Economics 314 Coursebook, 2009 Jeffrey Parker 9A APPENDIX: EXPLAINING RECESSIONS WITH THE IS/LM MODEL Appendix 9A Contents A. Why This Appendix? ....................................................................... 1 B. The Setting .................................................................................... 2 C. The Downturn ............................................................................... 4 D. Liquidity Trap ................................................................................ 5 E. Policy Choices ............................................................................... 6 F. Works Cited in Text ........................................................................ 8 A. Why This Appendix? The tools of the IS/LM model are well suited to understanding some aspects of the current macroeconomic situation. This appendix attempts to apply the model to the economic downturn that began in 2007, with comparisons to other recessionary episodes in the United States and elsewhere. The United States has had a turbulent macroeconomic history. After the repeated panics, recessions, and depressions of the pre-World War I period, the economy was buffeted in the first half of the twentieth century by two world wars and the Great Depression. Although things were quite stable in the 1950s and early 1960s, inflation was building and, when the Arab oil embargo and subsequent price increase hit in 1973, culminated in the “stagflation” of the mid-1970s: a period of high unemploy-ment combined with the highest sustained U.S. inflation ever experienced outside of wartime. Anti-inflationary monetary policy triggered a major recession in 1982 while bringing the inflation rate back down to acceptable levels. After all this excitement, the economy settled into a stable, low-inflation growth path after the 1982–83 recession. Macroeconomists have dubbed the period from 1984–2007 as the “Great Moderation,” though some may decide to revisit that appel-lation in light of the rather immoderate downturn that has followed it. Whether the Great Moderation followed from the absence of major shocks or the effective neutra-lization of shocks by policy authorities is a matter of some debate, but both factors9A – 2 probably contributed.1 The Great Moderation allowed macroeconomists to turn their attention away from traditional business cycles and the IS/LM framework of analysis received little attention. High on the macroeconomic agenda during the period were development of endogenous-growth models, exploration and testing of real-business-cycle models, and the further development of microfoundations of new Keynesian models based on rational price stickiness. We have or will study these models in con-siderable detail. However, the economic and financial crisis of 2008–09 has provided a new im-perative for macroeconomists, once again focusing attention on demand-driven busi-ness cycles. The IS/LM model provides a useful tool to begin such analysis, which is the task we undertake in this appendix. The current recession looks more like the Great Depression, for which the IS/LM framework was developed, than any busi-ness cycle since the 1930s. B. The Setting The mild U.S. macroeconomic fluctuations of the Great Moderation period were misleading because lurking under the serene surface of stable GDP growth were large and persistent, but ultimately unsustainable, imbalances. The United States through-out this period had an extremely low (and in some years actually negative) saving rate. In order to finance domestic investment spending (and at times a large govern-ment deficit) with a dearth of domestic saving, the U.S. has run a persistent current-account deficit (and capital-account surplus) leading to large accumulations of U.S. debt in Asian countries. One explanation for the low measured saving rate is that households’ wealth was growing rapidly through appreciation in the value of housing and financial assets. Such capital gains do not show up in personal income measured by the GDP ac-counts because they do not reflect current production. To see how this can lead to a very low saving rate, consider the following hypothetical example. Suppose during 1999 that the Allen family earned $70,000 after taxes from current “output.” The value of their house also increased in value by $20,000 and their stock portfolio rose in value by $10,000. Their “augmented” personal income, including appreciation in asset values, would be $100,000. Perhaps they choose to save 30% of this, which is 1 The term “Great Moderation” seems to have been introduced by Stock and Watson (2002), who find important roles for both reduced shocks and better monetary policy. For more re-cent research, see the papers presented at the Federal Reserve Bank of San Francisco confe-rence on “Recent Trends in Economic Volatility,” November 2007, available online at http://www.frbsf.org/economics/conferences/0711/.9A – 3 actually a rather high saving rate. Their consumption would exactly match their measured disposable income of $70,000, so their measured saving rate would be ze-ro. Nonetheless, they actually provided considerably for their future by leaving the $30,000 of capital gains in place for the future. Based on this example, it is easy to see how households could have negative sav-ing rates. By selling the appreciated stocks and/or using a home-equity loan to pull money out of their assets, they could easily spend more than $70,000. Very high levels of consumption spending helped to stimulate the U.S. economy by keeping the IS curve pushed out to the right. Much of the consumption was on imports, which were not balanced by high levels of exports. However, dollar-denominated, government-backed assets are viewed as extremely safe and liquid, making them very attractive to foreign savers. China and other Asian countries had very high saving rates (often induced by government policies) and were willing to accumulate large volumes of U.S. assets, especially government securities. For two decades (and actually since the 1960s) the persistent U.S. trade deficit pumped dollar assets into Asian central banks. Because of the high level of foreign saving, the United States was able to achieve substantial levels of domestic real investment despite the very low levels of domestic private saving and negative government saving. The large capital inflows largely