a.) Assume that the government’s economic outlook is shaped by Keynesian economi
ID: 1217826 • Letter: A
Question
a.) Assume that the government’s economic outlook is shaped by Keynesian economic philosophy and policies. i) Explain and use the AD/AS model to show what happens if there is no government or central bank intervention in the economy from both a short-run and long-run scenario for an inflationary gap. ii) How would this differ if the government’s economic outlook was shaped by Classical economic philosophy? What would be the difference in the reaction and introduction of policy? b.) According to Phillip’s curve theory, what happens in the long run if there is no intervention? How do expectations of inflation change and how is this illustrated using the Phillip’s curve graph?
Explanation / Answer
Answer 1:
An inflationary gap refers to the situation when Aggregate demand in the economy exceeds the potential level of output,This will lead to rise in prices in the economy. According to Keynesian analysis, government intervention is needed in the form of reduced government spending to reduce the level of aggregate demand in the economy. If there is no government intervention, prices will remain high as the economy is not self correcting. Since, Keynesian analysis is a short run economic so long run analysis is not a part of this explanation.
According to Classical, in this situation prices will rise in the short run due to rise in aggregate demand but in the long run, real wages will fall due to rise in prices. This will lead to excess demand of labor. Thus, money wages will increase and equilibrium wages will be restored to its initial level. Thus, economy will return to potential level of GDP through wage price flexibility. Thus, economy is self correcting and no government intervention is needed in Classical economics.
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