Introductory macroeconomics

Following a long period of economic growth, the country of Ambrosia was affected by a severe financial crisis in 2008/9. The initial impact came from outside the domestic economy. Exports collapsed due to falling demand from the USA and other major trading partners, and foreign investors began to pull their money out of Ambrosia, leading to a rapid decline in the stock market (as share prices fell) and in the property market. Property market speculators became insolvent, and banks facing increasing losses due to defaults cut back on their lending to the private sector. Consumers facing decreasing wealth and rising job insecurity cut back on their spending. Business organisations facing lower demand and more difficulty in borrowing cut back on their capital investments. The economy went into a severe recession, with real output falling by 4% in 2009 and a further 2% in 2010. Unemployment increased from a pre-crisis level of 6% to 11% by 2010.
a)Using either an injections/withdrawals diagram or a Keynesian cross diagram,illustrate the impact on Real GDP of decreases in exports, private investmentspending and autonomous consumption.

b)Some economists argued that the Ambrosian government should act to reduceunemployment back towards 6% to avoid permanent increase in unemployment dueto hysteresis. Explain what is meant by hysteresis, with reference to cyclical andstructural unemployment, and the natural rate of unemployment.
c)The central bank initially cut its official interest rate to promote recovery. Explain howthis policy might work.

d)The government’s budget went into deficit as an automatic consequence of therecession. Explain the main reasons for this, and illustrate using a relevant diagram.

e)After interest rates had been reduced to zero, the government decided to use adiscretionary fiscal stimulus to assist with economic recovery. Explain what this mighthave involved, and illustrate the effect of this policy measure on the governmentbudget balance diagram you used in part (d)


Introductory macroeconomics