Macroeconomic Policy: Traditional Keynesian Theory Essay


Discuss about the Macroeconomic Policy for Traditional Keynesian Theory.


IS-LM model is a graphical encapsulation of the traditional Keynesian theory that describes the relationship between the nominal interest rate and real output. Utilizing the IS-LM framework along with the paradox of thrift, it has been argued by the economists that decision taken by a group of a people could provide rise to a welfare while reducing the output of the economy. As per the article published by the Federal Reserve Bank of Minneapolis it has been seen that the great recession of 2008 can be explained through the IS-LM framework (Allsopp and Vines 2015). During 2001, in order to overcome the jibe of the recession in the US market Fed reduced the interest rate two times subsequently. It allowed interest rate on the adjustable mortgage to be lowered as well. It has lowered the revenue for the banks because in absence of proper incentive to invest money into the market would not be the ideal way. In another way, reduction in the Fed rate has enhanced the liquidity in the market that allowed another recession within three years of the Fed rate fall (Wolfson 2017). In this situation homeowners were delighted to get approved for the interest only loans and the direct outcome of this, subprime mortgage bubble started to grow. Fed has successfully crowded out the 2001 recession with the help of the lowered fed rate, however they missed the spot that they were moving towards another bug disaster (Odell 2014). IS-LM entails that, as the as the interest rate fell, investment reduced and the liquidity enhanced. It additionally enhanced the output of the nation that allowed the demand of the new homes in the country to rise. However, when the citizen of the US went to buy home, they were issued interest only loans and the buyers became happy with the same too. Most people started to buy home with the aid of cheap loan and created the asset bubble in order to sell the same in future. However, price started to fall as the asset bubble is over Now as per Keynesian model, as the demand started to fall Fed rate was raised by the Federal Reserve, however imprudent activity has made what it can do to the economy (Summers 2017).

Post-recession, US government and the other authoritative body introduced series of regulation during 2009 in order to reduce the implication of the crisis on the economy further. As the initial step to control the GFC, Housing and Economic Recovery Act of 2008 was introduced, which provided mortgage estimate to help the homeowners (Reifshneider 2016). In addition to this, Federal Housing Finance Agency was introduced, which were expected to supervise the GSEs. Next to this during 2009 Federal Deposit Insurance Corporation included the non-bank financial institutions into their framework to provide regulatory authority to the FDIC and in addition to this firms were allowed to fall and not to be rescued in crisis situation (Valdez and Molyneux 2015). It provided much amount of freedom to the government from restricting the microeconomic organizations to fall. Next to this during 2010 Dodd-Frank Wall Street Reform was introduced which enhanced the Federal Reserve power to oversee the performance of the other financial performance of the NBFCs (Kaal 2014).


Allsopp, C. and Vines, D., 2015. Monetary and fiscal policy in the Great Moderation and the Great Recession. Oxford Review of Economic Policy, 31(2), pp.134-167.

Kaal, W.A., 2014. The Systemic Risk of Private Funds after the Dodd-Frank Act. Mich. Bus. & Entrepreneurial L. Rev., 4, p.163.

Odell, J.S., 2014. US international monetary policy: Markets, power, and ideas as sources of change. Princeton University Press.

Reifschneider, D., 2016. Gauging the Ability of the FOMC to Respond to Future Recessions.

Summers, L., 2017. Crises in Economic Thought, Secular Stagnation, and Future Economic Research. NBER Macroeconomics Annual, 31(1), pp.557-577.

Valdez, S. and Molyneux, P., 2015. An introduction to global financial markets. Palgrave Macmillan.

Wolfson, M.H., 2017. Financial crises: Understanding the postwar US experience. Routledge.

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