Use of discretionary policy to stabilize the economy
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 curve (AD), short-run aggregate supply curve (AS), and long-run aggregate supply curve (LRAS) for the U.S. economy in April 2020.
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 April 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 June 2020, U.S. imports decrease because the United States has implemented trade restrictions on French goods. Because of the (inflation, consumer preferences, lags)associated with implementing monetary and fiscal policy,
the impact of the government’s new policy will likely (increase the long-run production capacity, fall short of the natural rate of output, leave the U.S. economy unchanged, push the economy beyond the natural rate of output) once the effects of the policy are fully realized.