Question

2. Do the following: a. Draw a graph consisting of AD, SRAS, and LRAS and mark the long-run equilibrium. b. In the same graph, show what happens to the short-run equilibrium if there is a collapse in the stock market. c. What type of gap is there after the shock? d. What would eventually happen to output and inflation if there were no active policies used to counteract the shock? e. What type of active fiscal and active monetary policies could be used counteract the shock?

Answer 1

The economy below is represented by AD-SRAS-LRAS condition where the long run equilibrium is at E

A stock market collapse/crash/crisis will result in lowering the wealth of the consumers as investors. With fewer funds now available, the consumption and investment will reduce. This will shift the AD to the left reducing the price level and real GDP in the short run. This gap will be called a recessionary gap. Unemployment is higher.

Under no active policies, the transmission from short run to long run will be painfull. With falling price level, real wage rate increases.In the long run firms revise wage contracts and lower nominal wages to maintain real wage. This will induce firms to hire more labor so output employment both are increased. With this there will be rightward shift of the AS curve which will reduce the price level further.

To counter this situation, expansionary fiscal and monetary policies can be used. These will stimulate the AD so that ot shifts rightwards which will raise price level and real GDP back to their original level