Question

5. tart at full employment GDP. Use an AS AD diagram and show what happens when the following occur:

Consumer confidence decreases, House values decrease, stock markets decrease, business expectations of returns decrease.

Given that situation, explain:

1. What the appropriate monetary policy would be (hint: think about interest rates)
2. How the Federal Reserve would implement that policy. (Hint - you need to discuss the FOMC and the buying and or selling of government bonds in the bond market. YOU NEED TO DRAW THE LOANABLE FUNDS MARKET DIAGRAM.).
3. Show on the AS AD diagram the expected result of the policy.
4. What would happen to the price of bonds?

Answer 1

If for some reason consumer confidence declines,consumers become less certain about their financial prospects, and they begin to spend less money;A decrease in consumer confidence causes a decrease (leftward shift) of the aggregate demand curve.from AD to AD' quantity decreases from Q to Q' and prices decreases from P to P' equilibrium level falls from E to E'.

Because households see a fall in house prices their main form of wealth declines, this reduces their confidence to spend. Falling house price cause more people to be trapped in negative equity.this will again cause leftward shift in aggregate demand curve as shown in diagram

If they are losing money on shares they will be more hesitant to spend money; this can contribute to a fall in consumer spending Often share price movements are reflections of what is happening in the economy. stock market decrease could cause share prices to fall. The stock market itself can affect consumer confidence. Bad headlines of falling share prices are another factor which discourages people from spending.and if spending falls aggregate demand curve shift leftward as shown in the diagram

The expected returns from capital investment are determined by the demand for and the price of the output generated by an investment and also by the costs of production. business expectations of returns decrease leads to falls in aggregate demand and aggregate demand curve shift leftward all the factors cause leftward shift in demand curve and fall in price and quantity.

monetary policy

government use expansionary monetary policy for increasing aggregate demand expansionary monetary policy is when a central bank uses its tools to stimulate the economy. That increases the money supply, lowers interest rates, and increases demand.so it lowers the interest rate lower interest rate make it cheaper to borrow. This tends to encourage spending and investment. This leads to higher aggregate demand and economic growth.

fiscal policy

for this government use expansionary fiscal policy .This involves the government seeking to increase aggregate demand through higher government spending and/or lower tax.Expansionary fiscal policy is usually financed by increased government borrowing and selling bonds to the private sector .If the government cut income tax, then this will increase the disposable income of consumers and enable them to increase spending. Higher consumption will increase aggregate demand and this should lead to higher economic growth. expansionary fiscal policy shift D_LF  to the right .

this cause interest rate rise and when interest rate rise, bond price fall, and bond investors, especially those who remain in bond funds, will feel some degree of pain

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