Question

a. Use a diagram to explain the process by which a sudden decrease in households’ wealth because of a decline in the stock market will, in the short run, move the economy from one long-run macroeconomic equilibrium to another. Illustrate your answer with a diagram. b. Assuming you have elected a liberal government, how would your public policymakers fix this economy? c. Would the actions you describe in your answers to question (b) cause crowding out? Explain.

Answer 1

a. This will cause recessionary gap. This is due to aggregate demand shifting left. As animal spirits are low(with wealth with the people going down), potential of an economy which is at Long run aggregate supply is not being achieved. Economy is at Y2 due to less aggregate demand and hence unemployment is also higher than natural rate.Refer fig. below.

b. Recession is when real GDP growth is negative for six months. To avoid recession there should be enough aggregate demand in an economy. Aggregate demand should keep shifting right and it should be complemented by shift in aggregate supply as well so that economy potential goes up without inflationary impact on an economy.

This will be helped by both demand and supply side policies. Demand side policies:

Fiscal policy is a policy controlled by the government and it has two tools: taxes and govt. spending. During recessions govt. decreases taxes and increases govt. spending which is called expansionary fiscal policy.

Supply side policies: This policy focuses on aggregate supply. It has two types- market based and interventionist based. market based policy focuses on incentives for businesses, labor market reforms and encouraging competition. Interventionist based policy focuses on human and physical capital.

c.

When budget deficit is higher then in order to keep accounts intact it has to borrow money and as government needs more money, demand for money goes up and as demand goes up, interest rates also go up. This is what crowding ot effect is. Crowding out drives efficient and effective private investments. It leads to more job loss and also increases interest burden on government. Government will be stuck in debt cycle and infrastructure is not developed properly, standard of living remains low in any country.