Using the above figure, the economy is at full employment at point Y. Full employment is where all the resources available have been used to produce a certain level of output where the economy cannot absorb any more labor. When the credit squeeze happens, there is a reduction in consumption. This is due to units becoming more expensive due to less money circulation. This affects aggregate demand that falls from AD to AD 1. The fall in aggregate demand reduces the supply levels which reduces investment spending and leads to cash outflows. As the aggregate demand decreases, the equilibrium position shifts to E1. The price levels will decrease from P to P1. Also there will be a reduction in real output from Y to Y1 (Mankiw, 2014).
A credit squeeze occurs when the banks reduce their rate of lending or they consider to stop lending completely. Households and firms are therefore unable to access loanable funds which are required for their consumption as well as their investment spending. This situation affects the level of aggregate demand as it reduces. Also the investment spending reduces since it is expensive to obtain local funds leading to capital outflows. In the event the aggregate supply remains the same, there will be a reduction in real output due to capital outflows. This means that the level of unemployment increases as the real output decreases. Also, there is reduction in the inflation since there are reduced price levels due to decreased demand. Overall, the economy will be performing dismally (Borio, 2014).
- Using the diagram below, illustrate how this scenario will:
- Influence equilibrium in the short run (SR) labelling the new SR equilibrium A. (0.5 mark)
In the short run, both the price and the real output decreases, that is there is a decrease in inflation as well as the level of unemployment.
Influence equilibrium in the long run (LR) assuming no government or policy intervention labelling the new LR equilibrium B.
In the long run, the equilibrium price reduces, there is a reduction in inflation and the rate of unemployment is not affected.
Illustrate here (Tips: to create new lines, simply copy the existing curves and move to the new locations)
Borio, C. (2014). The financial cycle and macroeconomics: What have we learnt?. Journal of Banking & Finance, 45, 182-198.
Mankiw, N. G. (2014). Principles of macroeconomics. Cengage Learning.