Question

1. Draw the AD-AS model in long-run equilibrium. Using this graph, depict what happens in the short run and in the long run if housing prices fall across the country.

2. Draw the AD-AS model when the economy is initially encountering an inflationary gap and then the government uses contractionary fiscal policy to return to long-run equilibrium.

Answer 1

When houisng prices crash the fall leads to domino effects and causes widespread unemployment into real estate sector and many companies go bust as well as banks go bankrupt. This causes liquidity freeze and thus disposable incomes reduce leading to subdued consumption in short run and thus aggregate demand falls and real GDP falls. In long run however the real GDP bounces back and achieve equilibrium.

When economy is into inflationary gap the potential output is above real output and thus government adopts contractionary fiscal policy by raising taxes and cutting down spending and thus the liquidity in market diminishing causes the disposable incomes to reduce and thus the consumption falls. Subsequently the real GDP falls causing sharp drop in prices as Aggregate demand shifts leftwards in short run and thus inflation cools down. In long run the equilibrium comes back to original and inflation moderates out.

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