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Macroeconomic theory

Evaluate the theoretical argument that price and wage flexibility allow an economy to correct a negative demand shock. Provide evidence from Japan in the 1990s to illustrate your answer and consider briefly what policy lessons may follow for dealing with the impact of the current world financial crisis. In the year 2007-2008, the global economy has been suffering deeply from the impact of the major financial crisis. This event is considered the worst of its kind in decades, since the great depression.

The cure for this crisis has been the topic of much debate; many economists suggest that the idea of price and wage flexibility can return the economy back to full employment as it could have done for Japan in its slump during the 1990s. The current crisis led to major failures and bankruptcy of many large banks and financial services such as Lehman Brothers, Northern Rock, Bradford and Bingley…and result in a liquidity crisis which reduce demand. This is somewhat similar to what the liquidity trap did in the Japan’s slump.

Therefore, once again the argument about price and wage flexibility being the solution for the current situation is consolidated. Thus, how does the flexibility of wage and price correct demand and bring the world economy back to full employment? A demand shock. To have a simple view at the situation, we can use the theory of demand and supply. When a negative demand shock takes place, demand decreases, lead to an excess supply. If price and wage are to be flexible, they will decrease with respect to the shift in demand curve; lead the economy to a new equilibrium point.

On the other hand, if price and wage are inflexible, they will stay the same, leave a demand shortage in the economy. This demand shortage can lead to a major failure, since price and wage are too high comparing with current demand, firms and companies can not make profit from selling goods and services and can not afford to pay their employees at the current wage. Output and employment rate will decrease as a result. The economy will have to suffer lower growth rate or even get into recession.

Back to the current situation, the world economy is going into a credit crunch period as many major banks and financial institutions fail to supply the adequate amount of credit, loans. Due to the shortage of credit availability, most economies might be incurring a negative demand shock, which reduce aggregate demand. As a multiplier effect, decreasing demand result in excess supply of goods as well as labour force in labour market; therefore unemployment is prolonged.

If prices and wages were to be flexible, money wage and price level would fall accordingly to adjust with the new demand curve, lead the economy to a new equilibrium point. Affect of a negative demand shock: When D1 shifts to D2, P1 decrease to P0 and Q1 decrease to Q2 (calculatedrisk. com, 2007) On the IS/LM model, a demand shock would lead to a decrease in real demand in the goods market, which makes the IS curve shift to the left. On the other hand, nominal money supply tends to be stable in the money market while real money supply fall accordingly to the fall in price level, lead LM curve to shift down to the right.

To correct the initial demand shock, what policy makers need to do is to keep the LM curve shifting down until the economy is restored with full employment. A demand shock on the IS/LM model Japan’s slump in the 90s. What happened in the slump in Japan’s economy in the 1990s was somewhat similar to the current situation of the world’s economy. Japan’s steady growing post-war economy came to an end in early 1990s, experiencing lower annual growth and increase in unemployment during the decade.

Especially, in the mid 90s, the country’s economy was stuck in a liquidity trap, in which nominal interest rate was close to zero, people were to be indifferent between holding money and holding bonds, consumer spending becomes flat and there is a demand shock. However, real interest rate has been positive even when nominal interest rate at zero. This makes up a liquidity shortage in the money market so that at this point, any use of expansionary monetary policy is inefficient in this situation.

If money supply is to be increased, people would hold more and more money as precautionary or further investment, making the economy fall deeper into the liquidity trap; on the other hand, this could even result in a monetary deflation. After a long trapped period, Japan’s economy showed its first sight of recovery in 2003 with higher output growth and rising employment, wage as well as investment. Policy lessons “What kept Japan down were repeated macroeconomic policy mistakes” (The New York times, 2008).

In fact, the Japanese government’s action was not effective regarding the situation of their economy. The use of monetary policy did not only worsen the effect of the liquidity trap but also create a deflationary pressure. On the other hand, their slow cuts in Bank of Japan nominal interest rate and deflation lead to nominal and real interest rate of different levels. Even nominal interest rate at zero, real interest rate has been positive.

Fiscal policy was inadequate to increase demand and output but led to deficits and accumulating government debt. Could we but suddenly double the productive powers of the country, we should double the supply of commodities in every market; but we should, by the same stroke, double the purchasing power. Everybody would bring a double demand as well as supply: everybody would be able to buy twice as much, because everyone would have twice as much to offer in exchange. ’ (J. S. Mill, 1862). As the matter of fact, to correct an adverse demand shock, we do not only need an appropriate supply of goods, labour, but also need an appropriate purchasing power.

Either with a Japan’s liquidity trap in the 90s or with a financial crisis today, purchasing power is worsened. Thus, how can we increase purchasing power? “It needs to take whatever steps are necessary to prevent the money supply from falling and to inject as much liquidity as required to prevent a Japanese-style debt/deflation spiral from developing. “(The guardian, 2008) Paul Krugman (1998) suggested that it is essential to increase inflation expectation in order to correct such situations. By doing so, real interest rate can be corrected to the same level as nominal interest rate, namely zero.

According to Keynes’s theories of investment, low real interest rate might lead to an increase in investment, which is the beginning of a multiplier effect. Increase in investment would raise level of output, higher level of output also lead to higher consumption as well as higher money demand. At this point, centre bank needs to increase the supply of money and, on the other hand, raise interest rate back to ensure that money market stay at equilibrium level. If price and wage were flexible, they will increase accordingly to investment, decrease unemployment.

Thus, as price and wage rise, the LM curve shifts back eventually to where it was before the monetary shock; as this backward shift in the LM occurs, the interest rate starts to increase, the demand for goods starts to fall and output falls back towards its full employment level Y’’ said Paul Krugman (1998). In fact, in this financial crisis, the demand shock can be corrected once credit availability is corrected. In conclusion, the most recent incident that have similar characteristic with the current financial crisis is Japan’s slump in the 90s.

Therefore, policy makers need to consider the lesson from what happened to Japan in order to make the right decision to solve the problem. The credit crunch which is followed up by a negative demand shock can be cured by the use of the flexibility of price and wage. This idea was proved to be the suitable solution for the liquidity trap in Japan before and it can now be used again in order to increase credit availability, decrease unemployment and correct the demand shock, bring the world economy back to its equilibrium level.

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