According to the economy's self-correcting mechanism, how does the economy return to potential output following a negative demand shock? How is the recovery process different, if the government implements a policy of economic stimulus?
What will be an ideal response?
The negative demand shock causes output to decline, which causes a negative output gap, which causes inflation to decline. Then, expected inflation adjusts down, shifting the short-run aggregate supply curve along the (new) aggregate demand curve: lower inflation causes an automatic response of monetary policy to lower the real interest rate, which stimulates planned expenditures, causing output to rise and the output gap to shrink (in absolute value). The short-run aggregate supply curve will continue to shift down until the output gap is eliminated. A demand stimulus shifts the aggregate demand curve back to the right, closing the output gap more quickly, so inflation does not fall as much (perhaps, not at all), so the short-run aggregate supply curve does not shift down as much (perhaps, not at all).
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Indicate whether the statement is true or false
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