Question

Suppose the economy starts out in steady state. Then there is a major financial crisis and as a result the risk premium, p¯, increases substantially. Assume that the crisis is only temporary and things go back to normal after a while. Use the AS/AD framework from part (b) to graphically show what will happen in response to this financial crisis. Draw two AS/AD graphs: one graph for the short/medium run dynamics, during which the risk premium stays elevated (assuming there is no discretionary policy action); and a second graph for what happens in the long run, after things go back to normal.

Answer 1

Ans. Suppose at study state output is Y and price level is P.

The increase in risk premium increases the cost of borrowing decreasing consumption and investment which leads to a decrease in aggregate demand shifting the curve leftwards from AD to AD’. This leads to a decrease in price level from P to P’ and decrease in output from Y to Y’.

In long run, the reduced price level decreases the cost of production inputs for firms which induces an increase in aggregate supply shifting the curve from AS to AS’ leading to increase in output from Y’ to Y, the steady state output, and price level falls further to P”.

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