IS-LM and AD-SRAS-LRAS: Reasons for Recession

Introduction

The current recession is a result of several factors, but the fiasco in subprime mortgages in the United States and high or fluctuating prices of crude oil are some of the key issues (IMF 56). The crisis in the subprime mortgage sector has had significant consequences on both banks and financial markets, which has resulted in a major slump in finance (IMF 56). On the other hand, fluctuating prices of crude oil in the world market have caused major panic in several industries (IMF 56). The result of the fluctuation has been major inflation in several commodities, thus raising the cost of living (IMF 56).

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This paper takes look at the recession based on the IS-LM and AD-SRAS-LRAS models, which explain the events that led to the recession. In addition, the paper covers the mechanisms through which monetary and physical policies can be used to reverse the trend in recession. Further, the paper gives an analysis of how the IS-LM and AD-SRAS-LRAS models can be used to help the United States out of the current economic recession. In the last section, the author presents an opinion on the approach being taken by the United States to combat the recession.

Subprime mortgage crisis

The ongoing financial crisis was triggered by a remarkable rise in foreclosures and mortgage delinquencies (IMF 53). This resulted in financial shortages among banks and other financial institutions around the world (Feldstein). Most of the mortgages were offered to subprime borrowers, and when house prices fell between 2006 and 2007, mortgage delinquencies increased (Feldstein). Consequently, the securities supported by subprime mortgages lost their value, resulting in a major capital decline among banks (Feldstein).

The skyrocketing price of crude oil

The high price of crude oil was instrumental in contributing to the current recession (Feldstein). There were constant speculations of wars in the Middle East, which lead to unwarranted panicking among oil dealers (IMF 62). The increases in demand for oil particularly by other countries such as China also lead to an increase in the prices of oil (IMF 62). However, the high prices led to concomitant rises in prices of other commodities and an increase in shortage of finance (IMF 62).

Illustration of the current recession using IS-LM and the AD-SRAS-LRAS models

IS-LM model

The IS model represents an “investment and saving” curve denoted by a plot that shifts to the right, indicating an increase in interest rates and an extension in the gross domestic product (GDP) (Figure 1). Since 1937 the IS curve has been used to represent the sum of consumer spending, government purchases, private investment, and net exports, which account for GDP (Taylor 147).

On the other hand, the LM schedule is denoted by an upward-oriented curve that shows the function of money and general finance incentives in an economy (Taylor 147). The LM curve (Figure 1) represents a preference in liquidity and the equilibrium supply of money in an economy, which is determined by the central bank and other banks (Taylor 147).

Recession results from various shifts of the IS and LM curves (Taylor 149). The government’s spending usually has a tendency of lowering the rate of saving and raising the total demand for national income (Taylor 149). However, a deficit in national income due to factors such as low tax collection as experienced recently in the United States leads to a shift in the IS curve to the right, which is an early indicator of recession (Taylor 148). Economic recession is characterized by a significant drop in economic activity (such as industrial production and trade), a reduction in GDP, real income, and employment (Taylor 149) as is currently experienced in the world, the United States included.

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AD-SRAS-LRAS model

The abbreviations used in the model are as follows: AD= aggregate demand, SRAS= short-run aggregate supply, and LRAS= long-run aggregate supply (Børsum), which are illustrated in figure 2.

The AD curve shows the number of goods and services demanded in an economy at any price level (Børsum). From this curve, the economy is affected by factors such as the price of goods, foreign exchange rate, and government sales taxes (Børsum), Thus, a low value of the United States dollar translates to a high cost of importation of essential services such oil, which has an effect of raising the price of many other commodities. In addition, the high inflation rate as has been the case in the United States implies a reduction in consumers’ wealth, which decreases the demand for goods, as shown by the AD curve, leading to a recession.

On the other hand, the AS curve denotes the number of goods and services that a country is able to produce and sell at a given price (Børsum). AS slopes in the short-run (SRAS) but is vertical in the long run (LRAS) (Børsum). The recession in the United States and around the world is caused by changes in LRAS, which are caused by factors such as more people getting college degrees and therefore increasing unemployment, the occurrence of disasters such as Hurricane Katrina, which damaged natural resources, and a decline in the supply of imported oil.

Over a long span, changes in technology shift the LRAS curve to the right while growth in the amount of money shifts AD to the right (Børsum). This results in ongoing inflation and recession (Gwartne 46), as is the current state of affairs.

How fiscal policies and monetary policies are used to combat the recession

Fiscal policies

Fiscal policies to fight recession are the measures implemented by the government in terms of spending and taxation (Sowell 56). The subprime mortgage crisis in the United States is being mitigated by ensuring that foreclosed borrowers are in a position to refinance their loans of thirty years operating on fixed interest rates (Feldstein). The United States government is also backing new mortgages in order to strengthen financial institutions (Feldstein). In terms of taxation, the current United States government has proposed to limit deductions on charitable contributions for workers who earn $250,000 per year or more from 35 percent to 28 percent (Bigg). This will definitely increase consumer wealth, thereby increasing the demand for goods and services.

Monetary policies

Monetary policies deal with controls on the supply and availability of money as well as interest rates (Feldstein). The current economic recession has been characterized by the unavailability of money due to the high interest rates charged by banks (Feldstein). However, measures are in place to ensure that banks charge lower rates to facilitate access to money by investors and the public (Feldstein). The Economic Stimulus Package will also bolster the fight against recession through opportunities such as increased employment (Feldstein).

Using IS-LM and AD-SRAS-LRAS models to reduce recession

Fiscal policies such as reduction in taxation will encourage investment and thereby increase GDP as denoted by the IS curve in the IS-LM model. In addition, increased income due to increased employment will encourage consumer spending, thus shifting the IS and LM curves away from the point of recession.

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On the other hand, as investment increases, it will trigger lower prices of goods and services, thus prompting an upward shift along the AD curve of the AD-SRAS-LRAS model, away from the points of the recession. Additionally, as more people are employed and importation of more oil is done to support production, the AS curve will stabilize at the LRAS on the y-axis, which is the point of full employment output.

Opinion on the measures taken to fight recession

The measures being taken by the United States government seem to deviate from Classical, which is about free markets, to Keynesian, where there is a lot of government intervention in the markets (Sowell 6; Coddington 17). It is evident that the United States government has realized that the private sector on its own may have contributed greatly to the recession. Thus, it has intervened by an approach that is more of Keynesian Economics through interest regulation, control of some banks, and the investment in the Economic Stimulus Package. This approach seems to be a good practice since unfair competition among investors may lead to further inflation in essential services.

Further analysis of the recession

Dollar devaluation

A low value of the US dollar during the period of war in Iraq led to a higher cost of importing crude oil. On the IS-LM model, this represents a decline in GDP since oil is a crucial factor in production. Thus, a shift is noted downwards on the IS curve since low production means low income.

Additionally, the high cost of importing crude oil translated to a high cost of production and ultimately a high cost of goods and services, implying that there was a downward movement on the AD curve of the AD-SRAS-LRAS model. In the same breadth, a decline in production means a decline in employment, which would shift LRAS away from the point of full employment output.

Devaluation of the dollar also led to recession since doing so actually prevented the Federal Reserve from lowering interest rates.

Conclusion

The current recession is a result of among other factors, subprime mortgage crisis, high prices of crude oil, and devaluation of the dollar by the United States during the period of war in Iraq. Each of the factors confers different effects on the IS-LM and the AD-SRAS-LRAS models of economic analysis. In a bid to stop the recession, the United States is taking an approach that is more of Keynesian Economics as opposed to Classical Economics in a bid to protect vulnerable investors from unfair market prices and revive the economy.

References

Bigg, Matthew 2009. U.S. charities fear proposed tax law change. Web.

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Børsum, Øystein. February 2006.AS-AD Model. 2009. Web.

Coddington, Alan. Keynesian Economics: The Search for First Principles. New York: Routledge, 2003

Feldstein, Martin. 2007.How to Avert Recession. The Wall Street Journal. Web.

Frenkel, Jacob A., Razin, Assaf and Yuen, Chi-Wa. Fiscal policies and growth in the world economy. New York: MIT Press, 1996

Gwartne. Economics. New York: Harcourt, 1987

IMF. Housing and the Business Cycle: Housing and the Business Cycle. New York: International Monetary Fund, 2008

Sowell, Thomas. On Classical Economics. New Haven: Yale University Press, 2006

Taylor, Lance. Reconstructing Macroeconomics: Structuralist Proposals and Critiques of the Mainstream. Cambridge: Harvard University Press, 2004

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