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According to the economy's self-correcting mechanism, how does the economy return to potential output following a...

According to the economy's self-correcting mechanism, how does the economy return to potential output following a negative demand shock? How does the recovery process differ, if the government implements a fiscal stimulus?

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Answer - Followed by the negative demand shock , the economy returns to its full employment level because of the flexible prices in the economy . Due to the fall in the demand , the price shift down, thus decreasing the suppy. This makes the economy come back to the equlibrium.

If the government runs the fiscal stimulus to boost the demand , it may take longer time. On the other hand , the increased spending may lead to the crowding out effect which will decrease the demand further. Hence the government policy here may not give the desired result.

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