Question

1. Suppose the stock market crashes lowering output and raising the price level in the short run. If policymakers do nothing,

a. the price level would further decline as the economy reaches a new long-run equilibrium.

b. the price level would eventually increase as the economy reaches a new long-run equilibrium.

c. the price level would stay at the same level as in the short-run equilibrium that followed the stock market crash.

d. None of the above is correct.

Answer 1

Question 1

When the stock market crashes, it leads to a decrease in aggregate demand due to the negative wealth effect.

This decrease in aggregate demand leads to fall in output and price level.

Fall in output implies lower production being undertaken in the economy which in turn will lead to a fall in employment and will put downward pressure in wages.

As wages will decline, the cost of production of firms will also decrease.

This decrease in the cost of production will increase the profit margin of firms and would induce them to produce more.

This will lead to an increase in aggregate supply. Eventually, the short-run aggregate supply curve will shift to the right and would bring the economy to a new long-run equilibrium with the further lower price level.

So,

Suppose the stock market crashes lowering output and raising the price level in the short run. If policymakers do nothing, the price level would further decline as the economy reaches a new long-run equilibrium.

Hence, the correct answer is the option (a).