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Chapter 5
Financial Markets, Financial Regulation,
and Economic Instability
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Chapter Outline
5-1 Introduction: Financial Markets and Macroeconomics
a. Integrating Financial Markets into the IS-LM Model
b. Bubbles, Risk, and Leverage
5-2 Case Study: Dimension of Global Economic Crisis
a. The Worldwide Economic Downturn
b. The Unique Severity of the Economic Crisis in the United States:
2007-11 Compared to 1981-85
5-3 Financial Institutions, Balance Sheets, and Leverage
a. Financial Institutions and Financial Markets
b. Balance Sheets and Leverage
c. Leverage: A Central Ingredient in the Financial Market Meltdown
d. Bank Insolvency and Deposit Insurance
e. Nonbank Institutions: The Wild West of Finance
5-4 A Hardy Perennial: Bubbles and Crashes
a. Two Bubbles Examined: Stock Prices 1996–2000 and
House Prices 2000–06
b. Why do Bubbles Occur?
Box: Understanding the Global Economic Crisis:
Two Bubbles: 1927-29 in the Stock Market Versus 2000–06 in the Housing Market
5-5 Financial Innovation and the Subprime Mortgage Market
a. Securitization
b. The Subprime Mortgage Market
c. Why Did Investors Buy the Risky Subprime Mortgage-Backed Securities?
d. The End of the Housing Bubbles and the Onset of the Financial Crisis
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Chapter 5
Financial Markets, Financial Regulation, and Economic Instability
5-6 The IS-LM Model, Financial Markets, and the Monetary Policy Dilemma
Monetary Policy Confronts a Normal Negative IS Shock
a. Monetary Policy Confronts an Unusually Big Negative IS Shock
b. The Term Premium and the Risk Premium
Box: Why Do Asset Purchases Reduce Interest Rates?
c. The Term Premium and Risk Premium Cause the Fed to Lose
Control of the Interest Rate for Private Borrowing
5-7 The Fed’s New Instrument: Quantitative Easing
a. The Fed’s Balance Sheet
b. How the Fed Uses Quantitative Easing
c. Quantitative Easing and the Term and Yield Premium
5-8 How the Crisis Became Worldwide and the Dilemma for Policymakers
a. How a Small Part of the U.S. Mortgage Market Caused the Global Economic Crisis
b. Amplification Mechanisms
c. Foreign Investors and the Dollar Shortage
IP Box: Weighing the Causes: Why Did Canada Perform Better?
d. The Policy Dilemma
Summary
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Chapter Overview
This chapter examines the role of the financial markets, financial regulations, and behavior of
economic agents for creating financial crisis and consequently economic instability. The text
discusses various financial intermediaries and their functions in the U.S. financial system. It is
believed that typical financial crisis occurs when financial assets experience a sharp decline in
values (bursting the bubble price which is well above its fundamental economic value). This results
in failures or bankruptcies of the financial institutions, which in turn create uncertainty or panic in
the financial system and may eventually lead to significant drop in normal economic activities such
as what happened after 2006. According to Gordon, there are several culprits to blame for the
recent Global Economic Meltdown of 2007-09. The Fed was to blame for keeping interest rates too
low for too long, others blame the financial innovations that have increased risk and leverage in the
financial system. Some others blame the lax regulation that allowed risky financial innovations to
occur to such an extent that they undermined the stabilization ability of monetary and fiscal policy.
Gordon presents and compares the main theories behind this recent financial crisis and concludes
with an analysis of the recent Fed behavior in this context and the dilemma it is facing to formulate
an appropriate monetary policy to correct the economic malfunctions.
Section 5-1 introduces students to the current macroeconomic instability that has engulfed the
global economy, which even the aggressive monetary policy seems impotent to rectify. Traditional
IS-LM model can explain the situation as a significant shift of both the IS and LM curves to the left,
caused by drastic decline in personal wealth (because of housing price crisis and stock price crisis)
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Chapter Overview
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and financial crisis. The compelling reason behind this is the emergence of subprime mortgages and
increased use of leverage in the financial market.
Section 5-2 analyzes the case study: Dimensions of the Global Economic Crisis. It compares the
economic severity (measured by output gap) of several countries: major developed countries of the
Euro Area, Japan, and the United States. These countries have experienced severe output gap
simultaneously after the year 2006. He compared specifically this experience of the United States
with the experience of 1981-85 and presented the contrast between these two time periods. It has
been exhibited in the Figure 5-3 that employment gap is the largest in 2007-09 among the last 50
years.
Section 5-3 describes the role of financial intermediation and financial markets in channeling funds
from savers to borrowers. Explain that while financial markets provide a direct channel between
borrowers and savers and are used by the government and large corporations, financial
intermediaries provide an indirect channel through deposits, contractual savings, and investment
institutions. The section also explains that while financial markets link savers and borrowers
directly, savers can also purchase financial market instruments through financial intermediaries.
Thus, not all financial market instruments provide a direct channel of finance from borrowers and
savers. The important point to stress is that leverage is an important financial tool, used by financial
managers to increase their profitability significantly, however, it also make them more open to
severe financial loss or risk. The higher the leverage the greater the profits when asset values
increase but the more quickly firms tumble into negative equity positions and go insolvent when
asset values decrease. These are particularly true for non bank institution which is not supervised
by the central banking authorities. In this context you may also explain the concepts of asymmetric
information, moral hazards, and adverse selection problems in the operations of the financial
institutions.
In Section 5-4, two bubbles have been examined in detail, stock price crash of 1999–2000 and
housing price crash of 2005–08. In the box, Gordon also compares the stock price crash of 1927–29
with the housing price crash of 2005–06. Explain to students that leverage is the main culprit in
both cases; however, financial regulations or lack thereof may also have played a significant role.
Explain to student also the causes of “why bubbles occur.” According to Gordon, these causes are
outside shock in the financial market, ready supply of credit, and financial innovations. These
issues are explained in greater detail in the following Section 5-5.
Highlight Section 5-5 by pointing out the importance of securitization of subprime mortgages by
the financial agents. This is done by issuing instruments like collateralized debt obligations (CDOs)
and credit default swaps (CDSs). In this context you may explain the agency problems “Principal–
agent problem.” in the mortgage market. Refer students to the concept of “NINJA Loans.” Also
point out that some economists blame the Federal Reserve Bank for maintaining low interest-rate
policy for a long time as the main reason behind the emergence of the subprime mortgage problem.
The role of the rating agencies such as Moody, S&P, and others has also contributed to the
transactions of these instruments such as CDOs and CDSs and subsequent end of the housing
bubble and the onset of the financial crisis.
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Chapter 5
Financial Markets, Financial Regulation, and Economic Instability
Section 5-6 discusses the implication of financial crisis and innovation for monetary policy.
Motivate this section by re-emphasizing the fact that because financial markets and institutions
provide the channel of funds from savers to borrowers between all sectors of the economy, it is the
very mechanism that facilitates the economy’s “circular flow of income” described in Chapter 2.
Thus, it would be reasonable to expect that the effects of financial crisis not only impact the
economy through the money market and the LM curve but also through the commodity market and
the IS curve. Stress that there are fundamental aspects of the financial crisis of 2005–07 which had
important effects on private spending creating a shock for the IS curve. This shock made the IS
curve steeper and significant shift to leftward. Furthermore, financial crisis also affects the LM
curve. Combined, these two effects have important policy implications. Stress that while any
discretionary monetary policy will shift the LM curve to the right by increasing the money supply
and or reducing the federal funds rate, the zero lower bound of the federal funds rate will prevent
the economy from moving toward the full employment position which requires negative nominal
federal funds rate. Moreover, actual interest rate confronted by the private sector is higher than zero
federal fund rate (because of term premium and risk premium) shifts the LM curve further to the
left resulting in further decline in output which is well below the desired natural level. Ask the
students to go over the box: “The IS-LM Summary of the Causes of the Global Economic Crisis.”
Section 5-7 turns to the operation of the Federal Reserve System. It describes the Fed’s balance
sheet and the instruments the Fed may use to influence the money supply. The primary instrument
the Fed uses is open-market operations. Point out that because purchases of government bonds or
Treasury bills add to the amount of excess reserves available for bank loans, the total money supply
will rise by exactly the multiplier times the amount of the initial bond purchase. Explain that, of the
other two Fed instruments of monetary control, the discount rate influences the quantity of highpowered money by affecting the interest rate the Fed charges on loans to member banks, while the
reserve requirement directly influences the reserve-to-deposit ratio and, thus, the money-creation
multiplier. Stress also that the Fed cannot exercise precise control over the interest rate as the zero
federal funds rate does not affect the consumer loan rate (for the existence of term premium and
risk premium) significantly. So, the Fed is attempting to affect the interest rate indirectly through
quantitative easing. You may point out the difference between the balance sheet of 2008 and that of
2010 and explain the existence of mortgage-backed security of more than $1.2 trillion. The Fed
intends to reduce the term premium and risk premium by buying these assets from the banking
sector to encourage them to grant more loans to the private sector of the economy. Show the
students that in the liability side also there is huge increase of excess reserves and this is
comparable with the time period of 1930s. For example, in 1938, the excess reserves were about 5
percent of nominal GDP, as compared to 7 percent of nominal GDP in mid-2010.
Section 5-8 captures the events that caused the Global Economic Crisis after 2006. It was caused
most directly by the 2000–06 U.S. housing bubble and its collapse after 2006. The causes of the
housing bubble can be divided up into three underlying causes, each of which interacted with the
other. First was the Fed’s maintenance of unusually low interest rates in 2002–04. Second was
financial innovations such as securitization, subprime mortgages, leverage, and increased risk of
default. Third was the failure of government regulators. However, Gordon has pointed out in the IP
box that although the Canadian economy has always been viewed as an appendage of the American
economy, the Canadian economy avoided the experience of the worldwide economic crisis.
According to Gordon, the institutional and regulatory environment of Canadian banks was a crucial
©2012 Pearson Education, Inc. Publishing as Addison Wesley
Answers to Questions in Textbook
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difference. Gordon concludes the chapter by pointing out the limitations of the monetary policies
because of the inability of the Fed to do anything substantial to bring the economy back to normal,
similar to the experience of the Great Depression decade of the 1930s in the United States and the
“lost decade” in Japan between 1992 and 2002. He suggests that fiscal policy should be in order.

Changes in the Twelfth Edition
This is a new chapter.
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Answers to Questions in Textbook
1. Figure 5-1 on page 123 shows that the output gaps fell by about the same amounts in Japan and Europe
as it did in the United States from 2007-09. This is evidence that the magnitude of the downturn
economic was not confined to the United States, which justifies the use of the term “global” to
describe the crisis that occurred at the end of the last decade. Also Figure 5-1 shows that all three
regions are sharing in the slow recovery from the 2007-09 drop in output, which reinforces the global
nature of the economic crisis.
2. Figure 5-2 on page 124 shows that while the output gaps dropped by similar amounts during the 198185 period and the 2007-09 recession, the economic downturn lasted two quarters longer in the recent
recession when compared to the earlier one. Figure 5.3 on page 125 shows that the employment gap
fell much more during the recent recession when compared to the earlier recession.
Figure 5.2 shows that the rebound of output was much larger following the end of the recession during
1981-85 than it has been following the 2007-09 recession. The sharp rebound in output during the
earlier period resulted in a quick rise in the unemployment gap as well, whereas there has been only a
slight increase in the unemployment gap following the end of the recent recession. Furthermore most
forecasts are that the unemployment gap will remain negative until at least 2015.
3. A bank’s assets are what it owns; they consist mainly of the loans that it makes, the financial
investments it has in government and privates securities, and the reserves in has in cash or in an
account with the Fed. A bank’s liabilities are what it owes, mainly to its depositors. The risk that a
bank faces is that people may fail to repay loans or that a financial investment that it has made will not
bring the expected return. A bank’s equity, the difference between its assets and its liabilities, provides
a margin between the bank’s assets and liabilities. It therefore provides the bank with some ability to
cover its liabilities in the event that there is a decline in the value of assets if loans go bad or financial
investments decline in value.
4. Leverage is the ratio of a financial institution’s liabilities to its equity. A bank can earn large profits
per dollar of equity by making loans or financial investments that rise in value. The reason is that when
the value of its financial investments increase by some amount, equity rises by the same amount since
the value of its liabilities do not change. But the reverse holds as well and if the value of its assets
falls, due to either bad loans or bad financial investments, by an amount that exceeds the bank’s equity,
then the bank becomes insolvent.
5. A nonbank financial institution does not have any reserves as part of its assets since it is not regulated
by the Fed or any other government agency. This type of financial institutions gets funds to acquire
assets by borrowing as opposed to accepting deposits. Finally, nonbank financial institutions tend to
have less equity than banks and therefore are more highly leveraged than banks.
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Chapter 5
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6. An asset bubble is a sustained large increase in the price of an asset relative to its fundamental value,
followed by a collapse in price that eliminates most or all of the initial price gain. An asset bubble
starts with an external shock that alters the perceived profitability of owning the asset. The
expectations of a higher future price drives up the asset’s price now. Furthermore the expectation of a
higher future price entices potential buyers to borrow now in anticipation that the higher price in the
future will enable them to easily pay off their loans. Therefore the development of a price bubble
requires a ready supply of credit and purchases of the asset are often highly leveraged. Finally, some
bubbles develop in part because financial innovations create new investments that seem to promise
higher returns than they eventually deliver.
7. The stock market and commercial real estate bubble of the late 1920s and the 2000–06 housing bubble
were fueled by highly leveraged purchases of assets. Both involved a greater deal of investor
speculation as exemplified by construction of office buildings in the late 1920s that lacked tenants and
mortgages in the 2000–06 period that required little or no down payment. Both bubbles resulted in
large profits for investment bankers and consumption expenditures fueled by the increases in real
wealth generated by the bubbles. Financial innovations included the development of mortgage backed
securities in the earlier period and the wider use of these instruments in the first decade of the twentyfirst century. In each case, buyers of these securities were often ignorant of the risks involved in owned
these securities.
However, there were important differences between the two periods. Deposit insurance did not exist
prior to 1933 which meant that depositors lost the funds they had in banks that failed as a result of the
collapse of the bubbles in the earlier period. Second, the Fed was indifferent to the collapse of banks
from 1930 to 1932, whereas it acted quite aggressively in an attempt to limit the fallout of the collapse
of the housing bubble.
8. Banks sell mortgages to a large financial institution. The financial institution then issues a debt
instrument similar to a bond. The principal and the interest of these debt instruments are to be paid out
of the proceeds from the mortgages that the financial institution owns, which is why the debt
instruments are called mortgage-backed securities. The subprime mortgage market consists of high-risk
borrowers who typically have some combination of low incomes, unstable employment and/or credit
histories.
Once banks started selling mortgages to larger financial institutions, the banks paid less attention to the
ability of borrowers to repay the loans since those loans were no longer part of the banks’ assets.
Furthermore the buyers of the mortgage-backed securities thought they were making relatively safe
investments, given that the securities had received high ratings from credit agencies. Similarly, the
development of the subprime mortgage market meant that less credit-worthy borrowers had the
opportunity to borrow. Finally, low interest between 2001 and 2004 meant that less credit-worthy
borrowers would be able to afford the mortgages as long as interest rates stayed low. All three of these
factors contributed to additional demand for housing and the expectation that house prices would
continue to rise. However, once interest rates started to rise, fewer people could afford mortgages,
which slowed the rise in the demand for housing and therefore the rise in house prices. Furthermore
some loans came with adjustable interest rates. As a result, some people found they could no longer
afford the mortgages they had taken out a couple of years earlier. Finally, as the rise in house prices
slowed, some speculative investors in the housing market switched from being buyers to sellers in an
effort to recoup their investments before price fell. That resulted in less demand and more supply than
otherwise. These factors all contributed to a fall of housing prices.
Once housing prices started to fall and people started to default on their mortgages, then sellers of
mortgage-backed securities were less able to pay the returns promised when the securities were issued.
That caused a decline in the value of the securities and resulted in some buyers and sellers of the
securities becoming insolvent as the down side of leveraging raised its head.
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Answers to Questions in Textbook
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9. The term premium is the average difference between the long-term interest rates, such as on a Treasury
bond, and the short-term interest rates, such as the federal funds rate or the interest rate on a Treasury
bill. The risk premium is the difference between interest rates on securities of the same maturity but
with different degrees of risk, such as difference between a riskier corporate bond and a safer Treasury
bond. The term and risk premiums cause the cost of borrowing by households to be different from the
federal funds rate for two reasons. First, short-term loans by banks to households and businesses, for
say, household credit card purchases or to finance the short-term operations of a business, are riskier
than overnight loans between banks, which is what the federal funds rate covers. Therefore there is a
risk premium on even short-term loans, as well as on a long-term loan to a household or a business.
Second, there is a term premium associated with a long-term loan to a household or business, such as a
mortgage or when a corporation sells a bond.
10. The Federal Reserve System’s assets are primarily the government and private sector securities that it
owns. Its liabilities are the currency it has issued and the reserves banks hold.
Quantitative easing is when the Fed buys assets not to drive down the federal funds rate, which is
already zero, but to raise bank reserves and to support the markets in the government and private
securities the Fed chooses to buy. When the Fed buys long-term securities, that added demand drives
up the prices of the securities, which reduces the yields on them and therefore the long-term premium.
Similarly, a purchase of riskier securities by the Fed increases their prices and reduces their yields,
thereby driving down the risk premium.
The evidence of quantitative easing following the financial crisis of the fall of 2008 is shown in the
upper frame of Figure 5-12 on page 150. Initially, the Fed bought private assets other than mortgagebacked securities. Over the course of 2009-10, the Fed scaled back its holding of those assets,
replacing them with mortgage-backed securities and government securities, without much of a change
in its total assets between the end of 2008 and 2010.
11. Two things were primarily responsible for turning the crisis in the relatively small subprime mortgage
market in the United States into the Global Economic Crisis. The first was the sharp rise of almost four
percentage points in the risk premium from the beginning of 2007 through the end of 2008, with the
sharpest jump after September 2008. That rise raised the cost of finance for all firms, causing them to
cut costs in other ways such as laying off workers, reducing inventories, and even stopping
construction on half-finished buildings The rise in the risk premium also caused providers of shortterm uninsured loans to closely monitor their borrowers and restrict lending. Declining asset values
also raised concern about their fundamental values, which increased uncertainty and make lenders
even more reluctant to make loans.
The second thing that turned the subprime mortgage crisis into a global event was that many banks in
Europe and Japan had made investments in other regions of the world, including U.S. subprime
mortgage-backed securities. These banks stopped lending to borrowers they thought to be at risk when
the U.S. subprime mortgage-backed securities declined in value. Furthermore banks had often paid for
those securities taking out short-term dollar denominated loans. Frozen credit markets in the United
States after mid-September 2008 created a shortage of dollars, making it difficult for banks to renew
their loans, which added to the insolvency problem and made the crisis spread beyond the shores of the
United States.
12. There are six features of the Canadian banking system and mortgage market that helped prevent the
development of a housing bubble during the last decade. First, Canada’s Financial Consumer Agency
has a mission to prevent the development of a subprime housing market. Second, banks face higher
capital requirements in Canada, which restricts their leverage to about half of that of American and
European banks in 2006-07. Third, down payments on houses are 20 percent of the purchase price in
Canada, in contrast to low or no down payments in the United States at the height of its housing bubble
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Chapter 5
Financial Markets, Financial Regulation, and Economic Instability
and there are restrictions on the amount of equity that can be taken out a home when a mortgage is
refinanced. These mean that homeowners are less likely to find themselves with mortgages that exceed
the value of their homes. Fourth, Canadian law allows a bank to claim non-housing assets from a
homeowner if the homeowner attempts to walk away from his or her mortgage, which makes default
on mortgages less likely. Fifth, mortgage interest is not tax deductible in Canada as it is in the United
States; instead Canadian law allows for the deductibility of capital gains from housing, giving
Canadian homeowners an incentive to pay off their mortgages rather than default on them. Finally, five
large banks dominate Canadian financial markets. Together, these six features are reason why banks in
Canada find mortgage lending profitable. As a result, mortgage securitization has not occurred in
Canada.
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Answers to Problems in Textbook
1. a. The equation for the IS curve, Y = kAp, is Y = 2.5(6,200 – 200r) = 15,500 – 500r. Your graph of the
IS equation has a value of Y = 15,500 as the horizontal intercept along the income axis for an
interest rate of zero. The equation for the IS curve tells us that equilibrium income in the
commodity market decreases by 250 billion dollars for each-half percentage point increase in the
interest rate. Finally when the interest rate equals 8, equilibrium income in the commodity market
equals 15,500 – 500(8) = 11,500. Therefore your graph of the IS curve should run from the point
(15,500, 0) up and to the left to the point (11,500, 8).
b. When the federal funds rate equals zero, the equation for the LM curve tells us that money market
is in equilibrium at an income of 13,500.
c. Part b indicates that the LM curves intersects the horizontal axis at an income level of 13,500 for an
interest rate of zero. The equation for the LM curve tells us that equilibrium income in the money
market increases by 50 billion dollars for each-half percentage point increase in the interest rate.
Finally when the interest rate equals 8, equilibrium income in the money market equals 13,500 +
100(8) = 14,300. Therefore your graph of the LM curve should run from the point (13,500, 0) up
and to the right to the point (14,300, 8).
d. Since the term premium equals 1.0 percentage point, the vertical distance from the LM curve for
the federal funds rate up to the LM curve for the government bond rate is 1.0 percentage point.
Therefore your graph of the LM curve for the government bond rate should run from the point
(13,500, 1) up and to the right to the point (14,200, 8). Since the risk premium equals 2.0
percentage points, the vertical distance from the LM curve for the government bond rate up to the
LM curve for the private bond rate is 2.0 percentage points. Therefore your graph of the LM curve
for the private bond rate should run from the point (13,500, 3) up and to the right to the point
(14,000, 8). Note that because of the zero bound on the federal funds rate, the LM curves for the
government bond rate and the private bond rate are horizontal at interest rates of 1.0 percent and
3.0 percent, respectively, for income levels less than 13,500 billion.
e. Since autonomous planned spending is determined by the private bond rate, equilibrium income is
determined by the intersection of the IS curve and LM curve for the private bond rate. That
intersection occurs at a private bond rate of about 3.8 percent and an income level of about 13,580
billion (the exact values are 3.833 percent and 13,583.33 billion). The government bond rate is
about 1.8 percent, which is the private bond rate less them risk premium of 2.0 percentage points.
The federal funds rate is 0.8 percent, which is government bond rate less the term premium of 1.0
percentage point.
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Answers to Problems in Textbook
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2. a. Since the drop in real wealth causes autonomous planned spending to decrease by 800 billion at
each interest rate, the new equation for autonomous planned spending is Ap = 6,200 – 200r – 800 =
5,400 – 200r. Therefore the equation for the new IS curve is Y = 2.5(5,400 – 200r) = 13,500 – 500r.
b. Because of the zero bound on the federal funds rate, the LM curves for the government bond rate
and the private bond rate are horizontal at interest rates of 1.0 percent and 3.0 percent, respectively,
for income levels less than 13,500 billion. That means new IS curve intersects the LM curve for the
private bond rate at an interest rate of 3.0 percent. Therefore equilibrium income equals 13,500 –
500(3) = 12,000 billion. The government bond rate is 1.0 percentage point, which is the private
bond rate less the risk premium. The federal funds rate is at its zero bound since it equals the
government bond rate less the term premium.
c. The collapse of the housing and stock prices that creates a financial crisis would lead to a rise in
the risk premium because concerns about the insolvency of financial institutions and private
companies would cause financial investors to demand a higher compensation for the added risk of
holding private bonds.
d. The new LM curve for the private bond rate would shift up by another percentage point, meaning it
would be horizontal at an interest rate of 4.0 percentage points for incomes less than 13,500 billion
and your graph should then should run from the point (13,500, 4) up and to the right to the point
(13,900, 8).
e. Because of the zero bound of the federal funds rate, the IS curve intersects the new LM curve for
the private bond rate at an interest rate of 4.0 percent. Therefore equilibrium income now equals
13,500–500(4) = 11,500 billion.
3. a. Quantitative easing would reduce the term and risk premiums because the Fed’s purchases of
government bonds and private bonds would increase the prices of those bonds, which results in a
decline in their interest rates. Since the federal funds rates in at its zero bound, lower interest rates
on governments bonds and private bonds reduce the term premium and risk premium, respectively.
b. The new LM curve for the government bond rate would shift down by a half-percentage point,
meaning it would be horizontal at an interest rate of 0.5 percentage point for incomes less than
13,500 billion and your graph should then should run from the point (13,500, 0.5) up and to the
right to the point (14,250, 8). The new LM curve for the government bond rate would shift down so
that it is again 2.0 percentage points above the LM curve for government bonds, meaning it would
be horizontal at an interest rate of 2.5 percentage points for incomes less than 13,500 billion and
your graph should then should run from the point (13,500, 2.5) up and to the right to the point
(14,050, 8).
c. The IS curve intersects the new LM curve for the private bond rate at an interest rate of 2.5 percent.
Therefore equilibrium income now equals 13,500 – 500(2.5) = 12,250 billion. The equilibrium
interest rate for government bonds is now 0.5 percent, which is the equilibrium interest rate for the
private bond minus the risk premium.
d. While quantitative easing did increase equilibrium income by 750 billion when compared to what it
was prior to the implementation of quantitative easing (see part (e) of Problem 2), real GDP is still
more than 1,330 billion below what it was before the housing and stock price bubbles collapse (see
part (e) of Problem 1). Furthermore, in these set of problems, even if more quantitative easing were
to drive all interest rates to their zero lower bounds by completely eliminating all term and risk
premiums, equilibrium income would be at 13,500 billion which would still be less than
equilibrium income prior to the collapse of the housing and stock market bubbles. These three
problems illustrate how monetary policy alone may not be capable of leading an economy out of as
deep a downturn as the one of the Global Economic Crisis.
©2012 Pearson Education, Inc. Publishing as Addison Wesley