Chapter 2: pg. 48
1) Outline three ways in which the behavior of the financial system could affect the level of aggregate demand in the economy.
The creation of liquid assets, the expansion of banking and money and the changes in people’s financial wealth are three ways by which the financial system could affect the level of aggregate demand in the economy. For a real economy to expand, liquidity of assets is a requirement and the availability of liquid assets increases the aggregate demand in the economy as consumers have easy access to cash when needed as liquid assets are assets that can be easily converted into cash. The expansion of banking and money also affects the level of aggregate demand in a positive way. The availability of proper banking systems which include financial intermediation increases the aggregate demand in the economy as people would be encouraged to spend and invest. Depending on the economy’s situation, changes in people’s financial wealth can have either a positive or negative on aggregate demand. Suppose the economy was experiencing a boom, the level of income and expenditure would be high and people would tend to spend more as a result of an increase in the aggregate demand. However, if the economy was going through a recession, the opposite would occur leading to a decline in spending thus a decrease in aggregate demand.
2) Suppose that prices in the US stock market suffer a major collapse. What effect would you expect this to have upon the rest of the US economy and the economies of other developed countries?
As a reflection to what has happened in January 2001 when the FTSE-100 index of stock prices fell by 50%, the US economy, economies of other countries and people within the US were greatly affected by this fall in prices. Possible effects would include central bank’s around the world lowering interest rates, aggregate demand would decline, saving would increase...