Principles of Macroeconomics / Unit 18 MAC 1729 worked example, 60 to 90 seconds
Diagnose the Economy
The idea
From a description of an economy, name which goal is failing and which model explains it. Ask four questions in order: where is output against potential, is unemployment cyclical or natural-rate, is the price level rising and why, and is the external position sustainable. The diagnosis fixes the instrument.
In practice
Output is below potential, unemployment rose in the last two years, and inflation is low. This is a recessionary gap with cyclical unemployment, explained by aggregate demand, and demand policy applies. Output is at potential, unemployment has sat high for two decades, and inflation is stable. This is a natural-rate problem, explained by labour-market institutions, and demand policy will not move it. Output is falling while prices rise sharply. This is a supply shock, and no demand policy improves both halves. Prices are rising at forty percent a year while the central bank finances the budget. This is monetary, with a fiscal cause.
Where people slip
The third and fourth cases are the ones that punish a reflex. A supply shock offers no good demand policy, and saying so is the correct answer rather than an evasion. A deficit financed by money creation is not fixed by monetary tightening alone, because the deficit will still be there. Naming the cause is what decides whether an instrument can work at all.
Your place on the trail
Every lesson rests on earlier ones and opens later ones. Tap any to jump.
Something wrong in this lesson? Flag it · Sources for Principles of Macroeconomics