Solution-

Global Financial Crisis and its impact on GDP [U.S.A.]

Global financial crices-

The global financial crisis (GFC) refers to the period of extreme stress in global financial markets and banking systems between mid 2007 and early 2009. During the GFC, a downturn in the US housing market was a catalyst for a financial crisis that spread from the United States to the rest of the world through linkages in the global financial system. Many banks around the world incurred large losses and relied on government support to avoid bankruptcy. Millions of people lost their jobs as the major advanced economies experienced their deepest recessions since the Great Depression in the 1930s. Recovery from the crisis was also much slower than past recessions that were not associated with a financial crisis.

Impact of global financial crisis on GDP in usa-

The country’s GDP fell 4.3% and the unemployment rate would eventually reach 10%. The recession lasted 18 months and required massive government stimulus to turn the economy around, including a $700 billion bailout of the financial industry, along with insurance and automobile companies, and another government stimulus package worth more than $800 billion.

It occurred on the tail end of a subprime mortgage crisis (where the U.S. foreclosure rate jumped 79% in 2007), which crashed the U.S. housing market and sunk home prices. That also spurred on a banking crisis, as numerous financial institutions that had taken on high-risk mortgage-backed securities saw those portfolios wiped out as borrowers defaulted on their loans. Huge financial institutions such as Bear Stearns, Fannie Mae, Freddie Mac, Lehman Brothers all collapsed as a result in 2008, leading to a stock market crash that saw the major indexes lose more than half of their value over the course of the crisis.

The Global Financial Crisis in the AS/AD Model – United States

I will use of the basic model of aggregate demand (AD) and aggregate supply (AS) to explain the changes in real GDP, CPI inflation and the unemployment rate for the United States. The data for the analysis comes from the World Development Indicators database of the World Bank.

Let’s start with a brief overview on the economic indicators of the United States in the 21^st century. For this I have prepared two diagrams. Figure 1 contains the United States’ real GDP (constant 2005 US$) together with the country’s annual percentage growth rate of real GDP over the period from 2000 to 2014. The unemployment rate (ILO estimates) and inflation, as measured by the Consumer Price Index (CPI), are shown in figure 2.

(Source: World Bank, 2016)

First it can be seen that the USA’s real GDP has risen steadily over the period except from 2008 and 2009, which corresponds to the GFC and the last global recession. In 2000, GDP stood at around $11.6 trillion and it has risen to $14.8 trillion in 2014. This is a 28 percent increase in real GDP over the complete period. However, despite an overall increase in GDP, GDP growth has been considerably volatile over the period. The US economy experienced the highest GDP growth in 2000 with a positive growth rate of 4.1 percent. The lowest GDP growth occurred in 2009 with a negative growth rate of 2.8 percent. This corresponds to a variation of 6.9 percentage points. The US surpassed its pre-downturn output level in 2011, meaning that it took the economy almost two years two recover from the 2008/09 recession. After the GFC, the economy has experienced more even growth from 2010 to 2014 compared to the clear rise and fall in the growth rate over the period from 2001 to 2007, which was driven by the US housing boom amongst other factors.

(Source: World Bank, 2016)

Unemployment ranged from 4.1 percent (2000) to 9.7 percent (2010) over the period from 2000 to 2014. In the beginning of the century it rose until 2003 and then fell until 2006. After stagnating in 2007 unemployment more than doubled by the end of 2010. Since then, unemployment has fallen significantly to 6.2 percent. However, this is still 1.5 percentage points higher than the pre-downturn unemployment rate.

Inflation ranged from an inflation rate of 3.8 percent in 2008 to deflation of 0.4 percent in 2009. The highest volatility in the inflation rate therefore occurred during the GFC. In the beginning of the century inflation came down to 1.6 percent (2002) and thereafter accelerated to 3.4 percent in 2005. During the period preceding the GFC it remained at a relatively high level compared to the years before. After a drop by almost 3.5 percent from 2008 to 2009 inflation receded to 3.2 percent in 2011 but it has recently dropped below the 2 percent level.

Figure 3 Supply and Demand Shock during the GFC

The fluctuations in real GDP, unemployment and inflation for the period of the GFC of 2007 can be summarized in the AS/AD model as follows (figure 3). Firstly, from 2007 to 2008 the US economy faced a negative supply shock (1) due to the collapse of a domestic housing bubble, a doubling of the oil price, as well as large price increases in other commodities (Krugman, 2009). This shifted the short run aggregate supply curve (SRAS) to the left. This negative supply shock explains the beginning of the GFC, i.e. the stagflation of 2007/08, because a negative supply shock triggers both rising inflation and lower output, as well as higher unemployment. However, this is not the end of the story, because the negative supply shock was followed by a negative demand shock in 2008/09. The aggregate demand (AD) curve also shifted to the left (2), causing disinflation in 2008 and deflation in 2009, negative output growth of almost 3 percent in 2009, as well as a further increase in the unemployment rate to almost 10 percent. It took the AD curve until 2011 to shift back to its initial position (3) as the government intervened and consumer and business confidence recovered. This caused inflation and GDP growth to pick up again as shown in figure 2. Subsequently, unemployment fell as demand recovered. Since 2011 it can be observed that unemployment and inflation are falling in tandem. This can be explained by the shifting of the SRAS curve back to its initial position (4) after the negative supply shock which occurred in 2007/08.