Question

Assume the Australian economy is originally at the long-run equilibrium.

An abrupt house price crash sends shockwaves throughout the economy.

In response to such a shock, households bring their spending on durable goods to the bare minimum, while firms cancel all future upgrade or expansion projects.

Required:

(a) Explain how the long-run aggregate supply (LRAS), the short-run aggregate supply (SRAS) and the aggregate demand (AD) will be affected by the above shock. Clearly explain why such change(s) would occur. (1 + 1 = 2 marks)

(b) Clearly explain how the above shock would affect the key macroeconomic variables (real GDP, unemployment rate and price level) in the short run. (1 mark).

(c) In order to counteract the above shock, do you recommend the government to implement expansionary fiscal policy or contractionary fiscal policy? Clearly explain why. (1 mark)

(d) Clearly explain what actions the government can undertake in order to implement the fiscal policy stance recommended in (c). (1 mark)

Answer 1

A.

Due to the house price crash, there is a negative demand shock in the economy. It will cause AD to decrease and shift to the left. SRAS will also decrease, but along the curve. So, there is no right or left movement in SRAS. LRAS will remain unchanged. It is shown as follows.

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B.

In the short run, real GDP will decrease as AD shifts to the left. It will also cause price level to decrease. Since there is a decrease in real output, then firms will layoff workers. It will cause unemployment rate to increase as well.

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C.

To counteract the given scenario, the government should implement expansionary fiscal policy, because it will boost demand in the economy, new jobs will be created and purchasing power of people will increase. So, it will make economy achieve long run equilibrium again.

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D.

Government should increase spending in terms of working on infrastructure development projects. Government can transfer direct cash to the bank accounts of unemployed people. Tax rebates can be given so that disposable income increases. These initiatives will increase AD in the economy.