Question

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, as well as the pros and cons of using these tools to combat economic fluctuations. the following graph plots hypothetical aggregate demand (ad), short-run aggregate supply (as), and long-run aggregate supply (lras) curves for the u.s. economy in january 2026. suppose the government chooses to intervene in order to return the economy to the natural level of output by using 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 level of output.

Answer 1

To stabilize the economy, governments use monetary policy, such as adjusting interest rates, and fiscal policy, like government spending and taxation. The coordination of these policies is crucial, noting that fiscal policy actions often have longer lags due to legislative processes. Using the AD/AS model, economic stability can be achieved by shifting either the AD or AS curve as needed.

Step-by-step explanation:

Government Intervention through Monetary and Fiscal Policy

To stabilize an economy and return it to its natural level of output, governments can use monetary policy and fiscal policy. Both policies can mitigate economic fluctuations with differing mechanisms and implications. An example of monetary policy in action is when the Federal Reserve lowers short-term interest rates, which was witnessed during the housing crisis to spur credit flow. On the other hand, examples of fiscal policy include government interventions like the Emergency Economic Stabilization Act of 2008 and the American Recovery and Reinvestment Act of 2009, which aimed to stimulate aggregate demand through increased spending, tax cuts, and transfer payments.

The coordination between fiscal and monetary policy is crucial for economic stability. However, these policies come with time lags. The recognition lag signifies the time taken to acknowledge an economic downturn before any policy can be enacted. Fiscal policies especially suffer from long and variable lags due to the time-consuming legislative process.

Using the aggregate demand/aggregate supply (AD/AS) model, the ideal intervention would involve shifting the AD curve rightward to stimulate demand or the AS curve to affect supply, depending on the specific economic context. It is essential to understand the interplay of fiscal and monetary policy to effectively combat recessions and manage growth, considering the implications of each on interest rates, investment, and inflationary pressures.