Question

Suppose it is mid-2007 and the stock market has been growing rapidly for the past 5 years. Some economists argue that the stock market has become “overvalued” and thus a “crash” is imminent

1. How does a rising stock market affect Aggregate Demand? Show this in an AD/AS diagram.

2. For a central bank that is trying to keep real GDP close to Potential explain what challenges are posed by a rapidly rising stock market

3. Suppose the stock market crashes how does this affect aggregate demand? Show this in an AD/AS diagram.

Answer 1

Let the economy is initially at the long run equilibrium level at point E1 at the potential level of output in the economy. A rising stock market will shift the aggregate demand curve rightwards to AD' and thus new equilibrium will occur at point E2 where the price level in the economy has increased to OP2 and the level of real GDP also exceeds its potential level and reaches to OY2. A central bank trying to keep the GDP at its potential level will try to reduce the amount of money supplied in the economy to reduce the level of aggregate demand in the economy and bring the economy back to its equilibrium level.

if stock market crashes then investment expenditure falls and aggregate demand will shift leftwards to AD" leading to fall in the price level and level of national income in the economy. This can be depicted in the following diagram: