Question

How could you have used relatively simple macroeconomic models (eg aggregate demand and aggregate supply, or IS/LM) to analyse and anticipate the likely effects of the crisis on levels of global economic activity, unemployment and inflation?

Answer 1

The financial crisis will slow down consumption expenditure and business investment, leading to lower aggregate demand. As a result the AD curve will shift leftward, lowering both price level (lowering inflation) and real GDP (output), therefore causing a recessionary gap and increasing unemployment rate.

In following graph, AD0, LRAS0 and SRAS0 are initial AD, long run AS curve and short run AS curves intersecting at point A with initial long rn equilibrium price level P0 and real GDP (= Potential GDP) Y0. In following graph, as AD0 shifts left to AD1, it intersects SRAS0 at point B with lower price level P1 and lower real GDP Y1, causing deflationary gap equal to (Y1 - Y0) in short run.

In terms of IS-LM model, the global financial crisis will decrease investment, therefore shifting IS curve leftward which will decrease both interest rates and output. In following graph, IS0 & LM0 are initial IS & LM curves intersecting at point A with initial real interest rate r0 & output Y0. As IS shifts leftto IS1, it intersects LM0 at point B with lower interest rate r1 and lower output Y1.