The debate over austerity—whether a country in debt should cut public spending, raise taxes, or both—has dominated European policy circles since the continent’s sovereign debt crisis began at the end of 2009. For its proponents, fiscal consolidation is the only way to restore business confidence, thus creating incentives for further investment and growth. For its opponents, austerity is only going to make matters worse, taking more demand out of the economy and reducing growth opportunities. Using the AD-AS framework, explain what happens to output and the price level when an economy implements an austerity policy in the short run and long run. Since the European Central Bank conducts monetary policy for many European economies, you can assume this economy implements the austerity plan without an accompany- ing change in monetary policy.

 

 

Effective federal funds rate 8 7 5 + 3 2 1 0 1990 1995 2000 2005 Year 2010 2015 2020