This suggests that output increases if real money, government expenditure increases and if taxes decrease i. e. increase peoples disposable income. If an economy is in recession the IS is likely to shift to the left, investments drop. Government expenditure will help to increase the confidence of the people and help o create jobs through building projects. We can use the AS/AD analysis to show how excess supply leads to less demand. An excess in supply results in the AS curve shifting to the right moving along the AD curve we arrive at point B.
The shift in the AD curve to the left and back along the AS1, we now arrive at point C this is where the economy is now known as the short run. In the short run Y has declined assuming Y = N employment has also declined resulting in an increase in unemployment along with lower interest rates and lower price levels. According to Blanchard in the medium run output returns to its natural level through the aggregate supply. Blanchard suggests depending on whether natural output is above or below its natural level prices will either increase or decrease respectively.
Monetary policy is the control of money through generally interest rates. Extensive use of this policy is outlined by Alan Greenspan who is the chairman of the American Federal Reserve (FED), has cut interest rates from 6. 75% to 1. 75%, this is a massive drop. In doing so it is hoped that people have increased disposable income and hence stimulate the economy. At any price level the demand for money increases, the LM curve shifts down. Therefore during recession the aim is to increase aggregate demand, a shift down in the LM curve results in an increase in aggregate demand.
The fiscal policy is related to the government spending and taxation. This is concerned with the IS curve. Government spending and reduction in taxes comes up both in the IS and the AD equationA reduction in the taxes results in increased spending power by the public, and business have increased profits. The inflation cycle kicks in and people spend and therefore economy grows. Diagram shows shift in IS to the right and movement along the LM curve show that output is increased whilst interest rates have also risen.
Part b shows that the AD had shifted to the right resulting in higher output with a higher price level. In theory this is the effect both policies should have on an ailing economy. The world economy needs to have these policies put into action to help kerb the negative growth. The current decline in the economy is closely related to the plight of the American economy. America was going down after the hi-tech bubble burst but furthermore to their problems was the terrorist attacks which threw the people back. This lowered confidence within the market and people withdrew money for safe keeping.
At this point the government needs to reassure the public that their capital is safe. Increased government spending is one way. The implication of monetary and fiscal policies thus far have not yet been very effective, it is worthwhile noting that the policies do take time o work through the economy i. e. government spending. To say that deflation is biggest risk of the world economy is a very debatable topic and economist will argue for years to come. It is argued the economy will get worse before it gets better.
The recession in the world economy is largely due to excess supply, with companies making false sales projections, expanding with new factories and then demand drops. Thus workforce has to be slimmed down and consumer confidence is lowered and thus recession. According to Blanchard we end up back at the natural level of output, questions arise how far away is the medium run? The government cannot wait for nature to take its course as such and therefore is doing all in its power to get the economy moving in the right direction again, given time it will grow, but how long?