Kevin12733167 Problem Set 4 Due Friday, February 28 Econ 105

Kevin12733167problem Set 4 Due Friday February 28econ 105 Intro To

Construct a comprehensive economic analysis based on the following instructions: First, sketch the Aggregate Demand (AD), Short-Run Aggregate Supply (SAS), and Long-Run Aggregate Supply (LRAS) curves for an economy in long-run equilibrium. Next, explain the effects of the dollar appreciating against all other currencies on U.S. imports and exports. Then, analyze how an appreciation of the dollar influences AD, SAS, and LRAS, including the short-term impact on the graph, real GDP, and the price level. Additionally, discuss the long-term effects on real GDP and the price level without any technological, capital, or labor input increases, according to the classical view of the AS-AD model, and illustrate these effects on the same graph.

Furthermore, examine the impact of a decrease in the money supply by the Federal Reserve on the equilibrium interest rate, and explain how an increase in the money supply affects AD, SAS, and LRAS, including graph implications. Justify why the Federal Reserve might decide to decrease the money supply.

In a separate section, depict the classical labor market with equilibrium wage and employment level. Analyze how downward wage stickiness could help explain higher unemployment during economic downturns using the graph. Then, modify the labor market graph to include a minimum wage set above the equilibrium wage; discuss how this may lead to unemployment, and how unemployment due to the minimum wage might change during downturns.

Finally, conduct independent research on the recent financial crisis, citing credible sources. Describe two plausible causes for the housing market collapse in 2007. Explain why the collapse negatively impacted commercial banks such as Wachovia and Washington Mutual, and investment firms like Bear Stearns. Conclude by outlining three measures taken by the US government or Federal Reserve to mitigate the damage of the crisis or prevent future financial crises.

Paper For Above instruction

The 2007–2008 global financial crisis marked a severe downturn rooted in the housing market collapse, which propagated through the financial system causing widespread economic instability. Analyzing this event requires understanding key macroeconomic concepts, including aggregate demand and supply, monetary policy, and labor market dynamics, all of which contribute to the broader understanding of financial crises and economic policy responses.

Graphical depiction of aggregate supply and demand in long-run equilibrium

In the initial state, the economy is represented by the intersection of the AD, SAS, and LRAS curves, indicating full employment and stable prices. The AD curve slopes downward, reflecting the inverse relationship between the price level and real GDP: as prices fall, real output increases. The SAS curve slopes upward, indicating that higher prices incentivize producers to supply more in the short run, while the LRAS is vertical, representing the economy’s potential output determined by technology, capital, and labor.

The impact of currency appreciation on trade balances

An appreciation of the U.S. dollar increases its value relative to other currencies. This makes U.S. exports more expensive for foreign consumers, leading to a decline in export demand. Conversely, imports become cheaper for U.S. consumers, resulting in increased import volume. These effects tend to deteriorate the trade balance by reducing net exports, which are a component of aggregate demand. Over time, persistent currency appreciation can shift the AD curve inward, signaling weaker overall demand in the economy.

Effects on aggregate demand, short-term supply, and long-run supply

In the short run, the reduction in net exports caused by the dollar’s appreciation shifts the AD curve inward, leading to a lower price level and reduced real GDP. The SAS curve remains unchanged initially, but the new equilibrium reflects decreased demand. The price level tends to fall, and output decreases temporarily. In the long run, assuming no change in productive capacity or technology, the LRAS remains anchored at potential output, and the economy stabilizes at a lower demand level, with prices adjusted accordingly.

Classical view: long-term effects without productivity change

According to classical macroeconomic theory, in the absence of technological progress, capital accumulation, or labor force growth, the economy’s real GDP remains at its potential level in the long run. The initial shocks caused by currency appreciation are absorbed, and the economy self-corrects through price level adjustments rather than changes in real output. The long-run aggregate supply curve is vertical, so when aggregate demand shifts leftward, the price level decreases, but real GDP returns to its full employment level, indicating no long-term change in output.

Monetary policy: effects of a decrease in the money supply

A contractionary monetary policy, such as decreasing the money supply, raises the equilibrium interest rate by reducing the amount of funds available for borrowing. Higher interest rates discourage investment and consumption, further shifting the AD curve inward. Graphically, this results in a lower price level and reduced output in the short run. The Federal Reserve might implement such a policy to combat inflation or cool down an overheating economy, aiming to stabilize prices and prevent asset bubbles.

Labor market dynamics and unemployment

The classical labor market model depicts wage-clearing behavior where wages adjust to equate labor supply and demand, establishing an equilibrium employment level. However, wages tend to be downwardly sticky, especially downwardly rigid due to contracts, minimum wages, or social norms. This stiffness prevents wages from falling freely during downturns, leading to unemployment. The graph reflecting this shows a surplus of labor, or unemployment, during recessions.

Introducing a minimum wage above the equilibrium wage further exacerbates unemployment by setting a wage floor that employers are unwilling or unable to pay, leading to excess labor supply. During economic downturns, the impact is magnified as firms cut back on hiring or lay off workers, and the minimum wage prevents wages from adjusting downward, prolonging or increasing unemployment. The graph demonstrates a widened gap between labor supply and demand, indicating higher unemployment levels, especially in recessionary periods.

The 2007-2008 financial crisis: causes and consequences

The collapse of the housing market in 2007 was precipitated by several intertwined factors. First, the proliferation of subprime mortgages—loans issued to borrowers with poor credit histories—fueled an unsustainable rise in housing prices. Financial innovations such as mortgage-backed securities (MBS) and collateralized debt obligations (CDOs) amplified risk, spreading exposure across a broad array of financial institutions. When housing prices peaked and then declined, many borrowers defaulted, leading to massive losses for banks holding MBS and related assets (Mian & Sufi, 2014).

Second, the widespread issuance of risky loans was driven by a belief in the continuous rise of housing prices, fostering a bubble that inevitably burst. The decline in home values rendered many mortgage-backed securities worthless, severely impacting commercial banks like Wachovia and Washington Mutual, which held significant portfolios of these assets. Their failure was exacerbated by liquidity shortages, inability to meet short-term obligations, and confidence crises, ultimately leading to bankruptcy or forced sale (Gorton & Metrick, 2012).

Investment firms such as Bear Stearns faced similar woes, as the value of their holdings plummeted, forcing government intervention and bailouts to prevent systemic collapse. The Federal Reserve and Congress responded by implementing measures such as aggressive interest rate cuts, liquidity injections, and the Troubled Assets Relief Program (TARP) to stabilize markets and restore confidence. These responses aimed to mitigate further damage and establish a framework for financial stability, although debates about the sufficiency and effectiveness of these actions continue (Acharya et al., 2011).

References

• Acharya, V. V., Schnabl, P., & Suarez, G. (2011). Securitization without risk: Why shouldbank capital matter? Federal Reserve Bank of New York Staff Reports, No. 458.
• Gorton, G., & Metrick, A. (2012). Securitized banking and the run on repo. Journal of Financial Economics, 104(3), 425-451.
• Mian, A., & Sufi, A. (2014). House of debt: How mortgage credit drove the great recession. University of Chicago Press.
• Federal Reserve Bank of St. Louis. (2008). The financial crisis: Lessons learned and why the economy remains fragile. Review, 90(4), 253–268.
• Brunnermeier, M. K. (2009). Deciphering the liquidity and credit crunch 2007–2008. Journal of Economic Perspectives, 23(1), 77-100.
• Shiller, R. (2008). The subprime crisis. Finance & Development, 45(3), 39-41.
• Taylor, J. B. (2009). The financial crisis and the policy responses: An empirical analysis of what went wrong. NBER Working Paper No. 14631.
• Chung, H., & Lundberg, M. (2014). Excessive Financial Risk and the Global Financial Crisis. Economic Policy, 29(78), 203-232.
• Bernanke, B. S. (2009). The great moderation, the Great Recession, and the Great Depression. American Economic Review, 99(2), 18-24.
• Rajan, R. G. (2009). Fault lines: How hidden fractures still threaten the world economy. Princeton University Press.