Chapter 24 – Case Studies - Illinois Wesleyan University



Chapter 24 – Case Studies

Case studies using the AS-AD model

▪ Use the AS-AD model to represent and analyze these historical events:

The Great Depression

▪ Historians speculate with a combination of factors as the motivators of the 1929 recession (that turned into a 10-year depression.) Here are some of them:

- The stock market crash produced a lack of confidence in households ((C).

- A real state speculative bubble burst sent many banks bankrupt (suddenly there were fewer lenders) and contracted investment by firms, that now became more pessimistic ((I).

- Congress was concerned about keeping a balanced budget and avoiding a deficit, following a partisan agenda instead of trying to stabilize the economy (so (T and (G).

- The Federal Reserve decided to retire a large fraction of the cash in circulation that was unused for transaction purposes due to the lack of economic activity ((M).

The Oil Crises of the Late 1970’s

▪ In 1973-1974, an again in 1979-1980, as a result of a political agreement by the OPEC (Organization of Petroleum Exporting Countries) the price of oil imports for industrialized nations multiplied four-fold in a matter of months (from $2.59 to $11.65 a barrel):

- The cost of the very inelastic energy imports skyrocketed ((NX).

- Firms found themselves with tremendous energy bills to pay ((P of inputs).

- Neither monetary nor fiscal policies could be applied to revert the incoming recession without incurring in even higher inflation rates.

The Vockler Deflation

▪ In the early 80's the US economy was still struggling with high inflation rates (9.7% by 1981) and Paul Vockler, the Fed chairperson at the time, decided to apply a rigorous contractionary monetary policy to bring down inflation.

- The reduction in output suffered in order to lower inflation is called the sacrifice ratio. According to Okun's law, that ratio is equal to two percentage points of GDP growth lost per one percentage point of inflation reduced.

- In this case, to lower inflation 6.7%, cost 19.0% of GDP over a period of 4 years.

The First Gulf War Recession

▪ Due to Iraq’s invasion of Kuwait on August 2nd, 1990, the world’s supply of oil was threatened and so the oil barrel went from $14 to $27. The cost of energy skyrocketed.

▪ As other OPEC members increases production the price of the oil barrel went back to $14.

▪ Launching the largest military campaign, since Vietnam, in the Persian Gulf shook the confidence of American consumers and investors, therefore slowing down economic activity.

▪ The Fed countered this weakening of aggregate demand with expansionary monetary policy, bringing down interest rates from 8% to 3%, and facilitating the recovery by early 1991.

Alan Greenspan and the Slow Deceleration

▪ The US economy has been growing for the last 9 years (straight since 1992, making this the longest peacetime expansion). The average annual growth rate has been consistently above 3%.

▪ The unemployment rate has been falling to levels not seen since 1969 (3.9%), potentially placing it below the natural rate of unemployment.

▪ Inflation was a clear risk and the Fed chairman slowly reduced the money supply. Over a period of 18 months the federal funds rate was taken from 3% to 6.5%.

▪ The cooling down is taking place, but may have been excessive. Perhaps the stock market plunge is affecting consumer's confidence and adding up to the slowdown.

The Bursting of the Dot Com Bubble

▪ After nine straight years of quarterly economic growth above 3% the US economy registered, in three consecutive quarters in early 2001, null and negative (-1.5%) growth.

▪ The main reason for this was the collapse in price of technology stocks, whose speculation had driven the stock market to historic heights, boosting consumer expenditure and confidence.

▪ Due to the excessive volume of investment in technology developed during the 1990s the bursting of the speculative bubble eliminated the main reason for additional investment.

▪ Additionally, major corporate scandals involving the largest energy corp. and the second largest telecommunications corp.–leading to their liquidations, shook consumer confidence.

▪ In order to counter these negative macroeconomic shocks Congress approved a tax rebate during the summer of 2001 and the Fed lowered interest rates from 6.4% (Nov. 2000) to 1.7% (Dec. 2001.) The recession was declared over by November of 2001.

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