Question

Question 9 (13.5 points) You've taken a job as a chief macroeconomic advisor in a $100 million start-up firm. As your firm's business plan is launched, and sales immediately surge, the 28-year-old CEO expressed concern that sales of her product are vulnerable to economic fluctuation. She asks "Trade war with many economies would influence consumer sentiment in our market. I also heard that there is a rumor that there might be a downfall in financial market soon. I would like to know what would happen in the overall health of the economy, so that we can predict our sales in future." You respond one of below. Explain your response using the theory from school of economics you are subscribing (Keynesian/Main Stream, Real Business Cycle, Monetarists etc.). A. The economy will self corrects, and the negative output gap from those shocks will disappear eventually, however long it may take. B. Price level will decrease and unemployment rate would increase, which means that overall consumption level will decrease, and we should prepare for some period of time of economic recession C. Government will always stimulate the economy, so we do not have to worry too much about economic downturn. D. This might be a good correction in the economy to shed inefficiency and redundant investment. Current shock is not a real shock. The economy will find its new equilibrium always, so trust the market. Go with a flow! A Format BIU- ... 4/> E B JL UNTE W 17 P х sty G Search or type URL

Answer 1

Question 9:

Response A is explained below: The economy will self-correct and the negative out-put gap from those shocks will disappear eventually, however long it may take.

This response is based on the classical view, which assumes economy to be self-correcting. According to classical economist, the economy is self-regulating which means it has the capability to achieve the natural level of GDP, at which all the resources in the economy are fully employed. The self-regulating mechanism is explained below:

Refer to the below figure: X-axis shows the real GDP; Y-axis shows the price level. Initially the economy is at its long-run equilibrium at point E1, where the vertical long-run aggregate supply curve (LRAS), short-run aggregate supply curve (SRAS1) and the initial demand curve (AD1) intersect each other. Here, the equilibrium level of Real GDP is equal the full employment level of output given as Yn and the equilibrium price level is P1.

If rumors are to be believed, then a fall in consumer sentiments caused due to trade wars and a downfall in the financial market would negatively affect the aggregate spending in the economy. Lower consumer confidence, higher savings and lower investment spending would lead to a fall in the aggregate demand. This would shift the aggregate demand curve leftwards from AD1 to AD2. The economy would move to short-run equilibrium at point E2 where prices will fall from P1 to P2. In response to lower prices and lower demand, the firms would have to cut down production in order to avoid further losses. This would induce firms to lay-off employees taht would cause unemployment rates to rise. The aggregate output would fall below the potential level to Y1 which would create a short-run recessionary gap equivalent to “Y1 – Yn”

Unlike in the short-run, where wages and resource price are rigid due to wage contracts, in the long run all prices become flexible. With a fall in price level, labor wages and other input prices experience a downward trend. Due to low cost of production, firms would respond by employing more labor and increasing production levels. This causes the short-run aggregate supply curve to shift rightwards from SRAS1 to SRAS2. The short-run aggregate supply curve keeps on shifting until it intersects both the aggregate demand curve and the long-run aggregate supply curve. Thus, with the self-correcting nature of the economy, it moves to the new long-run equilibrium at point E3, where LRAS, AD2 and SRAS2 intersect. Here :

o Real GDP stabilizes back to potential level Yn which clsoes negative out-put gap

o Employment rises and Unemployment rate equalizes to natural rate of unemployment

o Price level falls further to P3.