2. Economic Crisis and its Symptoms
Economic Crisis:
A situation where a country’s economy faces a
slowdown brought by a financial crisis
Result: Falling GDP, increase in inflation, liquidity
crunch
Symptoms:
• A balance of payment crisis
• Spending by a government exceeds its revenues
• Rapid increase in inflation
4. BUILD UP OF HOUSING BUBBLE
Relaxed lending
Sub-Prime In 2006 Sub-prime
norms, emergence of
were 50% of total
(Poor Credit History) non-bank independent
loans issued
mortgage originators
MBS were rated by Mortgages were
SIV converted these
agencies bundled and sold to
into Mortgages Backed
(Moody’s, S&P), and Structured Investment
Securities (MBS)
were traded in market Vehicles (SIVs)
These insurers were
Banks’ capital remain MBS were insured by
unregulated and their
intact, they again lent Credit Default Swaps
creditworthiness was
it (CDS)
not assessed
5. CRISIS
Revival of General price level
demand and was increasing and
supply side housing prices
pressure caused falling due to excess
increase in price supply driven by
level cheap loans
Increased
Interest rates
and falling
mortgage
price
Borrowers
Valuation of MBS defaulted, further Insurance market
suffered heavily housing price Collapsed
dipped
6. European Sovereign Debt Crisis
Causes:
• Rising Government Debt Levels and Maintaining High
Fiscal Deficit
Greece (Debt to GDP ratio of approx. 200%)
Portugal & Italy (Debt to GDP ratio more than
100%)
• Trade Imbalances
Increase in government spending decreases the
national savings thus decreases net export
• Structural Problem of Eurozone
• No Control on Monetary Policy
7. Possible effect and probable solution
Effect:
• Capital Flight
• Lock Out
• Currency Devaluation
Solution:
• Increase investment and productivity
• Induce economic reforms in the troubled nations
8. IS-LM model
• It establishes the
relationship between
interest rates and real
output in the goods and
services market and the
money market
• The intersection of the IS
and LM curves is the
"general equilibrium"
9. Fiscal Policy & Monetary policy
Fiscal Policy: Government adjusts its levels of spending in order to
monitor and influence a nation’s economy
Example:
Fiscal expansion: An increased government spending or reduction
of taxes.
Fiscal contraction: A decrease government spending or increase in
taxes.
Monetary Policy: Central bank controls the supply of money in the
economy
Example: Monetary expansion via open market
12. Monetary-Fiscal policy mix: German
Unification
• Policy Mix: The combination of monetary and fiscal policies is
known as monetary-fiscal policy mix or simply policy mix.
• Fiscal Policy: The German government sharply increased
government spending and transfers in order to revive eastern
Germany
• Monetary Policy: After implementing fiscal policy German
central bank (Bundesbank) feared high possibility of inflation
hence adopted tight monetary policy to slow down economic
activity
13. Monetary-Fiscal policy mix: German Unification
• IS curve from IS1 to IS2 by
increasing government spending
hence increasing aggregate
output
• The LM curve to the left from
LM1 to LM2 due to tight
monetary policy (Increase
interest rates )
• Resulted in fast growth (from
the fiscal expansion) and high
interest rates (from the tight
14. LIQUIDITY TRAP
Cash additions to the private banking system by the
central bank fail to lower interest rates
People anticipate adverse happenings like deflation, war
etc. and so store cash
Central banks try to lower interest rates by buying
bonds with the newly created cash
15. Understanding Through IS-LM Model
• LM curve is horizontal
• Money supply is
indifferent to interest rates
• Monetary policy is
ineffective in changing
output in the market
• Fiscal expansion leads to
higher output level
• No change in interest rates
• No crowding out