Question

1. What are the three premises the short run model is based on? Explain.

Answer 1

It shall be noted that the short-run model is based on three premises. They are:

1) The economy is constantly being hit by shocks generally called economic shocks such as changes in oil prices, technologies, spending, or disasters that cause fluctuations in output or inflation

2) The monetary and fiscal policies affect the output. The policymakers neutralize economic shocks to the economy using monetary & fiscal policy stance.

3) There is a dynamic trade-off between output and inflation. This is represented by Phillip's curve. As a result of this dynamic trade-off between output and inflation, the government does not want actual GDP to be as high as possible because a booming economy leads to an increase in the inflation rate. If inflation is high, a contractionary fiscal & monetary policy stance is usually required to lower it.