Question

Assume the economy is initially in long-run equilibrium.

1. Explain briefly how short-run stagflation (recession combined high inflation) results from an adverse supply shock. (Hint: Use AD-AS diagrams to show what happens to P and Y.)
2. Suppose that stagflation occurs. To help economy go back to its full-employment output, how should the government use her budgetary tool that is based on corporate tax? Briefly explain your answer.

Answer 1

a)

Decrease in aggregate supply lead to left shift of SRAS ( due to oil prices Increase, Increase in wages, electricity cost and etc)

Decrease in aggregate supply Decreases in gdp and increase in prices . So economy is in recession with High inflation.( Stagflation)

B)

Goverment can lead economy again to full employment by Decreasing corporate tax.

Decrease in corporate tax will lead to increase in Investment and increase aggregate demand and AD curve shift right ,so that gdp Increases to full employment potential GDP.

But due to increase in aggregate demand ,prices Increases.

So goverment can increase gdp to full employment level on the cost of more higher inflation.