Consider an economy that is in
Consider an economy that is initially in long-run equilibrium.Unexpectedly, there is a sudden massive decrease in houseprices.
a) Explain why this is likely to lead to a reduction in privateconsumption. Theoretically, could consumption also increase?Explain. (3 points)
b) Show in the AS-AD diagram, and explain, the consequences ofthis decline in consumer spending. (3 points)
c) If the central bank does not change its monetary policy rule,how will it react to the situation in (b)? Illustrate and explainyour answer. (3 points)
d) Now suppose that, in addition to the house price shock, theeconomy is hit by an adverse inflation shock. (i) Explain how theadverse inflation shock affects the SRAS line. (ii) With referenceto the AS-AD diagram, discuss the monetary policy choices thecentral bank now faces. (4 points)
Answer:
a)A massive decrease in house prices lead people to make allocationbetween consumption and purchase of Households which are availablenow at comparatively lower prices. Purchase of household iscategorized under Residential investment component of Aggregatedemand. A large part of income is spent on buying houses. That’swhy there is reduction in the spending on private consumption. Noconsumption of goods cannot increase because more money is nowspent on buying houses which has become cheaper.
b) This part is explained in the picture above.
c) If the central bank does not intervene, then market forces ofdemand and supply comes into play. Demand for houses will continueto rise until its price matched up with the initial level. At theinitial prices of house, demand for household will decline andthere would be increase in consumption.
d) 1. Adverse inflation shock would lower the real money balancein the economy (at a constant money supply). This would shift ADcurve to left resulting in the decline of prices and output atpoint E’ (See the above figure in the above picture) . Now priceadjustment comes into play. Wage setters see a lower output thanpotential level and lower price level so they would revise theprice level downwards. As a result short run AS curve shiftsrightwards to reach at point E”.At this point output is atnatural(potential) level and prices is lower.
d) 2. Central bank could increase the money supply by the sameamount or more than that of inflation rate to stimulate real moneybalance. This would either shift AD curve at its original position(In the case money supply completely negate the effect of inflationrate ie real money balance is unchanged) or shift the AD curverightwards again raising prices and output. This would cause theprice adjustment and shifting of AS curve which is explained indetail in the above part.
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