Question

11) (≈ 21 ???) The 2007-08 Financial Panic and The Great Recession 2007-2009: Declines inwealth due to the fall in housing prices decreased “autonomous consumption”. In addition the financial crisis (bank runs) induced banks to decrease lending which decreased investment spending.
a) Draw the Multiplier Model graph and indicate on your graph which way the Aggregate Demand (AD) curve shifts and what happens to equilibrium Real GDP due to declines in both autonomous consumption and investment. Be sure to label the curves and both the vertical and horizontal axis of your graph.
b) Use a flow diagram provide the intuition for the change in Real GDP, income and consumption in response to the decline in autonomous consumption and investment.
c) How did monetary and fiscal policy make the Great Recession less severe thus avoiding another Great Depression? In your answer use The Multiplier Model graph and a flow diagram to explain what happens to aggregate demand, real GDP and consumption due to the monetary and fiscal policy changes.

Answer 1

a. This is a clear case in which economy will have a deflationary gap. Aggregate demand depends on consumer confidence and investments, investor confidence and investments, government expenditure and net exports .

As animal spirits (consumer confidence) are low, potential of an economy which is at Long run aggregate supply (LRAS)will not be achieved. Economy will be at Y2 due to less aggregate demand (aggregate demand shifting left from AD1 to AD2 ) and hence unemployment will also higher than natural rate.Refer fig. below. Price levels will go down from P1 to P2, this will discourage producers from producing at hence a gap of Y2-Y1 will be created.This gap will be closed if investments come in through consumer or business people or through certian policies.

b.As there is less flow of money, money demand shifts left and due to less economic activity, Y1 output shifts to Y2.

c. Here, expansionary monetary policy will be used by Ireland to shift aggregate demand to right and real output will go up to Y2 again.

Fiscal policy is a policy controlled by the government and it has two tools: taxes and govt. spending.During recessions govt. decreases taxes and increases govt. spending which is called expansionary fiscal policy During inflation govt. increases taxes and decreases govt. spending which is called contractionary fiscal policy.

When there is recession and central bank wants to boost economic activity then it decreases interest rates and increases money supply. This is called as expansionary monetary policy.

Here, expansionary fiscal and monetary policy was used to shift aggregate demand to right and real output will go up to Y2 again and jobs will be produced along with boost in confidence of consumers and investors. Depending on multiplier these investments were made. If shortfall between Y1 and Y2 was $100 billion and multiplier was 2, then investment worth $50 billion was needed. AD2 shifting back to AD1 brings confidence back and potential output with more jobs is achieved.