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).
You might also like to view...
Even if some people are hurt by international trade, the HO model predicts that free international trade improves the standard of living for the country as a whole
Indicate whether the statement is true or false
If the level of interest rates paid on time deposits rise relative to that paid by money market accounts, ceteris paribus, individual will
A) reduce their real money balances. B) first reduce then increase their real money balances. C) increase their real money balances. D) hold the same amount of money.
In class action lawsuits, interested parties to the lawsuit are not required to pay attorney fees directly. This is an example of an attempt to
a. maximize attorney fees. b. reduce the incentive of attorneys to file class action lawsuits. c. reduce the transaction costs of finding a private solution to an externality. d. regulate attorney fees.
Which of the following statements about asymmetric information is true?
A. Asymmetric information can only be solved through government intervention. B. Asymmetric information reduces market failures because it makes it easier for individuals to engage in transactions that in the presence of perfect information would take place. C. Asymmetric information occurs when one party to a transaction has relevant information to the transaction that the other party does not have. D. Asymmetric information occurs only in the market for used cars and in the insurance market.