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Chapter 26: Q.7 (page 690)

During the 2007-2009 recession, the value of common stocks in real terms fell by more than 50%. How might this decline in the stock market have affected aggregate demand and thus contributed to the severity of the recession? Be specific about the mechanisms through which the stock market decline affected the economy.

Short Answer

Expert verified

The ways in which the stock market's downturn from 2007 to 2009 influenced aggregate demand and contributed to the recession's severity.

Step by step solution

01

Step 1. Concept of  Recession

A recession is a situation of a substantial decline in an economic activity like industrial production, real income, employment and wholesale-retail trade.

02

Step 2. Explanation

The following are the four processes via which the stock market's declension has affected aggregate demand and generated recession:

- Stock price declines: Stock price declines may have resulted in lower investment spending.

- Decrease in financial wealth: As financial wealth declined, consumers' lifetime resources were diminished, resulting in a decrease in consumption.

- Depreciation in the value of financial assets: Depreciation in the value of financial assets raised the likelihood of financial trouble for individuals, resulting in lower consumption of durable goods and residing.

- A decrease in the company's net worth: as a result of poor lending decisions and lending issues, the company's lending and investment spending are lowered.

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Most popular questions from this chapter

If adverse selection and moral hazard increase, how does this affect the ability of monetary policy to address economic downturns?

A "rate cycle" is a period of monetary policy during which the federal funds rate moves from its low point toward its high point, or vice versa, in response to business cycle conditions. Go to the St. Louis Federal Reserve FRED database, and find data on the federal funds rate (FEDFUNDS), real business fixed investment (PNFIC96), real residential investment (PRFIC96), and consumer durable expenditures (PCDGCC96). Use the frequency setting to convert the federal funds rate data to "quarterly," and download the data.

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c. Based on your answers to parts (a) and (b), how effective was the traditional interest rate channel of monetary policy over this rate cycle?

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