Consider the AS-AD model with money, where money is neutral. Suppose that half of the banks in the economy magically disappear. What will happen to the supply of credit? Suppose that the central bank responds to this by keeping the supply of money fixed. What will happen to the price level P?

The net worth of a firm is equal to the value of the firm’s assets (things the firm owns) minus the value of the firm’s liabilities (things the firm owes). In our model, the representative firm owns capital, K. One way to value capital is at replacement cost. Simply put, this means the value of capital is the value of the investment goods the firm would have to buy to replace its entire capital stock. To replace the capital stock, the firm would need I = K units of investment goods. This has a nominal value of P × K. We have not discussed liabilities of the firm in class. A substantial amount of the money owed by firms is in the form of loans owed to banks and bonds. Both loans and bonds are promises by the firm to pay a fixed amount of dollars. Assume the total fixed amount of dollars the firm has promised to pay is B. This means that the net worth of the firm is given by NW = P × K − B

What happens to the net worth of firms in response to the bank closures in i.)?

Suppose that the representative firm needs to use its net worth as collateral to finance its investment projects. When net worth is high, the firm has more collateral and can invest more. When net worth is low, the firm has less collateral and must decrease investment. Using the AS and AD curves, explain why GDP will fall.

In part i.), what could the central bank have done to avoid the drop in output in part iii.)?