Q. No: 1
In this case, it not plausible to derive the Keynesian multiplier because one of the key assumptions in the derivation of multiplier is that the Investment is autonomous which means investment is independent of income. Furthermore, it is also assumed that investment is not the function of interest rate. Here, in this case, investment is dependent upon income and is a function of interest rate as well, therefore, it is not possible to derive the Keynesian multiplier.
We can derive the Keynesian function in this case only when investment was autonomous. Let’s assume investment to be autonomous then derivation of Keynesian multiplier is as follows:
Substitute equation 2,3 and 4 in equation 1
Q. No: 2
There are three factors that affect the slope of IS curve which are interest sensitivity, marginal propensity to consume and the tax rate.
Effect of Tax Rate on The Slope of IS Curve
There is a reduction in the slope of IS curve with the increase in tax rate. t prime shows higher tax rate. Due to increase in tax rate, aggregate demand curve become flatter because of which it generates a steeper IS curve.
Q. No: 3
There are two factors that affect the slope of LM curve which are responsiveness or elasticity of demand for money and the responsiveness of money demand to the change in income.
Effect of Interest Sensitivity of Demand for Real Money on The Slope of LM Curve
Initially, the money demand curves are flat. With the decrease in the interest elasticity of demand for money, the curve with lower h prime would indicate a decrease in interest rate to produce a resulting increase in the money demand curve. Therefore, as a result of a decrease in the interest elasticity of demand for money,LM curve slope has increased.
Q. No: 4
Effect of Recession on The US Housing Market
Numerous factors have contributed to reduce the economic swing. The 2007-09 recession had adversely affected several families who bought houses or were in search to buy a new house. One of the most important factors that contributed to the economic turn has been the housing market(Hindmoor and McConnell, 2014).The breakdown was due to the extreme provision of housing credit. Individuals who took loans for the purchase of new house had to struggle very hard. It was due to the effect of recession that there was a sharp decline in the value of the house. Per Harvard university, housing market remained in disequilibrium till 2014, with trivial increase in home construction prices and values.
Residential Fixed Investment
Building house is included in fixed residential fixed investment. In this investment, depreciation is not included.
Effect of Decrease in The Housing Construction Activity
Decrease in the housing construction means a decrease in the investment expenditure. Investment is a component of aggregate demand. Hence, ceteris paribus, a decrease in investment means decrease in aggregate demand.
Decrease in Investment Spending
Short Run Effect
SRAS curve slopes upward as it reflects the fact that firm can adjust both prices and quantity in response to a change in aggregate demand. With the decrease in aggregate demand, there is a decrease in both the price level and the real output.
Long-Run Effect
In the long run, the aggregate supply curve is vertical which means output is fixed whereas prices are variable. Decrease in the aggregate demand will lead to decrease in the price level.
Combined Effect of Short Run and Long Run
Initially, the economy is in equilibrium at point A where SRAS curve, SRADo curve, and LRAS curve intersect each other. With the decrease in investment, aggregate demand curve shifts downward, where AD1 interests the SRASo at point B. At this new short run equilibrium point, there is a decrease in both the price level and the aggregate output.
As the economy moves towards the long run, the expected prices come in line with the actual prices and firms makes adjustments to the expectations. Therefore, the SRAS will continue to shift as long as SRAS curve intersects the SRAD1 and LRAS curves, which is shown by point C.
Hence, in the short run there is a decrease in both the output and price level, whereas, in the long run, there is a decrease in prices only.
Q. No: 5
Role of Central Banks in Housing Crash
To control the housing crash or bubble economies, central banks can play a very legitimate role in this regard. It is the responsibility of the central banks to observe the developmental changes in the economy and should keep track of the change in assets prices in different sectors of the economy. If the central bank observes any problem in any sector, it should inform the concerned authorities.In rare cases, if the bubble becomes so large that it poses a serious threat to the economic system of the country, then central bank should opt to make use of monetary policy to offset the effect of the crash.
Zero Lower Bound Rate
One of the main monetary policy tool used by the central banks is the interest rate. If the interest rate has fallen to zero and can’t fall further below this particular level, then it is known as zero lower bound rate. It is not a practical situation to have zero interest rate as nobody would lend at negative interest rate, rather people will prefer to hold cash. Moreover, central bank can’t boost the economy via interest rate.
However, in the recent collapse of the American housing finance system, the Fed lowered its interest rate to nearly zero in 2008. The interest rate remained there for approximately seven years, even after the end of recessionary phase and housing crash period. It is only three years that housing prices have started to recover.
The Fed along with the central bank intended to increase the assets prices but ended up in worse. If the interest rate is lowered, then there is an increase in the assets prices i.e. high bond prices, high stock prices and an increase in the house prices. But this initiative of increasing the assets price turned into worst ever outcomes experienced by the economy.
Hence, it is not practical to make use of lower bound rate in case of housing trash.
Q. No: 6
Useful features of IS-LM framework
The IS-LM model explains how interest rate and aggregate output are determined when prices are fixed. Although the economy tends to move towards an aggregate level of output but it is not necessary that this level is at full employment level.
If there is a high rate of unemployment, then the policymakers might want to reduce it by increasing the aggregate output. The IS-LM framework shows this can be achieved by employing either fiscal or monetary policy.
Limitations
It is comparatively a static equilibrium model. It does not take account of time lags which are essential to analyze the effects of changes in economic policy over time.
The model is limited in scope as it does not explain how tax and spending policies should be formed. Moreover, it does not explain anything related to inflation, rational expectations, and international market. Furthermore, it completely overlooks the aspects of capital formation and labor productivity.
Reference
Hindmoor, A. and McConnell, A. 2014. Who saw it coming? The UK's great financial crisis. Journal of Public Policy, 35(1), 63-96.
