Quiz 31: Supply-Side Policies


Differences between active policy and passive policy: Passive policy and active policy are used to bring the equilibrium output through the adjustment of wage rate and price level. These two approaches differ in terms of time period that adjust the price and wage.Passive approaches believe the market mechanism that is demand and supply forces can bring the adjustment in the price and wages with a reasonable time period of time. The higher unemployment reduces the wage level, which reduces the cost of production. The reduction in production cost leads to an increase in profit. The higher profit induces the producer to produce more. Hence, the output reaches an equilibrium level. On the other hand, active policy takes too much of time to bring the adjustment in price and wages. If there is a higher unemployment due to supply shock, then the market forces take too much of time to adjust the price and wages to bring the equilibrium level of output. Since there is a higher unemployment, there will be a greater supply shock, which reduces the output and further reduction in the level of unemployment.

Expansionary gap: Expansionary gap refers to the positive difference between the potential output and real output. Requirement of government intervention to reduce expansionary gap: When there is an excess output than the full employment level, then the price will go up, which results in inflation and increase in profit. At this point, the firms produce more goods, which induce more demand for labor. The increasing demand for labor increases the wages. Even though wage increases, firms employ more labors since there is a high profit. Therefore, at this point, the government intervention is necessary to reduce the expansionary gap. The government reduces the demand for goods through different ways, which reduces the demand. Since there is a lower demand, the price will fall, which in turn reduces the output to equilibrium level.

Passive policy: The passive policy states that the equilibrium in the labor market would attain through wages. If there is higher wages than the equilibrium wages, then it leads to an increase in production cost, which in turn reduces the labor and output to the equilibrium level and vice-versa.Active policy: Active policy argues that the wage contract does not allow the wage to be flexible. At the higher level of unemployment, demand for labor would be lower than the supply of labor due to higher wage. At this point, labors do not accept to reduce the wages. The wage will be reduced in the long-run after multiple negotiations. Hence, the movement of short-run aggregate supply curve toward right takes more time.On the other hand, when there is a higher demand for labor, then the firms increase the wage level in the short-run. Hence, the movement of short-run aggregate supply curve toward left takes place quickly.

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