Question

This year is a good year for the economy, and the economy is currently in an inflationary gap (point A).

Note: Use the AS-AD model to answer the question and be sure to identify the new equilibriums in the diagram.

a) If the policy makers decide to let the natural adjustment mechanism to work its way out, what

happens to the long-run equilibrium levels of output and price? Explain. (5 points)

b) Suppose the government wants to bring output back to its long-run level in the short run via a

change in lump-sum tax, what should it do? What happens to output and price level in the short

run? Explain. (5 points)

Answer 1

a)The long run self adjustment process can bring the economy to normal after a shock.Self correction mechanism is about price adjustment ie prices adjust and bring the economy back to long run equilibrium.In the diagram the economy is in long run equilibrium . Output is Y1 which is the full employment output Yf. If AD increases because of inflation ,AD1 shifts to the right ie AD2., output and price level increases.An increase in the price level will increase input prices and inflation and decrease in AS in the short run ie leftward shift.In the long run price level has increased and the new output Y3 is again equal to full employment level Yf.

b)If the economy is in inflation and the government wants to follow contractionary fiscal policy by imposing a lumsum tax,a change in tax will shift AD1 to the left ie AD2 . The decrease in AD will restore the economy to full employment output.So output and price level will fall.