Suppose you have an inflationary gap how would a classical economist, for example, explain how how to get rid of that gap?
My Answer: I would think that the goods market would be affected. So, prices go down, aggregate supply decreases, and the aggregate supply curve shifts to the left. With the decrease of the aggregate supply, the price level decreases as well as quantity demanded of RGDP. The quantity demanded of RGDP moves along the aggregate demand curve towards the long run equilibrium. Until the acutal RGDP is equal to the potential RGDP the price level continues to fall, and when the actual RGDP = potential RGDP, the economy has reached its long run equilibrium.
Your answer: Huh??
First of all an inflationary gap occurs when aggregate output exceeds "full employment" which generates inflationary pressures. Your questions is, what would a classical (Keynesian) economist prescribe?
The answer is contractionary fiscal policy. E.g., raise taxes or cut government spending.
Now look at your answer. When aggregate supply shifts left, prices go up not down. Your answer, as best I can tell, calls for a supply response. No No No.
Contractionary fiscal policy shifts the aggregate demand curve inward, causing output to fall and prices to fall.
Thanks for clearing that up. Though I thought when the question said, "classical" it meant the Classical Macroeconomic Theory and not the Keynesian Economic Theory, since we just studied those two theories just before we were given the question by our instructor?
No problem! It's important to differentiate between the Classical and Keynesian theories in macroeconomics. Classical economists believe in the self-regulating nature of the economy, where markets adjust themselves to reach equilibrium. They often advocate for limited government intervention and believe that supply creates its own demand.
In contrast, Keynesian economists argue that in certain situations, the economy may not self-correct and that government intervention is necessary to stabilize the economy. They focus on the role of aggregate demand in shaping economic outcomes.
If you are specifically studying the Classical Macroeconomic Theory, then the answer to the question would indeed involve supply-side measures to address an inflationary gap. These measures could include policies that promote increased production and efficiency in the economy, such as reducing regulations and taxes that hinder business activity. By improving productivity and expanding aggregate supply, the economy can reach a long-run equilibrium without relying on demand-side policies.
However, if your instructor intended to refer to Keynesian economics when mentioning the "classical" economist, then contractionary fiscal policy, as I mentioned earlier, would be the appropriate response to reducing an inflationary gap. This would involve reducing government spending or increasing taxes to reduce aggregate demand and bring it back in line with aggregate supply.
It's always important to clarify the specific economic theory being referred to in order to provide the most accurate answer.