How inflation and output respond in the short run

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Question: Housing and the Australian Economy

Roughly speaking, approximately two-thirds of Australian households either own their home or are in the process of purchasing their own home. For the majority of these individuals, housing represents the majority of their wealth. This question investigates what role a large decline in house prices would have upon the Australian economy.

(a) Consider the AD-AS model. Start in an initial equilibrium in which output is equal to potential output and inflation is equal to expected inflation. Suppose a large fall in house prices results in a decline in the wealth of households and this decline in wealth leads households to reduce the amount they would like to consume at any given real interest rate and level of output. Analyse this event using the AD-AS model. Use a diagram to explain how inflation and output respond in the short run.

(b) Use a diagram to explain how the economy responds to this fall in house prices in the long run. Describe the behaviour of inflation and output over time?

(c) What is the effect of this shock on the real interest rate in both the short run and long run? What is the effect of this shock on the components of aggregate expenditure in the short run and the long run?

Reference no: EM132197971

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