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Apply the IS-LM Model

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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 313A fall in aggregate demand (planned expenditure)Decline in stock market → reduced wealth→ →Falling C and I→IS curve shifts to left911attack→ rising uncertainty→ FallingC and I → IS curve shifts to leftAccounting scandals→ Falling C and I → IS curve shifts to left
Policy
Tax cut→ IS curve shifts torightRising government expenditure to help banks and airline industry→ IS curve shifts torightExpansionary monetary policy (rising money supply)→LMcurve shifts torightResult: the 2001 recession is short, and interest rate remained low
Animal Spirit
Self-fulfilling wave of optimism and pessimismFor example, pessimism causes consumption and investment to fallThen GDP falls, making the pessimism self-fulfillingOptimism will cause bubble
Example of animal spiritBoomin Housing Market
Lowinterest ratehttp://en.wikipedia.org/wiki/Community_Reinvestment_ActButthe highprice (bubble)is not sustainable
2008 Recession
After housing price fell, there is rise in mortgage default and home foreclosuresFinancial institutions that owned mortgage-backed securities see large lossesStock market and consumer confidence fellAll pushed IS curve to the left
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
What’sWrong in Labor Market
http://economics.mit.edu/files/6346http://economics.mit.edu/files/6613There is a trend in labor market caused by automation, globalization and fallingeducational attainment
Ineffective Policy
Fiscal policy is ineffective when LM curve issteep (crowding out is big)Monetary policy is ineffective whennominal interest rate is close to zero (liquidity trap)
Liquidity Trap (LT)
LT happens when nominal interest rate is close to zeroHow 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)
Is Deflation Good
Case Study: Japan
Aging populationDemand is shrinkingDeflation is persistentPessimistic animal spiritExpansionary fiscal policy is limited by huge government debtExpansionary monetary policy is limited by liquidity trap
Case Study: Eurozone
Huge government debtAusterity is necessaryBut austerity would cause IS curve to shift to left, and recessionUS faces similar dilemma (tradeoff)
Tradeoff
A policymaker needs to determine the priority: balancing budget or stimulating economy?Essentially, this is long-run versus short run
What Causes US HugeDebt?
Entitlement program and rising health costWarDollar is specialEvery four years we have a new president

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Apply the IS-LM Model