Question

Imagine the New Zealand economy is initially at the potential level of output, but that due to a decrease in house prices, the level of consumption within the economy falls (because consumer confidence decreased).

(a) Show what effect this has on the New Zealand economy in the context of an AD-AS diagram.

(i) Label the original long-run equilibrium point "A". Label the short-run equilibrium outcome of the decrease in house prices "B"

(ii) Briefly explain what happens to output and the inflation rate.

(b) Explain and show on your diagram in part (a) what would happen to output and the inflation rate in the long-run if the government does nothing to accommodate this shock. Label this long-run outcome "C".

(c) If the government accommodates this shock, what policies would return the economy to the potential level of output? Explain how these would work, and make sure you also explain what happens to output and the inflation rate.

Answer 1

(a)

(i) In following graph, initial long-run equilibrium is at point A where AD0 (aggregate demand), LRAS0 (long-run aggregate supply) and SRAS0 (short-run aggregate supply) curves intersect, with long-run equilibrium price level P0 and real GDP (equal to Potential GDP) Y0.

(ii) Decrease in consumer confidence decreases consumption demand, in turn lowering aggregate demand. AD curve will shift to left, reducing price level (inflation) and reducing real GDP (output), causing a recessionary gap in short run.

In above graph, AD curve will shift leftward from AD0 to AD1, intersecting SRAS0 at point B with lower price level P1 and lower real GDP Y1, with recessionary gap being equal to (Y1 - Y0) in short run.

(b)

In long run without intervention, lower price level reduces input costs, so firms increase production, in turn increasing aggregate supply. SRAS shifts rightward, intersecting new AD curve at further lower price level but restoring original real GDP (output), eliminating the recessionary gap.

In above graph, SRAS0 shifts right to SRAS1, intersecting AD1 at point C with further lower price level P2 and restoring real GDP to potential GDP level Y0.

(c)

Government could accommodate this shock by increasing aggregate demand, using expansionary fiscal policy (increasing government spending and/or decreasing tax). As aggregate demand increases, AD curve will shift rightward, increasing price level and increasing real GDP (output).