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Project 1following The 2008 Financial Crisis Many Countries Used Fisc

Following the 2008 financial crisis, many countries employed fiscal stabilization policies aimed at ending the recession swiftly. This paper examines the economic responses of China and the United States (US) to their respective fiscal stimulus measures, analyzing changes in key macroeconomic variables such as money supply, inflation rates, exchange rates, and unemployment rates. The discussion also explores how these policies align with core macroeconomic models, identifies potential violations of model assumptions, and assesses the effectiveness of the efforts to close output gaps.

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Introduction

The 2008 global financial crisis was a pivotal moment that prompted governments worldwide to implement aggressive fiscal policies to stabilize their economies. China and the US, two of the primary economic powers, adopted significant fiscal stimulus measures: China launched its "Four Trillion" plan, injecting approximately 12% of its GDP, whereas the US passed multiple stimulus packages totaling about 19% of its GDP. While these interventions aimed to stimulate economic growth, their impacts on macroeconomic variables such as money supply, inflation, exchange rates, and unemployment provide insights into the efficacy and limitations of fiscal policy during a crisis.

Economic Context and Policy Measures

China, an open economy with a historically fixed or pegged exchange rate policy, unofficially rep pegged its currency from late 2008 to 2010, responding to the crisis. The large fiscal injection was intended to boost investment, infrastructure development, and consumption. In contrast, the US relied on a mix of fiscal stimulus measures including the Economic Stimulus Act, the Housing Economic Recovery Act (HERA), the American Recovery and Reinvestment Act (ARRA), the Troubled Assets Relief Program (TARP), and bailout initiatives to stabilize financial markets and foster recovery.

Analysis of Macroeconomic Variables

Money Supply and Inflation

The expansionary fiscal policies in both countries likely increased the money supply. In China, the injection of nearly $600 billion corresponded with increased liquidity, which under the Quantity Theory of Money (MV=PY), would put upward pressure on the price level if the velocity of money remains stable. Similarly, in the US, the near $3 trillion fiscal stimulus significantly expanded the money supply, potentially fueling inflationary pressures. Empirical data indicates that, over the subsequent years, China’s inflation remained relatively stable, hovering around 2-3%, while the US experienced a modest increase, with inflation rates settling around 2% by the mid-2010s, consistent with expansionary monetary influences.

Size of Money Supply and Inflation Rates

The overall money supply, measured through M2, increased considerably in both countries. According to the Federal Reserve and People’s Bank of China reports, M2 grew by approximately 10-12% annually post-crisis, aligning with the monetary expansion policies. These increases contributed to moderate inflation in both economies, although the US experienced slightly higher inflation due to different monetary policy responses and economic structures.

Exchange Rate Dynamics

The USD/CNY exchange rate experienced fluctuations following the crisis. Initially, China unofficially re-pegged its currency to the US dollar to stabilize exports, which limited currency appreciation despite the rising capital inflows. Over subsequent years, the yuan appreciated gradually as China moved towards a more flexible exchange rate regime, but the initial period was characterized by a stable or even depreciating yuan relative to the dollar. The US dollar, on the other hand, saw periods of strength, driven by safe-haven flows and monetary policy divergence.

Unemployment Rates and Output Gap

The natural rate of unemployment in the US is around 5%, but during the crisis, unemployment soared above 10%, reflecting a significant output gap. Conversely, China’s unemployment hovered around 4.5%, despite the shock, indicating less slack but also less transparency regarding labor market conditions. The policies in both countries aimed to reduce the output gap, but the results varied. In the US, the fiscal stimulus helped reduce unemployment gradually but remained elevated for several years. In China, rapid infrastructure investment and fiscal spending helped maintain lower unemployment levels, confirming the theoretical expectations from Keynesian models.

Model Applications and Assumption Violations

The models most relevant here include the IS-LM model, Aggregate Demand-Aggregate Supply (AD-AS) framework, and the Quantity Theory of Money. The IS-LM model suggests that fiscal stimulus shifts the IS curve rightward, increasing output and employment. The AD-AS framework predicts an increase in aggregate demand, leading to higher output and, potentially, inflation.

However, violations of assumptions—such as perfect price and wage flexibility, closed economy assumptions, and constant velocity of money—are evident. For instance, China’s fixed or semi-fixed exchange rate regime affects the open economy dynamics, and changes in velocity or expectations may have distorted the expected outcomes. Additionally, in the US, the zero lower bound on interest rates and quantitative easing complicate traditional models' applicability.

Effectiveness of Fiscal Stimuli

Both countries’ efforts contributed to economic stabilization; however, the magnitude of their success varies. The US’s large fiscal stimulus appears consistent with the Keynesian prediction of increased output; unemployment declined more slowly but broadly improved over time. China’s rapid infrastructure investment maintained high growth rates, but concerns about debt sustainability emerged. The findings suggest that while the models predict initial positive effects, long-term outcomes depend on fiscal sustainability, the responsiveness of monetary policy, and external factors like exchange rates and global economic conditions.

Conclusion

The responses of China and the US to the 2008 crisis, viewed through macroeconomic models, largely align with expectations, although some assumptions—such as stable velocity and flexible prices—were violated or complicated by open economy considerations. The observations emphasize that fiscal policy can be effective in closing output gaps but must be complemented with prudent monetary and exchange rate policies. The experiences of these two economies highlight the importance of considering context-specific factors and model assumptions when designing macroeconomic interventions during crises.

References

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