Question

The Financial Crisis and the Great Depression of 2008 and 2009. (ECON 4030- Macroeconomics)

During 2008, the U.S. economy experienced a financial crisis and economic downturn that to some observers mirrored events from the 1930s. The crisis began with a boom in the housing market a few years earlier, the result of low interest rates that made buying a home more affordable. Increased use of securitization in the mortgage market further fueled the housing boom by making is easier for subprime borrowers to obtain credit. These borrowers had a higher risk of default that may not have been fully appreciated by the purchasers of mortgage backed securities (banks and insurance companies). The high level of house prices proved unsustainable and prices fell by 30 % from 2006-2009. This decline had several repercussions that intensified what was a moderate to severe house price correction into a full blown crisis.

First, mortgage defaults and home foreclosures increased sharply, in large part due to lose mortgage lending standards that had permitted little or no money down on home purchases. As prices fell, these homeowners were "under water", and many decided to stop paying on thier mortgages. Overall, there was a significant reduction in residential spending. Second, numerous financial institutions suffered heavy losses on the mortgage backed securities that they owned. As a result, banks cut back on lending to other banks out of fear and distrust that they might not be repaid. Third, companies that rely on the financial system for funds to run thier business found it difficult to obtian short term loans for investment. There were concerns about the expected profitability of these companies. Finally, gyrations in stock prices, in turn, led to a sharp decline in consumer confidence and resulted in a huge drop in consumer spending.

Government responded strongly to the crisis. The Fed lowered its target for the federal funds rate from 5.25 % in September 2007 to approximately zero in December 2008. Congress appropriated $700 billion for the Treasury to use to stabilize the financial system by providing funds for banks in return for a temporary ownership stake in these institutions. The Obama administration proposed, and Congress passed a fiscal stimulus program to expand aggregate demand. And the Fed implemented a number on unconventional monetary policies, such as purchasing long term bonds, to lower long term interest rates and thereby support borrowing and private spending. These forceful policy actions were taken in the hope of preventing the downturn from becoming another depression, and they seem to have succeeded. By the end of 2009, the economy was growing once again, and the unemployment rate had begun to decline, although the recovery remained sluggish for several years. Policy makers certaintly can take credit for avoiding another Great DEpression. The unemployment rate peaked at 10%, comapred with 25% in 1933, and industrial production fell by 17% over a period of 18 months during the Great Depression, compared with a decline of more than 50% over 3 years during the Great Depression.

a) Identify the type of shock(s)

b) Identify what phase of the business cycle the economy was in after the shock. State what happened to unemployment, Real GDP, output gap.

c) Explain the impact of the shock on the economy using the ISLM model, use both the goods and money market to supplement your answer. (graoh)

d) According to the passage, what steps (policies) did the government and the Federal Reserve take?

e) Explain the impact of the policies on the economy using the ISLM model. (graph)

Answer 1

a) This is a case of negative demand shock. As a result of recesion, the level of unemployment goes up and thus the living standards of the population goes down leading to a sudden decrease in the demand of the commodities. This is a case of negative demand shock.

b) After the shock, the economy started improving gradually.It came out of the depression and started recovering from the recession. During recovery phase, the level of employment starts improving and thus the level of GDP improves. The outgap also started filling as the level of production improves.

c) As a result of recession the aggregate demand of the economy reduces, bringing the AD curve leftwards. The demand of the commodity reduces and finally the supply of the output reduces. The supply of the money in the market reduces.

As the LM curve shifts leftwards from LM₀ to LM₁, the new equillibrium income level is Y_2. It shifts from Y₁ to Y_2.

d) Government and Federal Reserve purchased long term bonds, thereby reducing long term interest rates and thereby support brrowing and private spending.