5. From the short-run equilibrium to the long-run equilibrium: an adjustment to

Question

5. From the short-run equilibrium to the long-run equilibrium: an adjustment to the potential Real GDP

A. Recessions and an adjustment to full employment level of Real GDP (potential Real GDP).

a. No government action: Self- regulation economy (self-correcting economy, automatic adjustment)

b. Government action: active government policy, fiscal and monetary policy

B. Expansions with inflationary gap and adjustment to full employment level of Real GDP (potential Real GDP)

a. No government action: self-regulating economy (self-correcting economy, automatic adjustment) - Conditions for automatic (self-correcting) adjustment to potential (full employment) Real GDP

b. Government action: active government policy, fiscal and monetary policy

C. Short-run trade- off between unemployment and inflation: Short-run Phillips Curve

Explanation / Answer

A) Recessions and an adjustment to full employment level of Real GDP (potential Real GDP).

a) Classical Economics: Follows say's law that supply creates its own demand. While during the great recession, 25% population was unemployed and self-correcting mechanism was not helpful to reattain the full employment output level. When wages fall, there will be less demand in the economy and at that time reduction in AS will automatically correct the economy without government interference.

b) Keynesian economics: AD deficiency causes great depression. Required government action to generate demand via expansionary fiscal policies and to reattain the level of full employment output.

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