Credit Squeeze and Macroeconomic Effects

This assignment examines the economic consequences of a credit squeeze. It analyzes how reduced lending by banks impacts aggregate demand, leading to a decrease in both price levels and real output in the short run. In the long run, the equilibrium price decreases, inflation reduces, but unemployment remains unaffected. The assignment utilizes graphs to illustrate these scenarios, highlighting the dynamic changes within an economy facing a credit squeeze.

Course
Name
Institution Affiliation
Part 1
Price LRAS SRAS
level
P E
P1 E1
AD
AD1
Y1 Y Real output
Using the above figure, the economy is at full employment at point Y. Full
employment is where all the resources available have been used to produce a certain level of

output where the economy cannot absorb any more labor. When the credit squeeze happens,
there is a reduction in consumption. This is due to units becoming more expensive due to less
money circulation. This affects aggregate demand that falls from AD to AD 1. The fall in
aggregate demand reduces the supply levels which reduces investment spending and leads to
cash outflows. As the aggregate demand decreases, the equilibrium position shifts to E1. The
price levels will decrease from P to P1. Also there will be a reduction in real output from Y to
Y1 (Mankiw, 2014).
Part b
A credit squeeze occurs when the banks reduce their rate of lending or they consider to stop
lending completely. Households and firms are therefore unable to access loanable funds
which are required for their consumption as well as their investment spending. This situation
affects the level of aggregate demand as it reduces. Also the investment spending reduces
since it is expensive to obtain local funds leading to capital outflows. In the event the
aggregate supply remains the same, there will be a reduction in real output due to capital
outflows. This means that the level of unemployment increases as the real output decreases.
Also, there is reduction in the inflation since there are reduced price levels due to decreased
demand. Overall, the economy will be performing dismally (Borio, 2014).

a. Using the diagram below, illustrate how this scenario will:
i) Influence equilibrium in the short run (SR) labelling the new SR equilibrium A.
(0.5 mark)
In the short run, both the price and the real output decreases, that is there is a decrease in
inflation as well as the level of unemployment.
ii) Influence equilibrium in the long run (LR) assuming no government or policy
intervention labelling the new LR equilibrium B. (0.5 mark)
In the long run, the equilibrium price reduces, there is a reduction in inflation and the rate of
unemployment is not affected.
Illustrate here (Tips: to create new lines, simply copy the existing curves and move to
the new locations)
i)
ii)
SRAS
Quantity of output
Inflation
rate LRAS
AD
Quantity of output
Inflation
rate
AD
SRAS
LRAS

References
Borio, C. (2014). The financial cycle and macroeconomics: What have we learnt?. Journal of
Banking & Finance, 45, 182-198.
Mankiw, N. G. (2014). Principles of macroeconomics. Cengage Learning.