Question

QUESTION ONE

During the onset of the global financial crisis many of the world’s central banks and governments prevented large banks to fail. If these institutions had allowed this occur there would have been large-scaled bank failure which would have had a negative impact on bank deposits. Using the Keynesian model illustrate and explain the impact of a large-scale bank failure on planned aggregate expenditure.

QUESTION TWO

An economy is initially in a recession. Using the aggregate demand and aggregate supply model illustrate what would happen if:

1. The central bank responds by cutting the interest rate.
2. The central bank takes no action

Answer 1

Answer 1:

Bank failure can have a large negative impact on the level of national income in the economy. In case there was no government intervention and large scale bank failure occurs in the economy, there will be fall in investment expenditure and consumption expenditure in the economy because of negative consumer and investor sentiment in the economy.. This reduces both consumption and investment exoenditure and also reduce government expenditure. This will reduce aggregate expenditure in the economy which is the sum of consumption expenditure, investment expenditure and government expenditure in the economy and thus aggregate expenditure will shift downwards. In the graph, the intial equilibrium occurs at point E1. A decrease in autonomous expenditure will shiift the AE curve downwards to AE2 and thus new equilibrium shifts to point E2 where the level of National income has decreased to OY2 which creates recessionary gap in the economy.