Question

a. Suppose that the election of a popular candidate suddenly increases people’s confidence in the future. Use the model of aggregate demand and aggregate supply and a graph to analyse the effects on the economy.

b. Suppose now a wave of negative animal spirits overruns the economy, and people become pessimistic about the future. What happens to aggregate demand? If the Central Bank (or Fed) wants to stabilise aggregate demand, how shout it alter the money supply? If it does this, what happens to the interest rate? why might the Central Bank (or Fed) choose not to respond in this way?

Is it possible to include some academic references aswell please? Thanks

Answer 1

a. Consumer Confidence is one of the determinant of the Aggregate Demand curve. It is kept constant while graphing the AD curve between price and output level. An incresease in the consumer's confidence about the future will shift the aggregate demand curve to the right. In the AD AS model, the AD curve shifts from AD to AD1 leading to increase in the ouput level and the price.

b. When people become pessimistic about the future, then the aggregate demand falls. The AD curve in this case will shift to left and both output and price level will fall.

In order to stabilize the economy, the Fed will adopt EXPANSIONARY MONETARY POLICY. This would increase the flow of money in the market. People's purchasing power will rise as they have more money in their hands. This would lead to rise in consumer spending and hence the AD curve will shift to the right. The economy again reaches to its old equilibrium level.

An expansionary monetary policy reduces the interest rate and increase consumer spending and boost investment level.

There are multiple reasons for the Central Bank to not favour this policy:

1. May lead to Hyperinflation: an expansionary monetary policy increases the general price level and the inflation rate. If this rise is persistent for a long period of time, then economy may caught into a trap of hyperinflation and the value of money start eroding very quickly.  

2. Time Lags: Impact of monetary policy is experienced after some point of time. This can be 3 or 4 months. So, the implemenation would not give the results faster.

Alternative to this policy is the Fiscal Policy which is a better option to increase consumer spendind.