Question

Briefly explain Greece Crisis with ADAS / ISLM models.

Answer 1

Greece has a very high level of sovereign debt and when it announced a possibility of debt default on sovereign debt in 2010. This drastically lowered investor confidence, so investment decreased in Greece.

(i) IS LM model

Lower investment shifts IS curve to left, decreasing interest rate and output. A recessionary gap arises.

In following graph, IS0 and LM0 are initial IS and LM curves, intersecting at point A with initial interest rate r0 and output Y0. As IS0 shifts left to IS1, it intersects LM0 at point B with lower interest rate r1 and lower output Y1 in short run. Recessionary gap is (Y0 - Y1).

(ii) AD AS model

Lower investment spending decreases aggregate demand, shifting AD curve leftward, decreasing both price level and real GDP. A recessionary gap arises.

In following graph, AD0, LRAS0 and SRAS0 are initial aggregate demand, long-run aggregate supply and short-run aggregate supply curves intersecting at point A with initial price level P0 and real GDP (potential GDP) Y0. As investment spending decreases, AD0 shifts left to AD1, intersecting SRAS0 at point B with lower price level P1 and lower real GDP Y1. Recessionary gap is (Y0 - Y1).