Question

The world economy, in the last few months, has started to slow down due to many factors, such as
trade wars, uncertainty over Brexit, and general slowdown in other economic activity.
a. Assuming an economy starts initially at the full employment equilibrium, discuss (with the aid of
aggregate output market and money market diagrams) the short run effect of a decrease in demand
for goods due to drop in consumption. Explain what will happen output, unemployment, the
general price level and interest rate.

b. Discuss (with the aid of aggregate output market diagram) what kind of monetary policy can be
adopted to restore the economy back to the full employment equilibrium.
c. Suppose the president of the central bank of this economy is convinced that there is no need for any
monetary policy action.
If his/her opinion is followed, then how will the problem you discussed in part (a) adjust by itself?
How will the economy go back to equilibrium in the long run? Explain in under 250 words
whether you think the president’s opinion is good for the citizens of this economy?
Illustrate this self-adjustment on an aggregate output market diagram.

Answer 1

a) The economy starts with full employment level now due to fall in consumption there is a fall in demand thus the AD curve will shift leftward thus price level will fall and the output level will also from initial full employment level. In short run we consider mainly cyclical unemployment ; it depends upon the GDP level of the economy. When GDP is near to the full employment level then unemployment level will more less ; on the other hand high unemployment rate is there when GDP is low thus in this situation as output falls from initial full employment level thus unemployment will increase. Fall in price level will decrease annual wages and interest rate of the economy.

b) To bring back the economy to its initial full employment level the govt should use expansionary monetary policy where either the govt will lower the interest rate or they will increase the money supply of the economy.As the interest rate is lower and money supply rises the consumption or spending will increase thus AD will shift rightward, similarly lower interest rate will make big investment more attractive and saving less attractive thus people will increase their consumption level.Even a lower interest rate could lead to have a depreciation in exchange rate that will make export more attractive that import.thus AD will shift rightward and the economy will be again in the full employment level.

c) In long run self adjustment process leads to have the initial employment level eventually , in short run as price level and output level falls due to fall in AD in long run,a decrease in the price level will drive down input prices expectations about inflation which will increase the short run aggregate supply thus in long run though the price level will be lower but the employment will be at the initial level.