Question

Should the government use monetary and fiscal policy in an effort to stabilize the economy? The following questions address the issue of how monetary and fiscal policies affect the economy, and the pros and cons of using these tools to combat economic fluctuations.

The following graph shows a hypothetical aggregate-demand (AD) curve, short-run aggregate-supply (AS) curve, and long-run aggregate-supply (LRAS) curve for the Canadian economy in March 2023.

Suppose the government decides to intervene to bring the economy back to the natural rate of output by using   (expansionary/contractionary) policy.

Depending on which curve is affected by the government policy, shift either the AS curve or the AD curve to reflect the change that would successfully restore the natural rate of output.

Suppose that in March the government undertakes the type of policy that is necessary to bring the economy back to the natural rate of output given in the previous scenario. In July 2023, Canadian exports decrease because China implements trade restrictions on Canadian goods. Because of the   (consumer preference/ lags/ inflation)associated with implementing monetary and fiscal policy, the impact of the government's new policy will likely   (push the economy below the natural rate/ leave the economy above the natural rate/ leave the Canadian economy unchanged/decrease the long run production) once the effects of the policy are fully realized.

Answer 1

In the given figure, the aggregate demand and aggregate supply curves intersect corresponding to an output level that is higher than the potential output. Therefore, to bring the output level back to the potential (or natural) level, the government should undertake contractionary policy.

The contractionary policy will shift the aggregate demand curve towards left. A leftward shift of the AD curve that will successfully restore the economy to its natural level of output is shown in the following figure:

Owing to the lags associated with implementing monetary and fiscal policy, the impact of the government's new policy will likely push the economy below the natural rate of output once the effects of the policy are fully realized.