Question

Assume that the economy is in equilibrium at potential GDP and then the demand for housing sharply declines. What actions could the government take to move the economy back to potential GDP? Support your discussion with an appropriate graph

Answer 1

Ans. A decline in demand for housing leads to a decrease in aggregate demand for goods and services. This will shift the aggregate demand curve leftwards from AD to AD' creating a surplus of goods in the market. This will cause the price level to fall in the market from P to P' and real GDP tk fall below potential level pf Y to Y'.

Price level AS P P AD AD AD Y Y Output

Government could use fiscal expansionary policy (like tax benefits on housing loans etc.). This will increase government spending in the economy leading to increase in consumption spending as well which will increase the aggregate demand for goods and services shifting the aggregate demand curve rightwards from AD' to AD''. This increase in consumption spending will increase the transaction demand for money leading to increase in interest rate in the economy which will increase cost of bowtie and will decrease investment spending partially offsetting the increase in aggregate demand due to increased government and consumption spending. This will shift the aggregate demand curve slightly leftwards from AD" to AD. So, overall the aggregate demand for goods and services has increased which will lead to increase in price level back to P and output back to potential level Y.

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