Macroeconomic Essay

1448 Words Dec 29th, 2010 6 Pages
Macroeconomic theory essay.
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
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This makes up a liquidity shortage in the money market so that at this point, any use of expansionary monetary policy is inefficient in this situation. If money supply is to be increased, people would hold more and more money as precautionary or further investment, making the economy fall deeper into the liquidity trap; on the other hand, this could even result in a monetary deflation. After a long trapped period, Japan’s economy showed its first sight of recovery in 2003 with higher output growth and rising employment, wage as well as investment.

Policy lessons

“What kept Japan down were repeated macroeconomic policy mistakes” (The New York times, 2008). In fact, the Japanese government’s action was not effective regarding the situation of their economy. The use of monetary policy did not only worsen the effect of the liquidity trap but also create a deflationary pressure. On the other hand, their slow cuts in Bank of Japan nominal interest rate and deflation lead to nominal and real interest rate of different levels. Even nominal interest rate at zero, real interest rate has been positive. Fiscal policy was inadequate to increase demand and output but led to deficits and accumulating government debt.

‘Could we but suddenly double the productive powers of the country, we should double the supply of commodities in every market; but we should, by the same stroke, double the purchasing power. Everybody would bring a double
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