Question

Suppose that f is determined by two factors: financial panic and asset purchases.

1. Using an MP curve and an AS/AD graph, show how a sufficiently large financial panic can pull the economy below the zero lower bound and into a destabilizing deflationary spiral.
2. Using an MP curve and an AS/AD graph, show how a sufficient amount of asset purchases can reverse the effects of the financial panic depicted in part (a).

Short answer

1. The diagram showing the impact of financial panic on the economic system beneath zero lower bound is as follows:
2. The diagram showing how the sufficient purchase of assets can reverse the financial panic is as follows:

Step-by-step solution

Part (a) Step 1: Concept Introduction

The term "zero lower bound rates" refers to interest rates that have fallen to zero.

Part(a) Step 2 : Explanation

The diagram showing the impact of financial panic on the economic system beneath zero lower bound is as follows:

Where,

- MP is the monetary policy.

- I represent the inflation rate.

- LRAS is the long-run aggregate supply.

- SRAS is the short-run aggregate supply.

- AD is the aggregate demand.

In a situation of financial panic, financial friction will increase, raising the actual interest rate on investments. The economy will be pushed to B by a considerable increase of panic. Inflation will be lowered by a self-correcting mechanism at point B. Real interest rates will rise at this moment since the economy has passed the zero nominal lower bound. Increasing real rates will result in a deflationary spiral.

Part (b) Step 1: Concept Introduction

The term "financial panic" refers to a situation in which stockholders sell their stock, customers withdraw their bank deposits, and market participants demand their assets be liquidated.

Part (b) Step 2: Explanation

The diagram showing how the sufficient purchase of assets can reverse the financial panic is as follows:

Where,

- MP is the monetary policy.

- I represent the inflation rate.

- LRAS is the long-run aggregate supply.

- SRAS is the short-run aggregate supply.

- AD is the aggregate demand.

The purchase of a suitable amount of assets will reduce financial friction. Because of the reduced friction, the panic effect will be reversed, and the actual interest rate on investment will fall. This gets the economy from point A to point B, where there is no possibility of a deflationary spiral. Because of the self-correcting process, the economy may now be moved to a stable, long-run equilibrium. Because of the zero lower bound inflection point on the right of the Long run aggregate supply curve along the aggregate demand curve, the economy is moved to long-term equilibrium by the self-correcting mechanism.