Answer to Question #47867 in Macroeconomics for Aditi

Question

In October 2008, Canadian consumer confidence plunged to levels last seen in the 1982 recession. According to some economic analysts, the global credit crunch and major stock market declines appear to have had an effect on Canadian consumer confidence.
a. Explain, and draw a graph to illustrate, how declining consumer confidence can change real GDP and the price level in the short run.
b. If the economy was operating at full-employment equilibrium, what is the state of equilibrium after the fall in consumer confidence? In what way might consumer expectations have a self-fulfilling prophecy?

Answer 1

a. Consumer confidence is one of several specific aggregate demand determinants assumed constant when the aggregate demand curve is constructed, and which shifts the aggregate demand curve when it changes. A decrease in consumer confidence causes a decrease (leftward shift) of the aggregate demand curve. Other notable aggregate demand determinants include interest rates, federal deficit, inflationary expectations, and the money supply.
b. If the economy was operating at full-employment equilibrium, both equilibrium level of GDP and equilibrium price will decrease after the fall in consumer confidence. Consumer expectations may have a self-fulfilling prophecy. If firms and consumers expect future inflation then it can become a self-fulfilling prophecy. If workers expect future inflation, they are more likely to bargain for higher wages to compensate for the increased cost of living. If workers can successfully bargain for higher wages, this will contribute towards inflation.