• Short run or long run?
• Supply side or demand side?

• Case study on page 313
• A fall in aggregate demand (planned expenditure)
• Decline in stock market → reduced wealth →
→ Falling C and I → IS curve shifts to left
• 911 attack → rising uncertainty→ Falling C and
I → IS curve shifts to left
• Accounting scandals → Falling C and I → IS curve shifts to left

• Tax cut → IS curve shifts to right
• Rising government expenditure to help banks and airline industry → IS curve shifts to right
• Expansionary monetary policy (rising money supply) → LM curve shifts to right
• Result: the 2001 recession is short, and interest rate remained low

• Self-fulfilling wave of optimism and pessimism
• For example, pessimism causes consumption and investment to fall
• Then GDP falls, making the pessimism selffulfilling
• Optimism will cause bubble

Example of animal spirit
Boom in Housing Market
• Low interest rate
• http://en.wikipedia.org/wiki/Community_Re investment_Act
• But the high price (bubble) is not sustainable

• After housing price fell, there is rise in mortgage default and home foreclosures
• Financial institutions that owned mortgagebacked securities see large losses
• Stock market and consumer confidence fell
• All pushed IS curve to the left

• Fed cut interest rate (how?) What happens to
LM curve?
• Treasury used $700 billion to rescue banks
(Bail out). What happens to IS curve?
• Result: GDP recovered, but employment did not

• http://economics.mit.edu/files/6346
• http://economics.mit.edu/files/6613
• There is a trend in labor market caused by automation, globalization and falling educational attainment

• Fiscal policy is ineffective when LM curve is steep (crowding out is big)
• Monetary policy is ineffective when nominal interest rate is close to zero (liquidity trap)

• LT happens when nominal interest rate is close to zero
• How to get out of LT?
• The idea of QE3 is to generate expectation of inflation (so real interest rate can fall and investment can rise), and depreciation of dollar (so export can rise)

• It depends
• Deflation can move Y back to 𝑌
• Deflation can also move Y further away from 𝑌

• Aging population
• Demand is shrinking
• Deflation is persistent
• Pessimistic animal spirit
• Expansionary fiscal policy is limited by huge government debt
• Expansionary monetary policy is limited by liquidity trap

• Huge government debt
• Austerity is necessary
• But austerity would cause IS curve to shift to left, and recession
• US faces similar dilemma (tradeoff)

• A policymaker needs to determine the priority: balancing budget or stimulating economy?
• Essentially, this is long-run versus short run

• Entitlement program and rising health cost
• War
• Dollar is special
• Every four years we have a new president