Suppose the economy enters a recession. If government policymakers- Congress, the president, and members of the Federal Reserve -do not take any policy actions in response to the recession, which of the alternatives listed below is the likely result? Be sure to carefully explain why you chose the answer you did. 1\. The unemployment rate will rise and remain higher even in the long run, and real GDP will drop below potential GDP and remain lower than potential GDP in the long run. 2\. The unemployment rate will rise in the short run but return to the natural rate of unemployment in the long run, and real GDP will drop below potential GDP in the short run but return to potential GDP in the long run. 3\. The unemployment rate will rise and remain higher even in the long run, and real GDP will drop below potential GDP in the short run but return to potential GDP in the long run. 4\. The unemployment rate will rise in the short run but return to the natural rate of unemployment in the long run, and real GDP will drop below potential GDP in the short run and remain lower than potential GDP in the long run.

Step by step solution

01

Understanding a recession

A recession is a period of temporary economic decline during which trade and industrial activity are reduced. It is generally identified by a fall in GDP in two successive quarters.

02

Short term effects of a recession

In the short term, a recession typically causes an increase in unemployment due to company layoffs and a drop in hiring. Furthermore, real GDP falls below potential GDP because the output of goods and services declines.

03

Long term effects of a recession

In the long term, assuming no policy intervention, the economy naturally adjusts to absorb some of these effects. The unemployment rate will return to the natural rate of unemployment as workers find new jobs or create new businesses, and real GDP will adjust to align with potential GDP as market forces set in and resources are reallocated more effectively.

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