UK economy during 2008 recession - Essay Example

It is worth mentioning that decline in consumption has direct adverse impacts upon production, which then leads to closure of businesses followed by retrenchment and unemployment. Also, the subprime mortgage property crises in USA triggered closures, mergers and acquisitions of US financial institutions, but it also negatively affected UK investment, commercial banks and financial institutions as they were among the businesses that also made huge investments in US banking and property sectors.

Finally, this led to a credit crunch like situation that sabotaged the financial position of UK banks, which were facing liquidity problems and were reluctant in sanctioning loans to borrowers. Finally, the expectations and forecasts that UK economy would contract by more than 2 – 2.5% in 2009 also aggravated the situation and interest rates were reduced to 3% from 4.5% by Federal Bank after instructions of UK government regarding formulation of new monetary policy to reduce business costs, to boost investors and consumers’ morale and to trigger greater purchase responses.

Recall that economic theory argues that the greater the number of transactions and consumption level, the more employment and jobs opportunities will create due to multiple exchanges of money among people (Hetzel, 2009). As far as the fiscal policy is concerned, it should be pointed out that UK government announced financial bailout packages of ?12bn and ?18bn so that it could pump money in the economy to eradicate liquidity crises and trigger consumer purchase responses. In addition, the government also announced tax cuts (direct and indirect levies) so that businesses could ensure their survival in challenging external business environment.

Had the above measures not been taken, the UK cumulative negative GDP growth rate had surpassed 3% due to credit crunch and rising debts (Wren-Lewis, 2010). 2. Explain UK monetary and fiscal policy during the crisis according to IS - LM model. It is worthwhile to mention the fact that IS – LM model shows the relationship between real interest rate and output level. The IS curve shows the corresponding interest rate that clears the good market. The IS curve slopes downward because the aggregate output increases at low real interest rates and vice versa.

Indeed, IS curve is derived from changes in desired investment and desired saving in an economy. The LM curve shows the real interest rate that clears the asset market. For instance, the LM curve is actually derived from changes in real money supply and real money demand. In addition, economic theory talks about Full Employment Line that shows the labour market equilibrium i-e employment and output are at Full employment level. As far as the UK economy is concerned, I would assume that the IS – LM had been in general equilibrium prior to recession i-e the goods, asset and labour market were in equilibrium simultaneously.

Real interest IS LM Equilibrium point Output Now when UK economy entered in recession, the UK government changed the monetary and fiscal policies that would cause shifts in IS and LM curves. For example, the reduction in nominal interest rate on money will reduce money demand, thereby reducing the real interest rate that clears asset market and causing a downward shift in LM curve. Similarly, increasing nominal money supply in market through stimulus package will reduce real interest rat