Argument That Price And Wage Flexibility Allow An Economy To Affect A Negative Demand Shock

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Macroeconomic theory essay.
Evaluate the theoretical argument that price and wage flexibility allow an economy to correct a negative demand shock. Provide evidence from Japan in the 1990s to illustrate your answer and consider briefly what policy lessons may follow for dealing with the impact of the current world financial crisis.

In the year 2007-2008, the global economy has been suffering deeply from the impact of the major financial crisis. This event is considered the worst of its kind in decades, since the great depression. The cure for this crisis has been the topic of much debate; many economists suggest that the idea of price and wage flexibility can return the economy back to full employment as it could have done for Japan
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Mill, 1862). As the matter of fact, to correct an adverse demand shock, we do not only need an appropriate supply of goods, labour, but also need an appropriate purchasing power. Either with a Japan’s liquidity trap in the 90s or with a financial crisis today, purchasing power is worsened. Thus, how can we increase purchasing power? “It needs to take whatever steps are necessary to prevent the money supply from falling and to inject as much liquidity as required to prevent a Japanese-style debt/deflation spiral from developing."(The guardian, 2008)

Paul Krugman (1998) suggested that it is essential to increase inflation expectation in order to correct such situations. By doing so, real interest rate can be corrected to the same level as nominal interest rate, namely zero. According to Keynes’s theories of investment, low real interest rate might lead to an increase in investment, which is the beginning of a multiplier effect. Increase in investment would raise level of output, higher level of output also lead to higher consumption as well as higher money demand. At this point, centre bank needs to increase the supply of money and, on the other hand, raise interest rate back to ensure that money market stay at equilibrium level. If price and wage were flexible, they will increase accordingly to investment, decrease unemployment. “Thus, as price and wage rise, the LM curve shifts back eventually to where it was before the monetary