Answer to Question #258403 in Macroeconomics for Sanda

Question

In your role as an economist at the South African Reserve Bank, you are required to present to the monetary policy committee on how the fall in household wealth will affect the economy in both the short- and mediumrun, as well as how the bank should respond to these changes. [Hint: use clearly labelled diagrams to illustrate your answer]

Answer 1

Solution:

A fall in household wealth will result in a reduction in consumer spending and investment, shifting the aggregate demand curve to the left. This will have a negative effect on the economy as a whole, since households, through their reduction in spending and investment, will not be able to stimulate the economy and Real GDP will drop.

This is depicted by the below graph:

Banks can respond to these changes through monetary policies to increase the money supply in the economy and stimulate economic growth. This can be achieved through expansionary monetary policies such as a decreased discount rate, purchasing of government securities, and lowering the reserve ratio. This will reduce interest rates, and stimulate spending, borrowing, and investment, thus stimulating economic growth. An increase in money supply causes a rightward shift in the aggregate demand curve, causing the aggregate demand curve to shift to the right.

In the short run, expansionary monetary policy raises real GDP, lowers unemployment, and raises the price level as flexible prices rise. Simply increasing the money supply leads to an increase in real employment and real output.

This is depicted by the below graph: