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2nd year economics essay

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    I have recently been given my first piece of coursework for economics at university and I am a bit lost.

    In the AS/AD model, describe an economy where the level of production (Y) is below the natural level (Yn).
    Would the economy stay forever in this position? Explain the adjustment process in the economy.
    Suggest a monetary policy or a fiscal policy to increase output. Analyse the effect of this macro-policy on the price level and employment.
    Find, collect, present and analyse data from one of the following economies --UK, Germany, France, Netherlands, Italy, or Spain—that illustrate your answer (by identifying and describing two occasions/time periods that better fit with your answers.)

    Could anyone guide me in the right direction?

    Thank you
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    It wouldn't stay forever in that position if markets work perfectly because if the aggregate supply curve would adjust to return it to the natural level, through price expectations. In the medium run, price expectations will always be in line with actual prices. When output is below the natural level, price expectations are above actual prices so price expectations then fall which makes wage demands lower and so labour becomes cheaper so the AS curve shifts down (to the right).

    For your monetary policy or fiscal policy to increase the output you could use either a monetary expansion or a fiscal expansion. Both of these will make the economy return to Yn more quickly than relying on AS alone as they will push AD out to the right.
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    (Original post by MagicNMedicine)
    It wouldn't stay forever in that position if markets work perfectly because if the aggregate supply curve would adjust to return it to the natural level, through price expectations. In the medium run, price expectations will always be in line with actual prices. When output is below the natural level, price expectations are above actual prices so price expectations then fall which makes wage demands lower and so labour becomes cheaper so the AS curve shifts down (to the right).

    For your monetary policy or fiscal policy to increase the output you could use either a monetary expansion or a fiscal expansion. Both of these will make the economy return to Yn more quickly than relying on AS alone as they will push AD out to the right.
    Thank you, I appreciate your detailed response this has helped me a lot.

    One question though;

    why are price expectations above actual price when output is below the natural level?
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    (Original post by Devonte)
    Thank you, I appreciate your detailed response this has helped me a lot.

    One question though;

    why are price expectations above actual price when output is below the natural level?
    Well this is all assuming markets work perfectly and so prices are flexible and can move down as well as up. The idea is that when output is below the natural level, demand is lower than normal and so there is an excess of supply, so things get unsold and prices fall. Expectations in this kind of model would be that prices were constant. So at a given wage level based on a given level of price expectations, when prices fall, price expectations are above actual prices until price expectations adjust to catch up to the new lower price level. When they do, wage demands will fall (because of price expectations now being lower to adjust to the new price level) and so labour will become cheaper, firms costs will fall and the AS shifts out.

    The basic thing going on here is prices move first, then wages move to follow them (based on expectations adjusting to the new reality). There might be a lag here depending on how often wages are adjusted, and that's the period where price expectations will be stuck above actual prices (as this model is thinking of price expectations only in the context of wages).

    In reality wages are often sticky downwards which means you don't get the AS curve shifting to take you back to a medium run equlibrium.

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