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Apply the IS-LM Model

Apply the IS-LM Model. Ask Yourself. Short run or long run? Supply side or demand side?. US Recession in 2001. Case study on page 313 A fall in aggregate demand (planned expenditure) Decline in stock market → reduced wealth → → Falling C and I → IS curve shifts to left

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Apply the IS-LM Model

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  1. Apply the IS-LM Model

  2. Ask Yourself • Short run or long run? • Supply side or demand side?

  3. US Recession in 2001 • Case study on page 313 • A fall in aggregate demand (planned expenditure) • Decline in stock market → reduced wealth → → Falling C and I → IS curve shifts to left • 911 attack → rising uncertainty→ Falling C and I → IS curve shifts to left • Accounting scandals → Falling C and I → IS curve shifts to left

  4. Policy • Tax cut → IS curve shifts to right • Rising government expenditure to help banks and airline industry → IS curve shifts to right • Expansionary monetary policy (rising money supply) → LM curve shifts to right • Result: the 2001 recession is short, and interest rate remained low

  5. Animal Spirit • Self-fulfilling wave of optimism and pessimism • For example, pessimism causes consumption and investment to fall • Then GDP falls, making the pessimism self-fulfilling • Optimism will cause bubble

  6. Example of animal spiritBoom in Housing Market • Low interest rate • http://en.wikipedia.org/wiki/Community_Reinvestment_Act • But the high price (bubble) is not sustainable

  7. 2008 Recession • After housing price fell, there is rise in mortgage default and home foreclosures • Financial institutions that owned mortgage-backed securities see large losses • Stock market and consumer confidence fell • All pushed IS curve to the left

  8. Policy • Fed cut interest rate (how?) What happens to LM curve? • Treasury used $700 billion to rescue banks (Bail out). What happens to IS curve? • Result: GDP recovered, but employment did not

  9. What’s Wrong in Labor Market • http://economics.mit.edu/files/6346 • http://economics.mit.edu/files/6613 • There is a trend in labor market caused by automation, globalization and falling educational attainment

  10. Ineffective Policy • Fiscal policy is ineffective when LM curve is steep (crowding out is big) • Monetary policy is ineffective when nominal interest rate is close to zero (liquidity trap)

  11. Liquidity Trap (LT) • LT happens when nominal interest rate is close to zero • How to get out of LT? • The idea of QE3 is to generate expectation of inflation (so real interest rate can fall and investment can rise), and depreciation of dollar (so export can rise)

  12. Is Deflation Good • It depends • Deflation can move Y back to • Deflation can also move Y further away from

  13. Case Study: Japan • Aging population • Demand is shrinking • Deflation is persistent • Pessimistic animal spirit • Expansionary fiscal policy is limited by huge government debt • Expansionary monetary policy is limited by liquidity trap

  14. Case Study: Eurozone • Huge government debt • Austerity is necessary • But austerity would cause IS curve to shift to left, and recession • US faces similar dilemma (tradeoff)

  15. Tradeoff • A policymaker needs to determine the priority: balancing budget or stimulating economy? • Essentially, this is long-run versus short run

  16. What Causes US Huge Debt? • Entitlement program and rising health cost • War • Dollar is special • Every four years we have a new president

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