9. Use of discretionary policy to stabilize the economy

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 May 2026.

Suppose the government chooses to intervene in order to return the economy to the natural level of output by usinga contractionary 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.

ADAS202224262830150130110907050PRICE LEVELOUTPUT (Trillions of dollars)AD1AD2ASLRASSlope: UndefinedY-Intercept: None

Suppose that in May 2026 the government successfully carries out the type of policy necessary to restore the natural level of output described in the previous question. In November 2026, U.S. exports increase because Europe eliminates all trade restrictions on U.S. goods. Due to the associated with implementing monetary and fiscal policy, the impact of the government's new policy will likelypush the economy beyond the natural level of output once the effects of the policy are fully realized.