Question

This question is about RBC models, and has three parts.

a) Give an example of a shock that would cause a typical RBC recession.

b) Describe which curves would shift, and in which direction, on IS-LM and AS-AD graphs.

c) Could government policy help get this economy out of a recession? Why or why not?

Answer 1

a) A demand side shock like huge rise in the level of interest rate will reduce the level of borrowing and investment in the economy. The subsequent result will be fall in level of aggregate demand and fall in employment opportunities in the economy. This will cause recession.

b) In IS-LM curve, with a negative shock of investment level going down, the IS curve will shift. Since the investment level is reducing, this curve will shift towards the left.

In the AS-AD curve, with increase in interest rate level, the cost of borrowing will increase. So the level of aggregate demand will come down and the AD curve will shift towards the left.

c) Yes, the government policy can help this economy come out of the recession. The government can make use of an expansionary monetary policy where it can bring down the level of interest rate. This will increase the investment level and help people borrow easily. So the demand level will also increase. So in this way government can help this economy come out of recession.