Question

The 2008-09 Financial Crisis & Recession

 2009: Real GDP fell, u-rate approached 10%

 Important factors in the crisis:

 early 2000s Federal Reserve interest rate policy

 sub-prime mortgage crisis

CHAPTER 11 Aggregate Demand II 42

 bursting of house price bubble,

rising foreclosure rates

 falling stock prices

 failing financial institutions

 declining consumer confidence, drop in spending

on consumer durables and investment goods

Analysis the 2008-09 financial crisis and recession using IS-LM model

Answer 1

The IS - LM model is a Keynesian macroeconomic concept which draws relation between Investment Savings and Liquid Money thus showing us the how the economic market for goods and money market. With the consumer spending plummeting during the financial crisis of 2008, IS-LM model could give us a comprehensive overview on the analysis. Now take a look at the figure below

According to prominent Economists, the steep decrease in consumer spending and low confidence in business primarily resulted from financial crisis ( decrease in real personal consumption shows this), led to significant shift towards left of the IS curve in an IS-LM model as shown in the graph above. In the short run, this resulted in an observable decrease in output and had the target interest rate been maintained, the output would have further decreased to Y" as shown in the graph above. Monetary and fiscal policies made a coordinated effort to bring back the economy to life by announcing interest rate cuts for banks, announcing stimulus package and many more.

Now let's analyze the IS-LM curve after substantial policy changes to revive the economy.

One of the vital moves by the Central bank was to reduce real interest rates. By doing so, it helped stimulate domestic demand viz the six channels transmission mechanism. For instance, the Reserve Bank of Australia
(RBA) increased liquidity in the cash market via a plethora of open-market purchases which helped in lowering the interest rate by shifting the LM curve downward as shown in the graph above. This measure counterbalances the leftward shift of the IS curve previously, and encourages the maintenance of output levels (Y"') over short run period. Refer to the graph for better understanding.

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