The IS curve fluctuates as aggregate demand changes, but not the LM curve. The LM curve fluctuates as the demand or supply of money or bonds changes, but the IS curve does not. In a recession, Keynesians consider the price level to be exogenous. Any price reduction as a result of surplus supply is minor.
Is LM Curve 2008?
In an IS-LM model, the substantial shift to the left of the IS curve in 2008) for the US economy resulted in a significant shift to the left of the IS curve. In the near run, this resulted in a significant drop in output, and if the target interest rate had been maintained, output would have dropped even further to Y” as illustrated in figure 8.
What was responsible for the 2008 recession?
The Great Recession, which ran from December 2007 to June 2009, was one of the worst economic downturns in US history. The economic crisis was precipitated by the collapse of the housing market, which was fueled by low interest rates, cheap lending, poor regulation, and hazardous subprime mortgages.
What is the Keynesian explanation for the 2008 recession?
For Keynes, the most prevalent cause of a crisis is a collapse in capital efficiency, rather than a rise in tax rates. Furthermore, the pessimism and instability that accompany a breakdown in capital efficiency leads to a preference for liquidity, which implies a reduction in investment.
Is-LM economic model?
- In the macroeconomy, the IS-LM model depicts how aggregate markets for real goods and financial markets interact to balance the rate of interest and total output.
- The model was created to be a formal graphic depiction of a Keynesian economic premise.
- “IS” indicates one curve on the IS-LM graph, while “LM” represents another.
- The IS-LM model can be used to explain how changes in market preferences affect the equilibrium levels of GDP and market interest rates.
- The IS-LM model lacks the precision and realism needed to be a successful economic policy prescription tool.
We expected that lowering inflation in the United States would result in lower real interest rates. This view is supported by David Wessel (1999, A1). He has suggested that a high rate of inflation could skew financial markets, causing investor uncertainty and undermining public trust in the government. As a result of their fear of a financial meltdown, consumers are holding on to their money longer. If the rate of inflation continues to rise, customers will borrow more money from banks, resulting in an increase in real interest rates because the loan depreciates over time. This argument implies that if the inflation rate is kept low, a lower level of real interest rates can be obtained, which validates our theory.
Wessel (1999, A1) also makes a compelling case for our idea. Wessel argues the negative impacts of a no-inflation economy on employment in his piece “With Inflation Tamed, America Confronts an Unsettling Stability.” A low inflation rate, in other words, creates major economic stability and attracts foreign investors who are confident in their excellent financial returns, lowering employment. Workers must become accustomed to minor rises that are worth the same as prior years from a psychological standpoint. More than that, some workers will be irritated by what they perceive to be a minor increase in their pay.
Wessel (1999, A1) has also suggested that no inflation and the economy are linked. One probable negative correlation is that corporate sales will remain stagnant, resulting in lower earnings. As a result, workers’ earnings may decrease, their skills may become obsolete, and new job openings may arise. Another positive correlation is that in a low-inflation economy, unemployment may fall as investments rise due to the economy’s stability, resulting in higher productivity. Increased government revenue results from low inflation and economic stability, allowing the government to lower taxes. Corporations will benefit from increased profits and revenues as a result of these tax cuts. Workers may consume more as a result of the psychological effect of having extra money in their hands rather than being concerned about the degree of inflation, as they are more likely to be during periods of hyperinflation.
In conclusion, all of the preceding reasons not only establish a significant relationship between lower real interest rates and lower inflation, but they also broaden the issue to include links between real interest rates and inflation rates and the actual economy. Our hypothesis is based on this connection, meaning that monetary policies can influence the economy. The new IS/LM model, on the other hand, does not support this idea. According to the new IS/LM model, a low inflation goal policy will maintain the economy operating at near capacity, and real interest rates will fluctuate in response to variations in output capacity. That is, if capacity expands rapidly while inflation remains low, real interest rates will increase significantly. Only if capacity expansion remains stagnant in a low-inflation economy would real interest rates remain low, as predicted by our hypothesis.
We expected that a rise in real GDP would lead to lower real interest rates along the IS curve. The monetary transmission mechanism, or the process by which monetary policy decisions are translated into changes in real GDP, has been examined in a number of earlier articles. The mechanism starts with a monetary policy move on the short-term interest rate, which then affects the long-term interest rate. The real interest rate is affected by the change in the long-run nominal interest rate, resulting in a change in real GDP. According to John B. Taylor, the monetary transmission linkages form a circle that is closed by using reaction functions to link variations in real GDP back to the interest rate (J. Taylor 1995, p.151-171). The authors of “Money, Prices, Interest Rates, and the Business Cycle,” Robert G. King and Mark W. Watson, contend that empirical evidence reveal a negative link between the real interest rate and output (King and Watson 1996, p.35-53).
Hypothesis III is mostly based on Kurt Richebacher’s work, which describes the primary elements that have influenced the economy’s growth in his article “America’s Recovery is Not What It Seems.” Richebacher (2004, 34) proposes a simple but forceful conclusion: that recent GDP growth was due to a significant increase in defense spending, which is a permanent, and possibly increasing, component of the US economy due to the country’s constant involvement in global peacekeeping and NATO functions. As a result of the increasing defense spending, capital investment grew, which increased real non-residential fixed investment and non-residential structures. Richebacher (2003, 34) continues his theoretical argument that an increase in GDP leads to more investments in national infrastructure and lower taxes for the general public, as well as allowing the government to invest its financial resources in the private sector, lowering real interest rates and increasing profits in the economy.
The sign of the association between real GDP and real interest rate is a contradiction between our hypothesis and the new IS/LM. The forward-looking IS equation demonstrates that if present production capacity increase is joined with predictable future output capacity expansion, the current real interest rate must likewise rise. That is, there is a positive link between real GDP and real interest rate.
Is-LM curve aggregate demand?
The downward dipping of the aggregate demand curve, as shown in, is the most prominent aspect. This association exists for a variety of reasons. Remember that a downward sloping aggregate demand curve suggests that the quantity of production requested rises as the price level falls. Similarly, as the price level falls, so does the national income. The downward sloping aggregate demand curve can be explained in three ways. Pigou’s wealth effect, Keynes’ interest-rate effect, and Mundell-exchange-rate Fleming’s impact are all examples of these effects. These three factors are separate, but they all contribute to the downward sloping aggregate demand curve.
Pigou’s wealth impact is the first reason for the aggregate demand curve’s decreasing slope.
Remember that money’s nominal value is fixed, but its true value is determined by the price level.
This is because a lower price level provides more purchasing power per unit of currency for a given quantity of money.
When prices decline, customers become wealthier, which leads to more consumer spending.
As a result, a decrease in the price level encourages customers to spend more, raising aggregate demand.
The interest-rate effect of Keynes is the second cause for the aggregate demand curve’s decreasing slope.
Remember that the amount of money demanded is proportional to the price level.
That is, a high price level indicates that purchasing something requires a significant quantity of money.
As a result, when the price level is high, people require significant amounts of currency.
Consumers desire a small amount of currency when the price level is low since it takes a small amount of currency to make purchases.
As a result, people deposit higher sums of money in banks.
As the amount of money in banks grows, so does the supply of loans.
The cost of loansthat is, the interest ratedecreases as the supply of loans increases.
As a result, a low price level encourages consumers to save, lowering the interest rate.
Because the cost of investing decreases as the interest rate decreases, a low interest rate promotes investment demand.
As a result, a decrease in the price level lowers the interest rate, which raises investment demand and thus aggregate demand.
The exchange-rate effect of Mundell-Fleming is the third cause for the aggregate demand curve’s decreasing slope.
Remember that when the price level declines, so does the interest rate.
When domestic interest rates are low compared to overseas interest rates, domestic investors choose to invest in foreign countries where the return on investment is higher.
Because the international supply of dollars grows as local currency flows to foreign countries, the real exchange rate falls.
Because domestic products and services are substantially cheaper, a reduction in the real exchange rate has the effect of increasing net exports.
Finally, because net exports are a component of aggregate demand, an increase in net exports boosts overall demand.
As a result, interest rates fall, domestic investment in foreign nations rises, the real exchange rate falls, net exports rise, and aggregate demand rises as the price level falls.
IS-LM model of aggregate demand
There is another important model that can be used to explain the aggregate demand curve’s nature. The IS-LM model is named after the two curves that are included in the model. The IS curve depicts equilibrium in the goods and services market, with Y = C(Y – T) + I(r) + G, while the LM curve depicts equilibrium in the money market, with M/P = L. (r,Y). The IS-LM model is represented in a plane by r, the interest rate, on the vertical axis and Y, which represents both income and output on the horizontal axis. The horizontal axis of the IS-LM model is the same as the aggregate demand curve, but the vertical axis is different.
In terms of r and Y, the IS curve reflects equilibrium in the market for goods and services.
The IS curve is slanted downward because when interest rates fall, investment rises, resulting in increased output.
The LM curve depicts a market for money in equilibrium.
Because rising income leads to more demand for money, the LM curve is upward sloping, resulting in higher interest rates.
The equilibrium interest rate and price level are determined by the intersection of the IS and LM curves.
Is-LM model demand shock?
Exogenous variations in demand for goods and services are known as IS shocks. Exogenous variations in the demand for money are known as LM shocks. The need for money is increasing as a result of a surge of credit card fraud.
How did the 2008 recession affect supply and demand?
The price level decreased by 22% and real GDP plummeted by 31% during the Great Depression, which lasted from 1929 to 1933. The price level climbed slowly during the 2008-2009 recession, and real GDP fell by less than 4%. For a variety of factors, the 2008-2009 recession was substantially milder than the Great Depression:
- Bank failures, a 25% reduction in the quantity of money, and Fed inaction culminated in a collapse of aggregate demand during the Great Depression. The sluggish adjustment of money pay rates and the price level resulted in massive drops in real GDP and employment.
- During the 2008 financial crisis, the Federal Reserve bailed out struggling financial institutions and quadrupled the monetary base, causing the money supply to rise. The expanding supply of money, when combined with greater government spending, restricted the fall in aggregate demand, resulting in lower decreases in employment and real GDP. (21)
The 20082009 Recession
Real GDP peaked at $15 trillion in 2008, with a price level of 99. Real GDP had declined to $14.3 trillion in the second quarter of 2009, while the price level had climbed to 100. In 2009, a recessionary void formed. The financial crisis, which began in 2007 and worsened in 2008, reduced the supply of loanable funds, resulting in a drop in investment. Construction investment, in particular, has plummeted. As a result of the worldwide economic downturn, demand for U.S. exports fell, and this component of aggregate demand fell as well. A huge injection of spending by the US government helped to soften the decline in aggregate demand, but it did not stop it from falling.
The supply of aggregates has also dropped. A decline in aggregate supply was caused by two causes in 2007: a spike in oil costs and a rise in the money wage rate. (21)
Why did the 2008 crisis happen?
The financial crisis, commonly known as the recession, that occurred in 2008 is well-known to all of us.
The 2008 Global Financial Crisis is largely recognized as the worst financial disaster since the Great Depression of the 1930s.
The subprime mortgage crisis in the United States began in 2007. The failure of Lehman Brothers, a large investment bank, on September 15, 2008, triggered a full-fledged international banking crisis.
The primary and immediate cause of the financial crisis was the burst of the US housing bubble, which peaked in FY 2006-2007.
But it all started after the September 11, 2001 terrorist strikes. The Federal Reserve System (Fed) decreased its interest rate to 1% as a result of the US economy entering a recession.
Fixed income investors who used to buy US Treasury bills got dissatisfied with the rates they were receiving and began looking for other investment choices because 1 percent is such a low interest rate.
When US investment banks became aware of the problem, they began to apply some of their financial wizardry to mortgages.
Investment banks in the United States were the first to securitize mortgages into Mortgage-Backed Securities (MBS), a type of asset-backed securities.
A mortgage-backed security (MBS) is a collection of several mortgages that are geographically dispersed to promote diversity and hence reduce risk.
MBS is used by investment banks to ensure that future returns on such investments are as high as feasible while reducing risk.
Almost no country in the globe has been spared the repercussions of the US financial crisis, whether developing or developed.
In August 2007, it became evident that the stock market alone would not be able to solve the US subprime mortgage crisis, which had already gone beyond the country’s boundaries.
Due to widespread dread of the unknown among banks around the world, the interbanking market was completely shut down.
Northern Rock, a British bank, had to contact the Bank of England for emergency capital due to a liquidity shortage.
At the time, central banks and governments all over the world were banding together in an attempt to avoid a worldwide financial disaster.
All of the world’s major economies were either in or trying to get out of recession by the end of 2008.
According to the World Bank, global economic activity would grow by 0.9% in 2009, the weakest rate since records began in 1970.