Question

Suppose someone says, “Using monetary or fiscal policy to pump up the economy is counterproductive —you get a brief high, but then you have the pain of inflation.”

a. Explain what this means in terms of the AD-AS model.

b. Is this a valid argument against stabilization policy? Why or why not?

Short answer

1. Suppose the authorities adopt expansionary monetary or fiscal policies when the economy is at the long-run macroeconomic equilibrium level. This can cause inflation because of the excess demand that cannot be met with additional supply.
2. The given statement is not a valid argument against the stabilization policy because expansionary policies are very effective in improving the economic conditions of a country.

Step-by-step solution

Explain the given statement in terms of the AD-AS model

An economy experiences an inflationary gap when the equilibrium output demanded exceeds the potential output, causing a supply shortage.

Once the economy has achieved the long-run equilibrium, an expansionary monetary or fiscal policy might be counterproductive and lead to an inflationary gap. The policy leads to an increase in expenditure due to a rightward shift of the aggregate demand curve.

However, as there is a supply shortage beyond the full-employment equilibrium, the additional output gap will put inflationary pressure on prices. As this is a short-run disturbance in the economy, it will adjust back to the long-run equilibrium through rising nominal factor costs. Thus, the economy will eventually return to the potential output level through market adjustments

Assessing whether the argument is valid, considering the stabilization policy

The given statement is not a valid argument against the stabilization policy.Expansionary policies are helpful for the economy as they boost the aggregate demand and trigger an increased expenditure in the economy.

The additional demand is often met with the increased aggregate supply by the producers. Thus, the economy is at equilibrium at a higher level than earlier.

Expansionary policies are counterproductive only when the economy already operates at the full-employment equilibrium output as further production cannot be done to meet increased demand. Apart from that, these policies are very effective in improving the economic conditions of a country.