answer:

Here the most suitable strategy is to control or stablizing price level is contractionary fiscal policy. Here potential level of output is Q2 and equilibrium point is E1 but the economy is  initially above potential output at the equilibrium point E2 where output and price level are Q1 and P3. Here now the government adopts a contractionary fiscal policy. Contractionary fiscal policy is a type of fiscal policy in which the government decrease spending or/and increase taxes. Decreasing spending or/and increasing taxes decrease income (disposable income) that decrease spendable income of consumers. Decreasing spendable income decrease consumption level and decreasing consumption will decrease AD. Decreasing AD shift AD curve left to AD3. It decrease price level at P1 level and output level to Q3 level. Other side decreasing AD due to decreasing consumption level shift IS curve left from IS1 to IS2 that decrease interest rate from r to r1 and output level from Q1 to Q2. Here the both interest and output level decrease and the policymakers achieved the objective of price stabilitywithout higher/increasing interest rates.

Graphical Representation:

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