The Financial Crisis and the G

The Financial Crisis and the Great Depression of 2008 and 2009.(ECON 4030- Macroeconomics)

During 2008, the U.S. economy experienced a financial crisis andeconomic downturn that to some observers mirrored events from the1930s. The crisis began with a boom in the housing market a fewyears earlier, the result of low interest rates that made buying ahome more affordable. Increased use of securitization in themortgage market further fueled the housing boom by making is easierfor subprime borrowers to obtain credit. These borrowers had ahigher risk of default that may not have been fully appreciated bythe purchasers of mortgage backed securities (banks and insurancecompanies). The high level of house prices proved unsustainable andprices fell by 30 % from 2006-2009. This decline had severalrepercussions that intensified what was a moderate to severe houseprice correction into a full blown crisis.

First, mortgage defaults and home foreclosures increasedsharply, in large part due to lose mortgage lending standards thathad permitted little or no money down on home purchases. As pricesfell, these homeowners were “under water”, and many decided to stoppaying on thier mortgages. Overall, there was a significantreduction in residential spending. Second, numerous financialinstitutions suffered heavy losses on the mortgage backedsecurities that they owned. As a result, banks cut back on lendingto other banks out of fear and distrust that they might not berepaid. Third, companies that rely on the financial system forfunds to run thier business found it difficult to obtian short termloans for investment. There were concerns about the expectedprofitability of these companies. Finally, gyrations in stockprices, in turn, led to a sharp decline in consumer confidence andresulted in a huge drop in consumer spending.

Government responded strongly to the crisis. The Fed lowered itstarget for the federal funds rate from 5.25 % in September 2007 toapproximately zero in December 2008. Congress appropriated $700billion for the Treasury to use to stabilize the financial systemby providing funds for banks in return for a temporary ownershipstake in these institutions. The Obama administration proposed, andCongress passed a fiscal stimulus program to expand aggregatedemand. And the Fed implemented a number on unconventional monetarypolicies, such as purchasing long term bonds, to lower long terminterest rates and thereby support borrowing and private spending.These forceful policy actions were taken in the hope of preventingthe downturn from becoming another depression, and they seem tohave succeeded. By the end of 2009, the economy was growing onceagain, and the unemployment rate had begun to decline, although therecovery remained sluggish for several years. Policy makerscertaintly can take credit for avoiding another Great DEpression.The unemployment rate peaked at 10%, comapred with 25% in 1933, andindustrial production fell by 17% over a period of 18 months duringthe Great Depression, compared with a decline of more than 50% over3 years during the Great Depression.

a) Identify the type of shock(s)

b) Identify what phase of the business cycle the economy was inafter the shock. State what happened to unemployment, Real GDP,output gap.

c) Explain the impact of the shock on the economy using the ISLMmodel, use both the goods and money market to supplement youranswer. (graoh)

d) According to the passage, what steps (policies) did thegovernment and the Federal Reserve take?

e) Explain the impact of the policies on the economy using theISLM model. (graph)


a) This is a case of negative demand shock. As a result ofrecesion, the level of unemployment goes up and thus the livingstandards of the population goes down leading to a sudden decreasein the demand of the commodities. This is a case of negative demandshock.

b) After the shock, the economy started improving gradually.Itcame out of the depression and started recovering from therecession. During recovery phase, the level of employment startsimproving and thus the level of GDP improves. The outgap alsostarted filling as the level of production improves.

c) As a result of recession the aggregate demand of the economyreduces, bringing the AD curve leftwards. The demand of thecommodity reduces and finally the supply of the output reduces. Thesupply of the money in the market reduces.

As the LM curve shifts leftwards from LM0 toLM1, the new equillibrium income level is Y2.It shifts from Y1 to Y2.

d) Government and Federal Reserve purchased long term bonds,thereby reducing long term interest rates and thereby supportbrrowing and private spending.

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