Assume an economy is in long-run macroeconomic equilibrium. The stock market suddenly declines signiﬁcantly. - What...

Assume an economy is in long-run macroeconomic equilibrium. The stock market suddenly declines signiﬁcantly.

- What curve is affected and which way would it shift?

- Explain how the economy will “self-correct” and the reasons why?

- What ‘gap’ is created by the shift in the curve? (recessionary or inflationary gap)

- What would be the appropriate monetary and ﬁscal policy response be to the station?

Expert Solution

Given that the economy is in long-run macroeconomic equilibrium.

The stock market suddenly declines signiﬁcantly.

- Wealth of investors is reduced so consumers would feel poorer and reduce consumption. This will reduce aggregate spending and so Aggregate demand curve shifts to the left.

- The economy will “self-correct” in the long run because of the wage price adjustment. In the long run when labor contracts are revised for nominal wages, firms will hire more as nominal wages are reduced and this results in increased production. Due to this output is increased and price level is reduced further. Output reaches its full employment long run macroeconomic equilibrium

- A recessionary gap is created because output in the short run falls below its long run macroeconomic equilibrium potential level

- An appropriate monetary policy would be to increase money supply and an appropriate ﬁscal policy response would be to reduce taxes or increase government spending

Rahul Sunny answered 1 hour ago

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