In: Economics
Congratulations! You have been appointed an economic policy advisor to the United States. You are told that the economy is significantly below its potential output and that the following will happen next year: World income will fall significantly due to the pandemic, and the price of oil will fall significantly due to lack of economic activities, as well as the availability of alternative and more sustainable energy sources (wind, solar, hydro, nuclear), and the U.S. is an oil exporter, along with shale and natural gas.
a) What kind of policies (under Fiscal policy) might you suggest to the government? Mention three.
b) Consider the economic principle held by Classical economists: The economy always returns to its potential in the long run. What are Keynes’s criticisms of this economic principle?
A.
In the given scenario, the expansionary fiscal policy will be applied. As a part of it, there will be increase in government spending ad or decrease in the tax rate so that domestic demand is boosted and economy is stimulated. It will increase new jobs as firms will increase the supply to cater the demand. So, output will increase and cover up the decrease in exports due to global economic slow down. While doing so, output gap will also be covered over a period of time when more people get jobs and unemployment rate reaches to the natural rate of unemployment.
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B.
Keynes first criticism is that supply does not create its demand, as it is taken up by the classical economists. So, automatic movement of the SRAS curve will not take place. The second criticism in the wage rigidity. Classical economists rely that wages are flexible and unemployed people will world at a lower wage. It will decrease the cost of operation and SRAS shifts to the right. But, Keynes says that wages are rigid in nature, and workers demand the same wage. So, SRAS will not change as wage rate will not decrease. Hence, economy will not move to the long run equilibrium.