Question

Your uncle is pleased to hear you are taking macroeconomics; the whole financial crisis of 2008-2009 puzzled him. He was not happy about “bailing” out the banks. He is pretty good with graphs, so do not be afraid to use the IS-MP framework to explain the following:

How does the rapid decline of the housing market and the subprime implosion affect the macroeconomy?

Why the monetary policy was not being effective to stimulate the economy?

And why, pray tell, would we bail out the banks? Aren’t there potential long-run problems with doing this?

Answer 1

The macro-economic impact of the sub-prime mortgage financial crises in USA during the period 2007-10 led to long recession in USA due to following reasons:

1. First, there was a large decline in house prices after a collapse of house bubble leading to mortgage default, foreclosures, and devaluation of housing-linked securities

2. This led to decline in residential investment followed by reduction in household spending and business investment

3. Decline in housing prices led to decline in housing construction and direct employment in the sector and indirect employment in other related industries. This led to decline in household income and spending and thus fall in aggregate demand in the economy

4. Home owners saw decline in their value of wealth and increased indebtedness due to it thereby reducing spending due to it which further reduced aggregate demand in the economy

5. Bad mortgage housing loans led to increases losses of lenders including banks and financial institution exposed to it. This further led to reduced capacity to lend and increased risk-averseness in lending even in non-housing sectors of economy thereby reducing business investment as well and thereby further reducing aggregate demand in the economy

6. Inter-connected of the industries in the economy further reduced aggregate demand in the economy

7. Risk of bank run increased as even non-affected household depositors/investors feared the loss of value of their money in banks and other financial and non-financial institutions exposed to risk. This leads to decline in stock market and also reduction in funds available for lending to other borrowers and thereby reduces aggregate credit flow and money supply in the economy

8. Central bank in response intervened to increase money supply by reducing interest rate to near-zero level but it too soon became ineffective as there was liquidity trap in the economy due to combination of low interest rates and risk-averseness among public to save and lend in the society.

9. Thus, in order to curb the downward spiral in the economy, it became imperative for government to roll out fiscal stimulus packages as well as bailout of affected banks in order to retain the confidence and stability in the financial system. Although this bailout would increase government debt in short run but eventually government will able to recover and reduce it in long run when economy grows again at higher rate.

10. Figure 1 in IS-LM framework below highlights the impact of crises in the macroeconomy and the responses of central bank and government. Initially there is downward shift of IS curve from IS1 to IS2 due to reduced demand followed by shift in LM curve from LM1 to LM2 due to montetary policy support although it exhausts its limit and fiscal poilicy beciomes