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 customers 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 1920s. 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 doesnt 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-Zones 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