Question

Graphically illustrate a recession and note the steps 1 to 2 and 2 to 3 both on the graphs and in a bullet list or narrative. a. identify the adjustment mechanism if policy is anticipated (per rational expectations) b. identify the Keynesian policy recommendations

Answer 1

Recession refers to decline in economic activity. It is accompanied by decline in output, employment and price levels. Generally, recession is the result of decrease in aggregate demand.

Refer to the figure given above. Let 1 show the initial long run equilibrium where the economy is functioning at its full employment level. A decline in aggregate demand due to exogenous factors (factors other than price) results in the leftward shift of the AD curve. This is the first shift. The relevant curve now is AD'. The movement of the AD curve results in economy functioning below the full employment level. The prices also fall from P1 to P2. The economy is thus in recession.

However, it is important to note that the fall in prices is not in line with the expectations of the people. The expected price level right before the fall of the aggregate demand was P1. However, over time the expectations of the people adjust. There is also a decline in nominal wages due to the decline in price level. Thus, the input costs fall and the short run aggregate supply curve (SRAS) shifts out. This outward shift continues till we reach point 3, where the new aggregate demand (AD') and short run aggregate supply curves (SRAS') intersect at the long run equilibrium level. The economy is now back to its full employment level. However, the prices are lower.

a) The rational expectations theory propounds that the expectations of the people adjust immediately. That is, there is no time lag. Any fall in prices would immediately result in downward correction of money wages. The aggregate supply curve shifts out immediately. Prices fall and the economy returns to its full-employment level.

The theory rests on the assumption that economic agents are rational and can anticipate the actions of the government using all information that is available to them. Thus, the agents anticipate the policy and adjust their behaviors so as benefit themselves. As per the rational expectations theory, government policy, specifically monetary policy will not have any effect on the economy.

b) Keynesian recommendations to counter recession include demand management policy. This means that as soon as the economic activity starts to slow down because of decrease in aggregate demand, the governmental authorities have to take action to increase it. This can be done by increasing government consumption and investment expenditure, expansionary monetary policy, etc. If the policy is expansionary enough, the initial decline in aggregate demand can be completely offset by government activity and the economy will return to its original level.