In response to the effects of a negative supply shock, which of the following policies is most likely to help stabilize output in the short run?

• A. Implementing trade restrictions to limit imports
• B. Reducing government spending to lower aggregate demand
• C. Expansionary fiscal policy, such as increasing government spending
• D. Contractionary monetary policy, such as raising interest rates

Answer: (C)

Verified step by step guidance

1. Step 1: Understand the nature of a negative supply shock. A negative supply shock reduces the economy's productive capacity, shifting the short-run aggregate supply (SRAS) curve to the left, which typically causes output to fall and prices to rise (stagflation).
2. Step 2: Analyze the effects of each policy option on aggregate demand (AD) and aggregate supply (AS). For example, trade restrictions may reduce imports but can also reduce efficiency and supply, potentially worsening the supply shock.
3. Step 3: Consider the impact of reducing government spending. This is a contractionary fiscal policy that lowers aggregate demand, which could further reduce output in the short run, making the recession worse.
4. Step 4: Evaluate expansionary fiscal policy, such as increasing government spending. This policy increases aggregate demand, which can help offset the decline in output caused by the supply shock, stabilizing output in the short run.
5. Step 5: Assess contractionary monetary policy, like raising interest rates. This reduces aggregate demand by making borrowing more expensive, which would likely decrease output further during a supply shock, thus not stabilizing output.