1. 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.”
Explain what this means in terms of the AD–AS model.
An economy is overstimulated when an inflationary gap is present. This will arise if an expansionary monetary or fiscal policy is implemented when the economy is currently in long-run macroeconomic equilibrium. This shifts the aggregate demand curve to the right, in the short run raising the aggregate price level and aggregate output and creating an inflationary gap. Eventually nominal wages will rise and shift the short-run aggregate supply curve to the left, and aggregate output will fall back to potential output. This is the scenario envisaged by the speaker.
Is this a valid argument against stabilization policy? Why or why not?
No, this is not a valid argument. When the economy is not currently in long-run macroeconomic equilibrium, an expansionary monetary or fiscal policy does not lead to the outcome described above. Suppose a negative demand shock has shifted the aggregate demand curve to the left, resulting in a recessionary gap. An expansionary monetary or fiscal policy can shift the aggregate demand curve back to its original position in long-run macroeconomic equilibrium. In this way, the short-run fall in aggregate output and deflation caused by the original negative demand shock can be avoided. So, if used in response to demand shocks, fiscal or monetary policy is an effective policy tool.