In 2008-2010 (and perhaps, extending to now), the United States has experienced

Question

In 2008-2010 (and perhaps, extending to now), the United States has experienced a recession of a relatively large magnitude and a slow recovery from this recession. Using the AD-AS framework, please address the following questions:

(a) What, in your opinion, has caused the recession, and how does your explanation fit within the AD-AS model? For example, please indicate whether the cause(s) that you describe resulted in a shift of AD or AS or both, the direction of the shift, and its magnitude.

(b) What fiscal and monetary policies has the government engaged in to correct the economy? In your response, please define fiscal and monetary policy, and give at least one example of each.

Explanation / Answer

a). In my humble opinion, the causes (some more significant than others) were the overextension of credit that led to the housing bubble, high gas prices, and ultimately, high unemployment or job losses. From the AD curve, the rising cost or inflationary prices had eroded real income, W/P, a component in the AS curve. This will shift the AS curve to the left, resulting in a lower output,Y, or GNP. The federal govt. tries to counter the effect by lowering the interest rate, i, or to incrase the money supply. The real money supply, M/P, is a component in the AD curve. With that in mind, an increase in M should shift the AD curve to the right, offsetting the initial shift of the AS curve and bringing the total output, Y, back to normalcy. But did that happen? Not quite. The problem is, prices, and the expectation of rising prices, ( let me call it Pe), is rising faster than the govt. can print its money. In other words, M/P is actually falling. As prices expectations began to spiral out of control, and US facing higher fuel cost, companies started to experience sloweer growth and cutting back. People's real wage is falling surmountably. All this will shift the AS curve to the left, slowing the overall growth of the economy( Y). Again, our govt. tried to spend more (G, a function in AD) to counter this sluggishness but can't keep pace, therefore, the small increase in AD will only be overshadowed by a larger shift of the AS curve to the left. The end result is a lower GNP, or output, Y. b) In terms of fiscal policies, the instruments that the govt. use to prop up the economy are as follows: Auto bailouts, banking and insurance bailouts, education stimulus, tax breaks, new homeowners tax breaks, appliances tax breaks...etc. In terms of monetary policies, the instruments were lowering interest rates by making borrowing cheaper among banks and increase liquidity so that business can borrow and expand during this crisis.

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