Question

Use the standard AD/AS model augmented with financial shocks to answer the following questions:

a) Show the effect of an increase in credit spreads due to the failure of a large financial institution. What happens to output and inflation in the short-run? What happens in the long-run?

b) Suppose that a financial crisis makes it difficult for firms to finance R&D expenditures. What effect might this have on potential output? Why?

c) Show graphically the effect of a financial crisis taking into account the mechanism in b)

d) In the Great Recession, inflation did not fall as much as expected despite a high rate of unemployment. Explain how your answers in b) and c) can explain this pattern.

Answer 1

(a) If there is a failure of a large financial institution it will have an impact on monetary policy of the country.In this situation the government uses expansionary fiscal policy where the government increase spending or reduce taxes or does combination of both.If there is an increase in government spending shifts the curve to the right

• In the short run real GDP increases and price level rises
• In the long run the SRAS curve shift leftward enough so that real GDP returns to potential GDP

*LRAS: Long run average supply; SRAS: Short run average supply

Effect on Inflation

• Aggregate demand continues to shift to the right when the economy is already at or near potential GDP and full employment. It is a situation where the firms are not able to meet the aggregate demand resulting from the shortage of labour and capital

(B) R&D expenditure play a significant role for the level of productivity and profitability.

-Because with recession ,part of the resource base of the firm itself which delays the project between conception and commercialisation.

(D) Inflation doesnot fall much during recession because expectations of future marginal cost didnot fall during recession .In other words marginal cost were expected to revert back to their normal level even though current marginal cost were low