Question

Using the New Keynesian model framework, try to use the model to explain the Great Recession, also include in the model the affects of the Monetary and Fiscal Policy pursued by the Federal Reserve and Federal Government, respectively. How would does your explanation change when using the Real Business Cycle model?

Answer 1

The Great recession was largely caused due to mortgages backed securities which was offered financial instruments by banks which led to booming demand of housing and prices shot and skyrocketed. Hence demand eventually fell and busted and caused huge losses as people sis not have money to pay back loans. Banks went bankrupt, slowly entire banking sector oerished leading to liquidity crunch and hence triggered The Great Recession of 2008. The Government stimulated the economy by providing TNAF fubds, 800 billion dollars stimulating relief pacjage, automatic stabilisers, unemployment insurance by adopting expansionary fiscal policy.

The US Fed then adopted expansionary monetary policy by adopting rock bottomnear zero interest rates to stimulate creditgrowth and boost consumption demand and hence real GDP and revive economy from recession.

If real business cycle model was asopted then government output would have maximised utility and adopted long term sustainability view rather than short term sustainability stance above.