Macroeconomics

Macroeconomic Policy Analysis under the IS-LM Framework

Submitted to

Prof. Rezina Sultana

By

Group 6A

(A.Krupa, Rishul ,Edwin, Avinash, Hari)

PGP 2013-2015

On

November 24, 2013

GREAT DEPRESSION

Situation

The Great Depression was an economic slump in North America, Europe, and other

industrialized areas of the world that began in 1929 and lasted until about 1939. It was the

longest and most severe depression ever experienced by the industrialized Western world.

According to the data, the primary initial cause of the Great Depression was a decrease in

investment spending. Real fixed investment fell by 74% from $14.9 billion in 1929 prices in

1929 to $3.9 billion in 1933. By 1939, real fixed investment was still 27% below the 1929 level

despite a 53% increase in the money supply (Wikipedia).

Causes

Monetary Policy Measures

The money stock had already declined nearly 4% from 1929 to 1930 and it continued falling till

1933. This failure can be mainly attributed to the failure of large scale banks. The banks did not

have enough cash reserves to meet the customer’s cash withdrawals. This led to deposit

destruction and reduced the money stock. The loss of confidence on part of the depositors further

reduced the money supply and hence the currency-deposit ratio has been increased. The rise in

the currency-deposit ratio and reserve-deposit ratio reduced the money multiplier and hence

sharply contracted the money stock. The collapse must also be explained by the loss of wealth in

the stock market and the overbuilding that occurred during the 1920’s. Fed took steps to recover

the fall in the money supply, but it did not act aggressively to stop the collapse (Dornbusch).

Fiscal policy Measures

The politicians tried to balance the budget in trouble times. The federal government ran large

deficits, especially for that period, averaging 2.6% of GNP from 1931 to 1933. The state and

central government increased taxes to match their expenditures. The fiscal policy has been

expansionary mostly in 1931 and it had moved to a more contradictory level from 1932 to 1934

(Dornbusch).

Weak Aggregate demand

According to the IS/LM interpretation of events in the 1930s, the IS curve shifted to the left

while the LM curve shifted to the right. The failure of investment to recover is consistent with

either a vertical IS curve or a horizontal LM curve.

The IS curve is vertical (or nearly vertical) when a decline in interest rates fails to

stimulate new investment spending. From 1934 to 1940, the interest rate declined from

3.1% to 2.2% while investment spending increased from $5.2 billion to $13.2 billion.

Apparently, the IS curve was not vertical. The LM curve is horizontal when an increase

in the money supply fails to reduce interest rates. From 1934 to 1940, the real money

supply increased from $26.0 billion to $45.8 billion while interest rates fell from 3.1% to

2.2%. So the LM curve was not horizontal (Chapman, 1988).

Euro Zone Crisis

Since 2009, a crisis has been affecting the countries of Euro zone called as Euro zone crisis.

Government crisis, banking crisis and a growth crisis are together under this Euro Zone crisis.

Because of this crisis, the countries were unable to repay the government debts, banks became

undercapitalized and faced problems of liquidity. The economic growth became very slow and is

unequally distributed among the states.

Causes: The main causes of this crisis can be said as globalization of finance, easy credit

conditions that encouraged high risk lending and borrowing practices, international trade

imbalances and real estate bubbles. Some crisis were also a part of causes for these crisis like

financial crisis of 2007-2008 and Great Recession of 2008-2012 in which the fiscal policy

choices also played an important role.

To fight the crisis some governments have focused on measures like higher taxes and lower

expenses which have contributed to social unrest. Despite sovereign debt having risen

substantially in only a few Eurozone countries, with the three most affected countries Greece,

Ireland and Portugal collectively only accounting for 6% of the Eurozone's gross domestic

product (GDP), it has become a perceived problem for the area as a whole, leading to speculation

of further contagion of European countries and a possible break-up of the Eurozone. In total, the

debt crisis forced five out of 17 Eurozone countries to seek help from other nations by the end of

2012. However, in Mid-2012, due to successful fiscal consolidation and implementation of

structural reforms in the countries being most at risk and various policy measures taken by Euro

zone member state leaders and the European Central Bank, financial stability in the Eurozone

has improved significantly and interest rates have steadily fallen.

Options: There are two options which can be taken to come out of this crisis.

The first option is to advance emergency loans to the countries. The loans will allow Greece to

continue to service its debts so that bondholders do not incur any losses. The conditionalities –

reduction of government spending on social sectors, freezing of public sector jobs, reduction in

wages, privatization of the pensions sector, labor market reform, tax increases, and other such

measures – will  serve two related purposes. First, it will severely contract the level of

aggregate demand in the Greek economy and thereby push it into a prolonged and deep

recession; this will ensure a disinflation or even a deflation in the Greek economy relative to

Germany, leading to a possible reduction in the Greek trade deficit.

Second, since a crisis always opens up channels to alter the balance of class forces, this occasion

will be used to weaken the European working class further – by pushing up unemployment

rates to historically unprecedented high levels – and push through reforms like privatization of

pensions, education, health care and insurance. All in all, this option will bail-out  financial

interests and impose the costs of adjustment on the working people. It is not clear whether this

option will work even on its own terms. Additionally, the deeply recessionary implications of

these measures will, in all probability, slow down the whole euro zone economy and militate

against efforts to get the core countries of global capitalism growing again.

IS-LM Model to explain the crisis

The Euro-Zone countries can be divided into two kinds: countries with strong economic power

and those with weak economic power. Based on IS-LM model, and taking Germany and Greece

as an example, assume that two countries’ economies are in equilibrium when they just entered

the Euro-zone. In the initial state, the real interest rate of the two countries is equal, since

European central bank applies unified monetary policy. Because the size of two economics are

quite different, the German output far outweigh the Greek, so the initial output level of the two

countries must be quite different as well.

Since the monetary policy of the two countries is unified, when the European central bank

doesn’t take large loose or tightening policy, the real interest rate of the two countries will not

change caused by monetary policy. However, due to the great difference in the fiscal policy and

factor endowments structure of Germany and Greece, the real interest rate of the German rises,

and the rapid development of Germany causes serious impact on Greek economy. Because

capital is profit-seeking and complies with capital law of one price, that is to say, the capital will

flow from the low real interest rates place to the direction of higher real interest rate place, and

due to Euro-Zone’s monetary unification, exchange rate adjustment does not exist between the

two countries, and the capital can flow smoothly. The German economic prosperity makes

domestic investment rate of return (real interest rates) much higher than that of Greece, which

therefore attracts the Greek capital to flow to Germany. The outflow of the Greek capital will

severely affect the development of domestic economy in Greece, so the Greek economy will

appear passively decline, and the Greek recession will inevitably lead to fiscal imbalance. In

order to maintain high domestic fiscal spending, Greece issues huge amounts of government

bond for debt financing towards its people and allied country at any cost.

Countries with weak economic powers in the Euro-Zone like Greece are exposed to serious debt

crisis, which is the problem of liquidity in the short term, and is the problem of output decline in

the long term. To rescue Greece, the Euro-Zone, led by Germany, first has to solve the problem

of liquidity in the short term. The solution is to let the European central bank and IMF

continually provide huge loan for countries in the debt crisis. Hence with huge government

spending the IS curve shifts to the right, and hence the equilibrium point moves across the LM

curve to the right thus increasing the interest rates. The debt crisis increases the inflation rate and

and since all the money is going out of the economy, the industrial production reduces and hence

unemployment rate increases. This fiscal policy of increasing the government spending without

any change in the monetary policy further puts the country into debt crisis. Hence the euro crisis.

Now Euro Zone has come with a 750 billion bail-out plan (monetary plan) and hence LM curve

shifts to the right, hence reducing the interest rates in the weaker countries. (The effects of

unemployment rate, inflation rate, industrial production and the effect on interest rates of all

countries is given in the exhibits)

ISLM Curve showing shift in IS curve

Exhibit 1: Interest rates

Exhibit 2: Industrial Production

Exhibit 3: Inflation Rate

Exhibit 4: Unemployment Rate