Apply the ISLM Model Ask Yourself Short run

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 • 911 attack → rising uncertainty→ Falling C and I → IS curve shifts to left • Accounting scandals → Falling C and I → IS curve shifts to left

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

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

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

2008 Recession • After housing price fell, there is rise in mortgage default and home foreclosures • Financial institutions that owned mortgagebacked securities see large losses • Stock market and consumer confidence fell • All 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’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

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)

Liquidity Trap (LT) • LT happens when nominal interest rate is close to zero • How to get out of LT? • The idea of QE 3 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 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 • • •

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)

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

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