Question

The U.S. economy is mired in the worst economic downturn since the Great Recession of 2008/2009. The decline in U.S. GDP in the first three months of this year was nearly the equal of that during the Great Recession. Real output is expected to fall by six times as much in the second quarter of 2020.  

The Federal Reserve Board pledged to provide the liquidity needed to prop up the failing economy. The Fed has bought treasury bills and mortgage-backed securities in large lots. And many economists supported the Fed’s actions.

A. Classical economists who looked at the demand side of the economy (as described in Froyen ch. 6 and ch. 7) have been especially supportive of the Fed’s decision. Using a money market diagram, an investment schedule, and an IS/LM diagram illustrate and explain why these classical economists expected the Fed’s actions to be highly effective.

B. At same time, both Keynesian economists (as described in Froyen ch. 6 and ch. 7) and classical economists who place their emphasis on the supply-side of the economy (as described in Froyen ch. 3 and ch. 4) are far more doubtful that the Fed’s actions would effectively bring an end to the current economic crisis.

Explain and illustrate why these Keynesian economists believed that the Fed’s actions by themselves are likely to be ineffective (again using a money market diagram, an investment schedule and an IS/LM diagram).

Then explain and illustrate why classical economists who put their emphasis on the supply-side of the economy also expected that the Fed’s action would be ineffective and are already voicing their concerns about the possible return of inflation.

C. Finally explain and illustrate what these two sets of critics (classical supply-siders and Keynesians) would do differently or in addition to the Fed’s actions.

Answer 1

So the Fed's action promises to increase liquidity in the economy by buying treasury bills and mortgage backed securities. Let us examine how this will impact money market, investment schedule, and IS-LM curves, and why the classical economists would generally support it.

MONEY MARKET CURVE

Due to Fed's action of buying more, the money supply in the economy would expand. This would lead the money supply curve to shift to the right. At this new meeting point, the equilibrium interest rate would be at a lower level now. This would enable borrowers to borrow at a lower interest rate and expand the GDP in general.

INVESTMENT SCHEDULE

Lower interest rates would lead to expanded investment schedule in general. More investment in the economy would lead to more GDP in general. The new interest rate would be i'.

IS-LM Curve

The expansionary monetary policy being followed by the government would lead to an expansion in the loanable funds market. LM curve would shift to the right leading to leadin to lower interest rates and expanded overall output.

The doubts permeate from the long-term impact that these actions might have on the economy. With the expanded money market, interest rates have gone down. This will lead to more funds available for banks and therefore people to loan. Now as people start borrowing more, this would put an upward pressure on the interest rates again and lead to resumption of earlier, higher rates. But by this time, the economy would have expanded and normal income and employment restored.