Question

Do you think the economy is self-regulating? Do you think economies will always go back to its potential as Classical view believes? Briefly discuss.

Answer 1

In my opinion the economy is not self-regulating. When there is an economic shock, leaving the market to itself may perpetuate the shock, widening the gap between real and potential GDP. For example, if there is a negative demand shock, aggregate demand will fall, lowering both price and real GDP. Lower price, in turn, will cause firms to produce less in short run (since price of their output will fall, decreasing profit), so they will hire less labor, increasing unemployment. Higher unemployment will lower income, which will cause a further decrease in aggregate demand and the downward spiral will continue until government intervention is made to boost aggregate demand. Similarly, a positive demand shock may lead to overheating the economy. Therefore, government intervention is required to prevent such economic shockwaves.