Assume the economy is in short-run equilibrium at a real GDP below its potential real GDP. According to Keynesian theory, which of the following policies should be followed?
A) The Federal Reserve should increase the money supply.
B) The federal government should increase spending.
C) The federal government should do nothing because the economy will self correct to potential real GDP.
D) All of the above.

Question

Quizplus · Accepted Answer

According to Keynesian theory, when an economy is in short-run equilibrium below its potential real GDP, it implies that there are unused resources such as labor and capital. In this case, the government should use expansionary fiscal policy by increasing government spending to stimulate demand and promote economic growth. Increasing money supply by the Federal Reserve may also help by reducing interest rates and encouraging borrowing and investment. However, this policy may be less effective in stimulating demand compared to fiscal policy as individuals and businesses might not be willing to borrow and invest. Doing nothing will not promote economic growth, and the economy might continue to operate below its potential. Therefore, increasing government spending is the best policy choice.

Assume the Economy Is in Short-Run Equilibrium at a Real