Question: During a 2008 interview, then German Finance Minister Peer Steinbrueck said, "We have to watch out that in Europe and beyond, nothing like a combination of downward economic [growth] and high inflation rates emerges-something that experts call stagflation." Such a situation can be depicted by the movement of the short-run aggregate supply curve from its original position, SRAS1, to its new position, SRAS2, with the new equilibrium point E2 in the accompanying figure. In this question, we try to understand why stagflation is particularly hard to fix using fiscal policy.
a. What would be the appropriate fiscal policy response to this situation if the primary concern of the government was to maintain economic growth? Illustrate the effect of the policy on the equilibrium point and the aggregate price level using the diagram.
b. What would be the appropriate fiscal policy response to this situation if the primary concern of the government was to maintain price stability? Illustrate the effect of the policy on the equilibrium point and the aggregate price level using the diagram.
c. Discuss the effectiveness of the policies in parts a and b in fighting stagflation.