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26. Suppose an economy that is in recession. The current price level is a CPI of...

26. Suppose an economy that is in recession. The current price level is a CPI of 225. The government desires to implement policy to achieve full-employment equilibrium and to simultaneously keep the CPI at 225. Explain how the government might be able to achieve this aim and illustrate your answer with an AD/AS model and appropriate shifts.

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If economy is in recession such that they are producing at poiny Y0 while potential output is Y1. Government wants to close the gap between Y1 and Y0 such that aggregate demand rises without causing price to rise. This is possible only if Government mandates a law that producers sell all the units at a fixed price such that short run aggregate supply is perfectly elastic. Rise in aggregate demand curve from AD to AD1 will close the gap without causing price to rise and keep the price at P*.

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