Low Spending Is Taking Toll on Economy

For months, beleaguered American consumers have defied expert forecasts that they would soon succumb to the pressures of falling home prices, fewer jobs and shrinking paychecks. Now, they appear to have given in. On Wednesday, the Commerce Department reported that the economy continued to stagnate during the first three months of the year, with a sharp pullback in consumer spending the primary factor at play. ... Americans cut back on a wide variety of discretionary purchases. ... As real estate prices plunge, so does the ability of homeowners to borrow against the value of their homes, crimping a major artery of spending. As banks grow tighter with their dollars in a period of uncertainty, families are running up against credit limits, forcing many to live within their incomes. And as companies lay off employees and cut working hours, paychecks are effectively shrinking. ... Consumer spending fell for a broad range of goods and services, including cars, auto parts, furniture, food and recreation, reflecting a growing inclination toward thrift. ... The New York Times, May 1, 2008

a) Explain and draw a graph to illustrate the effect of a fall in consumption expenditure on real GDP and the price level in the short run.

b) If the economy had been operating at a full employment equilibrium, describe the type of equilibrium after the fall in consumer spending in (a).

c) Why do changes in consumer spending play such a large role in the business cycle?

d) Explain and draw a graph to illustrate how the economy can adjust in the long run to restore a full-employment equilibrium.