The following are to be answered:
1.How did the decline in home prices in 2006-2008 affect aggregate demand?
2.What's wrong with classical theory? Why didn't sales and employment increase in 1929- 1933, in respect to decline prices and wages?
Due date: 11-14-15
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it will cause aggregate demand to rise
To answer both of these questions, we need to understand the concepts of aggregate demand and classical theory.
1. How did the decline in home prices in 2006-2008 affect aggregate demand?
To understand how the decline in home prices affected aggregate demand, we can consider the components of aggregate demand which include consumption, investment, government spending, and net exports. The decline in home prices had several effects on aggregate demand:
a. Wealth effect: When home prices decline, homeowners experience a decrease in their wealth. This decrease in wealth leads to a decrease in consumer spending, as households may feel less confident about their financial situation and reduce their consumption. This decrease in consumption lowers aggregate demand.
b. Investment effect: The decline in home prices can also lead to a decrease in real estate investment. As home prices fall, real estate developers and investors may be less willing to invest in new projects or buy existing properties. This decrease in investment reduces aggregate demand.
c. Confidence effect: The decline in home prices can also negatively affect consumer and business confidence. Homeownership is often seen as a significant investment and a measure of financial stability. When home prices decline, it can create uncertainty and anxiety among consumers and businesses. This decrease in confidence can lead to a reduction in spending and investment, further reducing aggregate demand.
Overall, the decline in home prices in 2006-2008 had a negative impact on aggregate demand by reducing consumer spending, lowering investment, and decreasing confidence.
2. What's wrong with classical theory? Why didn't sales and employment increase in 1929-1933, in respect to declining prices and wages?
Classical theory, also known as the classical economics framework, is an economic theory that suggests that market economies are self-regulating and tend to naturally adjust to equilibrium. According to classical theory, if prices and wages decline, it should lead to an increase in sales and employment. However, this did not happen during the Great Depression from 1929-1933.
The failure of the classical theory during the Great Depression can be attributed to several reasons:
a. The problem of sticky prices and wages: In reality, prices and wages do not always adjust quickly and easily to market conditions. During the Great Depression, even though prices and wages were declining, they did not adjust rapidly enough to stimulate sales and employment. Many firms and industries were unable or unwilling to reduce prices and wages due to various factors such as long-term contracts, labor unions, and rigidities in the financial system.
b. Negative feedback loop: The decline in sales and employment during the Great Depression created a negative feedback loop. As sales and employment declined, households and businesses reduced their spending and investment, which further led to a decrease in sales and employment. This cumulative effect resulted in a prolonged economic downturn, despite the decline in prices and wages.
c. Deflationary expectations: During the Great Depression, there was a widespread expectation of further declines in prices and wages. This expectation led to hoarding of cash and delayed spending by consumers and businesses, as they anticipated that prices would be lower in the future. This hoarding of cash and reduced spending further worsened the economic situation and hindered the effectiveness of the classical theory.
In summary, the failure of classical theory during the Great Depression can be attributed to the problem of sticky prices and wages, the negative feedback loop created by declining sales and employment, and deflationary expectations that hindered spending and investment.