Question

3. Consider an economy where current real GDP is equal to its potential level y'. (a) Suppose that as a result of uncertainty over the future of trade relations between Canada and China, investment by firms in Canada falls. Use an AD-AS diagram to illustrate the effect of this drop in investment in the Canadian economy. (b) In response to negative economic conditions created in part (a), households decide to increase their savings because they fear they may soon lose their jobs. This reaction by households is called the paradox of thrift. Use an AD-AS diagram to show that this reaction by households actually makes economic conditions worse.

Answer 1

3. a. The fall in investment by firm shift the aggregate demand curve down. The economy's output will fall short of potential output and price level decrease and the economy will experience a recessionary gap. LRAS PRICE LEVEL SRAS NEI ADI AD YPI YT GDP The Canadian economy is in longrun equilibrium with GDP YP and price level PL. The actual GDP is equal to the potential GDP at YP The drop in investment by firms shift the AD curve left to ADI. This fall in aggregate demand reduce the price level to PLI and unemployment increase above the natural level. The economy experiencing a recessionary gap equal to Yº-YP'. b) During recession the firms lay off workers and reduce their inventories. Thus in the fear of loss of job people save more. As more is saved less will be the aggregate demand. Then the aggregate demand further shift downward leading to the recession more worse off than before. LRAS PRICE LEVEL SRAS PLII PL2 -7121 ADI AD AD2 YP2YPI YP GDP The aggregate demand curve further shift downward to AD2 and price level to PL2. The actual GDP drops to Y and unemployment increase further. This makes the condition of the cconomy again worse. c) Under the longrun self adjustment mechanism the lower price level stimulates more demand in the absence of paradox of thrift. The unemployment in the labour market and resource market compels the resource owners and wage earners to

accept a lower resource price and wage rate. Thus the fall in cost of production shift the aggregate supply curve to the right and the economy reaches to it potential output where the price level will be low and the actual output of the economy is equal to its potential level and unemployment will be equal to the natural level. LRAS PRICE LEVEL SRAS SRASI PLI-- PL2- - + E3 K T AD2 ADI AD YPI YP GDP The aggregate supply curve shift to the right to SRAS1 and the economy reaches to the natural level of output at Y? Price level reaches to PL2. d. A fiscal policy by the government without knowing the paradox of thrift raises the aggregate demand. But the cconomy will not reach to its potential level of output. In order to reach to the potential fullemployment output the government expenditure must raise to the extent enough to compensate the loss in aggregate expenditure loss due to the paradox. Economy attains an output expansion below the potential output. LRAS PRICE LEVEL SRAS PL2 -7 I MAD2 Yp2YPI YP ADI AD GDP The government expenditures shift the aggregate demand curve to AD1. But this is insufficient to reach to the potential output YP. There still exists unemployment cqual to Y". YP!