Question

how the new Keynesian model framework can be used to explain the great recession, if the effects of monetary and fiscal policies implemented by the federal reserve and the federal government are also included in the model？？

Answer 1

The Great Recession was particularly severe and has endured far longer than most recessions. Economists now believe it was caused by a perfect storm of declining home prices, a financial system heavily invested in house-related assets and a shadow banking system highly vulnerable to bank runs or rollover risk. It has lasted longer than most recessions because economically damaged households were unwilling or unable to increase spending, thus perpetuating the recession by a mechanism known as the paradox of thrift. Economists believe the Great Recession wasn’t foreseen because the size and fragility of the shadow banking system had gone unnoticed.

The recession has had an inordinate impact on macroeconomics as a discipline, leading economists to reconsider two largely discarded theories: IS-LM and the paradox of thrift. It has also forced theorists to better understand and incorporate the financial sector into their models, the most promising of which focus on mismatch between the maturity periods of assets and liabilities held by banks.

The economic downturn the United States suffered from late 2007 to the third quarter of 2009 was particularly damaging. Output, consumption, investment, employment and total hours worked dropped far more during the recent recession than the comparable average figures for all other recessions since 1945. Employment, for example, dropped 6.7 percent during the 2007-09 recession compared with an average of 3.8 percent for postwar recessions. Analogous figures for output: 7.2 percent and 4.4 percent; for consumption: 5.4 percent and 2.1 percent. That higher level of severity across the board is why this recession has earned the adjective “Great.”

By the same token, however, this recession was definitely not the worst U.S. downturn on record. Conditions were far worse during the Great Depression. Employment fell 27 percent from 1929 to 1933 (compared with 6.7 percent from 2007 to 2009), output fell 36 percent (7.2 percent) and consumption fell 23 percent (5.4 percent). For that reason, the recent slump, though severe, is rightly considered a recession rather than a full-bore depression.

Another reason to consider this recession “Great” is how uncommonly long the economy has been taking to recover. The accompanying figure displays labor productivity (output per working-age person, adjusted for inflation) from 1977 through 2014. The vertical pink bars in the figure indicate the starting and ending dates for recessions, as determined by the National Bureau of Economic Research

At its heart, the narrative described above characterizes the Great Recession as the response of the economy to a negative shock to the demand for goods all across the board. This is very much in the spirit of the traditional macroeconomic paradigm captured by the famous IS-LM (or Hicks-Hansen) model, which places demand shocks like this at the heart of its theory of business cycle fluctuations. Similarly, the paradox-of-thrift argument is also expressed naturally in the IS-LM model.

The IS-LM paradigm, together with the paradox of thrift and the notion that a decision by a group of people could give rise to a welfare-reducing drop in output, had been largely discredited among professional macroeconomists since the 1980s. But the Great Recession seems impossible to understand without invoking paradox-of-thrift logic and appealing to shocks in aggregate demand. As a consequence, the modern equivalent of the IS-LM model—the New Keynesian model—has returned to center stage. (To be fair, the return of the IS-LM model began in the late 1990s, but the Great Recession dramatically accelerated the process.)

The return of the dynamic version of the IS-LM model is revolutionary because that model is closely allied with the view that the economic system can sometimes become dysfunctional, necessitating some form of government intervention. This is a big shift from the dominant view in the macroeconomics profession in the wake of the costly high inflation of the 1970s. Because that inflation was viewed as a failure of policy, many economists in the 1980s were comfortable with models that imply markets work well by themselves and government intervention is typically unproductive.

Now macroeconomists are actively thinking about the financial system, how it interacts with the broader economy and how it should be regulated. This has necessitated the construction of new models that incorporate finance, and the models that are empirically successful have generally integrated financial factors into a version of the New Keynesian model, for the reasons discussed above.

The IS-LM model—often depicted graphically and thought to encapsulate traditional Keynesian theory—describes the relationship between real output (GDP) and nominal interest rates. On a graph with real interest rates on the vertical axis and real GDP on the horizontal, IS-LM is seen as a downward-sloping IS curve (investment and savings, or the market for economic goods) and an upward-sloping LM curve (liquidity preference and money supply). The intersection of these curves indicates an economy’s equilibrium interest rate and GDP.