Evaluate the theoretical argument that price and wage flexibility allow an economy to correct a negative demand shock. Provide evidence from Japan in the 1990s to illustrate your answer and consider briefly what policy lessons may follow for dealing with the impact of the current world financial crisis.
In the year 2007-2008, the global economy has been suffering deeply from the impact of the major financial crisis. This event is considered the worst of its kind in decades, since the great depression. The cure for this crisis has been the topic of much debate; many economists suggest that the idea of price and wage flexibility can return the economy back to full employment as it could have done for Japan in its slump during the 1990s. The current crisis led to major failures and bankruptcy of many large banks and financial services such as Lehman Brothers, Northern Rock, Bradford and Bingley…and result in a liquidity crisis which reduce demand. This is somewhat similar to what the liquidity trap did in the Japan’s slump. Therefore, once again the argument about price and wage flexibility being the solution for the current situation is consolidated. Thus, how does the flexibility of wage and price correct demand and bring the world economy back to full employment?
A demand shock.
To have a simple view at the situation, we can use the theory of demand and supply. When a negative demand shock takes place, demand decreases, lead to an excess supply. If price and wage are to be flexible, they will decrease with respect to the shift in demand curve; lead the economy to a new equilibrium point. On the other hand, if price and wage are inflexible, they will stay the same, leave a demand shortage in the economy. This demand shortage can lead to a major failure, since price and wage are too high comparing with current demand, firms and companies can not make profit from selling goods and services and can not afford to pay their employees at the current wage. Output and employment rate will decrease as a result. The economy will have to suffer lower growth rate or even get into recession.
Back to the current situation, the world economy is going into a credit crunch period as many major banks and financial institutions fail to supply the adequate amount of credit, loans. Due to the shortage of credit availability, most economies might be incurring a negative demand shock, which reduce aggregate demand. As a multiplier effect, decreasing demand result in excess supply of goods as well as labour force in labour market; therefore unemployment is prolonged. If prices and wages were to be flexible, money wage and price level would fall accordingly to adjust with the new demand curve, lead the economy to a new equilibrium point.
Affect of a negative demand shock:
When D1 shifts to D2,
P1 decrease to P0 and Q1 decrease to Q2
On the IS/LM model, a demand shock would lead to a decrease in real demand in the goods market, which makes the IS curve shift to the left. On the other hand, nominal money supply tends to be stable in the money market while real money supply fall accordingly to the fall in price level, lead LM curve to shift down to the right. To correct the initial demand shock, what policy makers need to do is to keep the LM curve shifting down until the economy is restored with full employment.
A demand shock on the IS/LM model
Japan’s slump in the 90s.
What happened in the slump in Japan’s economy in the 1990s was somewhat similar to the current situation of the world’s economy. Japan’s steady growing post-war economy came to an end in early 1990s, experiencing lower annual growth and increase in unemployment during the decade. Especially, in the mid 90s, the country’s economy was stuck in a liquidity trap, in which nominal interest rate was close to zero, people were to be indifferent between holding money and holding bonds,...