Question

Consider an economy that is initially in long-run equilibrium. Unexpectedly, there is a sudden massive decrease in house prices.

a) Explain why this is likely to lead to a reduction in private consumption. Theoretically, could consumption also increase? Explain. (3 points)

b) Show in the AS-AD diagram, and explain, the consequences of this decline in consumer spending. (3 points)

c) If the central bank does not change its monetary policy rule, how will it react to the situation in (b)? Illustrate and explain your answer. (3 points)

d) Now suppose that, in addition to the house price shock, the economy is hit by an adverse inflation shock. (i) Explain how the adverse inflation shock affects the SRAS line. (ii) With reference to the AS-AD diagram, discuss the monetary policy choices the central bank now faces. (4 points)

Answer 1

a) A massive decrease in house prices lead people to make allocation between consumption and purchase of Households which are available now at comparatively lower prices. Purchase of household is categorized under Residential investment component of Aggregate demand. A large part of income is spent on buying houses. That's why there is reduction in the spending on private consumption. No consumption of goods cannot increase because more money is now spent on buying houses which has become cheaper.

b) This part is explained in the picture above.

c) If the central bank does not intervene, then market forces of demand and supply comes into play. Demand for houses will continue to rise until its price matched up with the initial level. At the initial prices of house, demand for household will decline and there would be increase in consumption.

d) 1. Adverse inflation shock would lower the real money balance in the economy (at a constant money supply). This would shift AD curve to left resulting in the decline of prices and output at point E' (See the above figure in the above picture) . Now price adjustment comes into play. Wage setters see a lower output than potential level and lower price level so they would revise the price level downwards. As a result short run AS curve shifts rightwards to reach at point E".At this point output is at natural(potential) level and prices is lower.

d) 2. Central bank could increase the money supply by the same amount or more than that of inflation rate to stimulate real money balance. This would either shift AD curve at its original position (In the case money supply completely negate the effect of inflation rate ie real money balance is unchanged) or shift the AD curve rightwards again raising prices and output. This would cause the price adjustment and shifting of AS curve which is explained in detail in the above part.