what is the impact of a contractionary policy on the U.S. economy from a new keynesian point of view? Show the impact using a graph.

Step 1:

New Keynesian Economics provide macroeconomic foundation for the Keynesian economics. Unlike Keynesian economics, new Keynesian assumes that public have rational expectation. Unlike classical economics, they assume that prices and wages are sticky in the short run. That’s why, prices and wages don’t adjust simultaneously in response to changes in economic variables. This stickiness implies why economy fails to attain potential output. Therefore, they argued that fiscal and monetary policy are quite effective.

Impact of contractionary policy:

New Keynesians believe that stabilisation through monetary or fiscal policy is possible since they assume that firms and households have rational expectation. Due to rational expectation, Central Bank can’t systematically surprise the public. The means that public’s forecasting about the economic variables are based on reasoned and intelligent examination of available economic data and any policy which can be anticipated by public doesn’t affect the output level to a greater extent. Therefore, when expectations are rational only pure random changes are unanticipated and can affect the output.   

Now, we’ll analysis how the contractionary policy affects the level of output.

Case 1: When this contractionary policy is unanticipated:

 Contractionary policy cause aggregate demand curve to shift inwards i.e. from AD₁ to AD₂ and aggregate supply curve stays at AS_1. This shows price falls from P₁ to P_U and output falls from Y₁ to Y_u.