Question

Discuss Aggregate Demand, Aggregate Supply, and their equilibrium. Discuss the Stimulus and the Great Recession from the text. Do you agree that the lowering of interest rates after the housing crash helped to reduce the negative economic impact?

Answer 1

In economics, the macroeconomic equilibrium is a state where aggregate supply equals aggregate demand.

• Equilibrium is the price -quantity pair where the quantity demanded is equal to the quantity supplied.
• In the long-run, increases in aggregate demand cause the output and price of a good or service to increase.
• In the long-run, the aggregate supply is affected only by capital, labor, and technology.
• The aggregate supply determines the extent to which the aggregate demand increases the output and prices of a good or service.

In economics, equilibrium is a state where economic forces (supply and demand) are balanced. Without any external influences, price and quantity will remain at the equilibrium value.

Determining the supply and demand for a good or services provides a model of price determination in a market. In a competitive market, the unit price for a good will vary until it settles at a point where the quantity demanded equals the quantity supplied. The result is the economic equilibrium for that good or service.

There are four basic laws of supply and demand. The laws impact both supply and demand in the long-run.

1. If quantity demand increases and supply remains unchanged, a shortage occurs, leading to a higher price until the quantity demanded is pushed back to equilibrium.
2. If quantity demand decreases and supply remains unchanged, a surplus occurs, leading to a lower price until the quantity demanded is pushed back to equilibrium.
3. If quantity demand remains unchanged and supply increases, a surplus occurs, leading to a lower price until the quantity supplied is pushed back to equilibrium.
4. If quantity demand remains unchanged and supply decreases, a shortage occurs, leading to a higher price until the quantity supplied is pushed back to equilibrium.

Aggregate supply is the total supply of goods and services that firms in a national economy plan on selling during a specific time period. It is the total amount of goods and services that firms are willing to sell at a specific price level in an economy.

Aggregate demand is the total demand for final goods and services in an economy at a given time and price level. It is the demand for the gross domestic product (GDP) of a country.

Equilibrium is the price-quantity pair where the quantity demanded is equal to the quantity supplied. It is represented on the AS-AD model where the demand and supply curves intersect. In the long-run, increases in aggregate demand cause the price of a good or service to increase. When the demand increases the aggregate demand curve shifts to the right. In the long-run, the aggregate supply is affected only by capital, labor, and technology. Examples of events that would increase aggregate supply include an increase in population, increased physical capital stock, and technological progress. The aggregate supply determines the extent to which the aggregate demand increases the output and prices of a good or service.

When the aggregate supply and aggregate demand shift, so does the point of equilibrium. The aggregate demand curve shifts and the equilibrium point moves horizontally along the aggregate supply curve until it reaches the new aggregate demand point.

The slope of the aggregate demand curve shows the extent to which the real balances change the equilibrium level of spending. The aggregate demand curve shifts to the right as a result of monetary expansion. In an economy, when the nominal money stock in increased, it leads to higher real money stock at each level of prices. The interest rates decrease which causes the public to hold higher real balances. This stimulates aggregate demand, which increases the equilibrium level of income and spending. Likewise, if the monetary supply decreases, the demand curve will shift to the left.

In economics, the aggregate supply shifts and shows how much output is supplied by firms at different price levels.

The aggregate supply curve may shift labor market disequilibrium or labor market equilibrium. If labor or another input suddenly becomes cheaper, there would be a supply shock such that supply curve may shift outward, causing the equilibrium price in to drop and the equilibrium quantity to increase.

The Federal Reserve, Treasury, and Securities and Exchange Commission took several steps on September 19, 2008 to intervene in the crisis caused by the late-2000s recession. To stop the potential run on money market mutual funds, the Treasury also announced that same day a new $50 billion program to insure the investments, similar to the Federal Deposit Insurance Corporation (FDIC) program. Part of the announcements included temporary exceptions to section 23A and 23B (Regulation W), allowing financial groups to more easily share funds within their group. The exceptions would expire on January 30, 2009, unless extended by the Federal Reserve Board. The Securities and Exchange Commission announced termination of short-selling of 799 financial stocks, as well as action against naked short selling, as part of its reaction to the mortgage crisis

• Rising house prices, generally encourage consumer spending and lead to higher economic growth.
• A sharp drop in house prices adversely affects consumer confidence, construction and leads to lower economic growth. (falling house prices can contribute to economic recession)
• Rising house prices can also redistribute wealth within an economy – increasing the wealth of homeowners (primarily older people), but reducing effective living standards for those who do not own a house (often the young)

The wealth effect looks at the impact of the rising value of assets on consumer spending.

A rise in house prices creates an increase in wealth for householders. As a consequence of this increase in house prices, householders will generally:

1. Be more confident about spending and borrowing on credit cards. They can always sell their house in an emergency.
2. Increase in equity withdrawal. A rise in house prices enables homeowners to take out a bigger mortgage. Banks can lend more on the basis of the increased price of the house. Households could use this bigger loan to spend on other items. This can create a significant increase in consumer spending. For example, in 2006, with rising house prices, equity withdrawal added an extra £14bn to consumer spending. In 2008, with falling house prices, equity withdrawal was -£7bn. (people taking the opportunity to pay off the mortgage)

House prices can impact the lending practices of banks. When house prices are rising rapidly, banks see an improvement in the value of their assets. They feel more confident in increasing bank lending and reducing their reserve ratio. The long housing boom of 1995-2007, was one factor that encouraged bank lending to increase. Some former building societies like Northern Rock and Bradford & Bingley were so keen to lend; they were borrowing money on money markets to lend more mortgages. This bank lending proved unsustainable when the credit crunch hit.

Falling house prices tend to cause a fall in bank lending. Banks will see a decline in the value of their assets and may lose money, should homes become repossessed. This was particularly a problem in 1991 when falling house prices were combined with high interest rates.

If house prices rise, then the wealth effect is likely to cause an increase in consumer spending. This will cause higher Aggregate Demand (AD), and it is likely to cause an increase in Real GDP and a higher rate of economic growth.

Similarly, a fall in house prices is likely to lead to lower consumer spending and

Multiplier effect

If there is an increase in aggregate demand from rising house prices, there may also be a multiplier effect which causes the increase in aggregate demand to be bigger than the initial effect.

• When there is a fall in house prices, there tends to be a negative wealth effect and a negative impact on economic growth.
• Because households see a fall in house prices, their main form of wealth declines, this reduces their confidence to spend. They are more likely to devote a higher % of their income to try to pay off their mortgage early.
• Falling house prices cause more people to be trapped in negative equity (a situation where your house is worth less than an outstanding mortgage). This causes a fall in spending and precludes any opportunity for equity withdrawal.
• Falling house prices have a negative impact on the construction of new houses.