Falling House Prices and Rising Oil Prices

Possible exam Question: Describe difficulties in achieving the main macroeconomic objectives given falling house prices and rising oil prices.

Falling house prices have a negative wealth effect. Therefore could lead to lower Aggregate Demand, lower economic growth and unemployment. (see effect of falling house prices)

To deal with this lower growth, the government will need to pursue expansionary fiscal policy (lower tax, higher spending). This should increase AD and help to avoid a recession. Alternatively, monetary policy could be used – lower interest rates

However,

– It Takes Time. If the government decide to change spending, it can take a few months to implement this. Even when spending rises, it may not lead to an increase in income straight away. Therefore AD may increase too late.

Cuts in interest rates may also take time. For example, people on fixed rate mortgages are insulated from the rate cuts until they remortgage in 2-5 years times

However, the real difficulty is that falling output occurs with rising inflation.
Rising oil prices are causing cost push inflation. Therefore, the fiscal and monetary stimulus will cause demand to rise and therefore inflation to get worse.

Therefore it is very difficult to achieve all the objectives of both low inflation and high growth.

In theory supply side policies could help to achieve all objectives. Successful supply side policies can reduce both inflation and increase growth and cut unemployment. However, supply side policies will take a long time to have effect and are likely to be ineffective.

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By on June 3rd, 2008

One thought on “Falling House Prices and Rising Oil Prices

  1. I wonder following an expansionary fiscal policy might not aggravate the inflationary situation, especially in the current sky-rokceted oil price scenario?

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