Question

Draw an equilibrium in the AD-AS model with the economy operating above the natural rate of output (Yp). How would the self-correcting mechanism lead to a restoration of the natural rate? What happens to the price level? Describe how a more activist fiscal and monetary policy would work in this situation. What would be their effect on the price level?

Answer 1

The figure below represents an economy operating above the natural rate of output and thus there is a inflationary gap. In this case price level and real GDP both are higher.

A self-correcting mechanism would start working during the transition from short run to long run when higher price level reduce raises nominal wage and reduces profits for firms. This discourages production and so aggregate supply shits to the left. Price level increased but output is reduced and so the self correcting method leads to a restoration of the natural rate of output

A more activist expansionary fiscal and monetary policy would work in this situation where lower government spending, money supply or increased taxes would depress aggregate demand so that AD curve shifts to the left, resulting in eliminating the GDP gap and bringing the economy back to its full employment level.  Price is reduced and reached its long run level