Question

Question 2. Consider the statement …. I think it’s clear the phenomenon of “secular (that is, long-lasting) stagnation” – exceptionally low inflation, low wage growth, low real interest rates, low business investment, low productivity improvement and low economic growth – applies to our economy…” and how cutting interest rates will change this situation.

              Use the dynamic AD-AS model to analyse the outcome associated with cutting interest rates. In your answer make sure to discuss the equilibrating process of moving to a new macroeconomic equilibrium output and the link between interest rates and each component of aggregate demand.                                              (Max 7 marks)

              Hint: Make sure to also discuss the impact on the general price level, and specify any assumptions you make.

Answer 1

The above mentioned scenario of "Secular stagnation" clearly points towards a economy in recession.In other words,this points towards deflation and lack of demand in the economy.In order to bail out the economy from such situation,we need to use different economical tools cautiously in a smarter way.The monetary and fiscal policies should be aimed at boosting the AD i.e.investment and consumption in the economy.It should be noted that investment and consumption are the 2 main components of AD and they play a very crucial role in the growth,expansion and develpoment of the economy.The above mentioned scenario clearly depicts low level of AD and AS leading to the equilibrium of the economy at a much lower level.Using interest rates as tool is a part of expansionary monetary policy and has deep implications on AD and AS,which can help us to improve the condition of the economy and help us to take the equilibrium level to new heights.Availability of credit is a very crucial factor in a economy which is directly or indirectly controlled by the market rate of interest.Here cutting rate of interest on credit can prove to be a very helpful tool.If interest rates are cut,it would increase the availability of credit in the economy and increase liquidity.As more easy funds are available in the economy,it would prompt the business houses to invest more encouraging investment.If there is rise in investment level,it will lead to setting up of more industries and factories and creation of employment opportunities.This would provide employment alternatives to more people carrying our economy towards full employment level.More employment in the economy will provide more income to households and lead to production of goods and services.If households are left with more liquidity and funds which would either be used for consumption or saving.If they are used for consumption,the demand for goods and services would increase in the economy increasing the revenue and profits of producers which would further increase the marginal efficiency of capital and prompt them to produce more leading to an outward shift in the AS curve.If those funds are used for saving,much of their part would be invested for earning interests.Thus prompting to produce more by producers would match with the availability of funds,this would prove to be an icing on the cake for the economy.We further know about multiplier effects,as per which a certain investment leads to many folds increase in the consumption.Thus boosts to the cconsumption and investment would cause an outer shift in the AD curve.Both shifts in the AD and AS would lead to an equilibrium in the economy at higher level and set the economy on the faster track of growth and development.