Germany and the Global Crisis 2006-2010

The Global Crisis explained in the AS/LM framework


Term Paper, 2011

12 Pages, Grade: A


Excerpt

Nora Görne

UK English – MLA Style

12 December 2011

Germany and the Global Crisis 2006-2010

When the United States housing bubble collapsed in 2007 and triggered a global financial crisis this also did not leave one of the economically strongest country in Europe unaffected. Amongst other, the insolvency of Lehman Brothers (and others) led to a liquidity shortage in German major banks like the Hypo Real Estate (Müller) and the BAA-AAA-spread increased. In the following, the performance of Germany during the global crisis from 2006 to 2010 will be examined in the IS/LM framework and show how the financial and monetary sector reacted.

One of the first effects of the U.S. financial crisis visible in the data was a drop in German consumer confidence which started to decline at the end of the second quarter of 2007 from a original value of 25 under 0 in the third term of 2007[1]. In the middle of 2008, consumer confidence then reached -60 and did not gain much strength before the beginning of 2009 but then reached almost the original value from the beginning of 2006 in the fourth quarter of 2009.

Fig. 1. Consumer Confidence in Germany 2006-2010. Data from “Germany Consumer Confidence.” Trading Economics. Trading Economics, 2011. Web. 11 Dec. 2011.

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German business confidence also started to decline in the middle of 2007 but it was not until the middle of 2008 that it dropped from 107 to 85 at the beginning of 2009.

Fig. 2. Business Confidence in Germany 2006-2010. Data from “Germany Business Confidence.” Trading Economics. Trading Economics, 2011. Web. 11 Dec. 2011.

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Even if the development of these two indicators was a bit different it can be interpreted in the same way because both eventually led to a shift of the IS-curve to the left. The drop in consumer confidence can then be seen in a drop in consumption starting at the beginning of 2008 and reaching its trough at the beginning of 2009.

Fig. 3. Real private consumption in Germany 2006-2010. Data from amecoselect.dta

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As sales decreased, business confidence decreased as well and led to a drop in investment because firms chose to spend less.

Fig. 4. Real private investment in Germany 2006-2010. Data from amecoselect.dta

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Because less was produced output dropped which effects can be seen in the following graph showing real GDP growth from 2006 to 2010. GDP had a sharp decrease from the beginning of 2008 though at the beginning of 2009 it started to increase again

Fig. 5. Real GDP in Germany 2006-2010. Data from amecoselect.dta

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Another important factor to be taken into consideration is the BAA-AAA spread. That is the difference between the rates charged by the bonds market of firms with a high (triple B) and low (triple A) risk rating. From the third quarter of 2007 this spread suddenly started to rise from under 1 to 3.4 at the beginning of 2009. That means that certain firms which were rated as having a high risk could suddenly only borrow at a much higher rate than the interest rate set by the central bank while before the interest rate for government bonds, triple A and triple B rated firms was almost the same.

Fig. 6. BAA-AAA spread as an average of all countries. Data from “Federal Reserve Economic Data.” Economic Research. Federal Reserve Bank of St. Louis, 2011. Web. 11 Dec. 2011.

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This increase in interest premium again had an effect on investment because most firms became more reluctant and further decreased their investment. Eventually, the decrease in confidence and the increase in interest premium led to a leftward shift of the IS-curve. The IS-LM-model as it is described in chapter 5 by Blanchard shows the equilibrium in the goods and financial market at the intersection of the IS- and the LM-curve as the relation of the interest rate and the level of output.

Fig. 7. IS-LM-relation 1 (Blanchard 603).

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This graph assumes that the economy was before the crisis at equilibrium point A with the level of output Y, intersection between the LM- and the IS-curve. Due to the decrease in confidence and the increase in interest premium the IS curve shifts to the left to the new equilibrium A' and the lower output Y'.

This shift can also be derived from the formula of the IS-curve:

This relation states exactly what has been observed. Consumer confidence c0 effects consumption C and business confidence b0 and interest premium effect investment I so that if these factors decrease, output Y will automatically go down as well.

Another way of looking at business confidence and consumer confidence is to look at the stock market index and the house price index. The house price index shows that there was a decline in house prices from the beginning of 2007 on, reaching its through at the beginning of the fourth quarter of 2007. This decrease in house prices led to that home owners feel less wealthy, increase their saving and therefore reduce their consumption.

Fig. 8. House Price Index in Germany from 2007-2011. Data from “House Prices World Wide.” Global Property Guide. Global Property Guide, 2 Dec. 2011. Web. 11 Dec. 2011.

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The economic intuition for the stock market index is similar: The stock prices fell from 8000 in January 2008 onwards to under 4000 in the first quarter of 2009. Lower stock market prices are a sign that investors are more reluctant to finance projects of firms because they are more pessimistic about their future and decide to buy less companies' stocks which leads to a decrease in investment.

Fig. 9. Stock Market Index in Germany from 2006-2010. Data from “Germany Stock Market.” Trading Economics. Trading Economics, 2011. Web. 11 Dec. 2011.

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Policy makers quickly reacted with a monetary-fiscal policy mix to keep the effects of the crisis as low as possible. First, as an indicator for fiscal policy budget balance as üercentage of GDP can be used.

Fig. 10. Budget Balance in Germany from 2006-2010. Data from amecoselect.dta

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As it can be seen in the graph, in the first quarter of 2008, the budget balance shows a sharp negative decline meaning that government spending increased (Karlsson) and taxes decreased (Kassenmäßige Steuereinnahmen) and the budget deficit therefore got larger.[2] If taxes decrease the disposable income increases and people increase their consumption. Together with an increased government spending this fiscal expansion increased output and speaking in the terms of the IS-LM-model shifted the IS-curve to the right again. However, till the end of 2009 budget balance was still decreasing even though at a much slower rate. From the beginning of 2010, the government decreased their budget deficit and budget balance increased so that it almost reached the same level as at the beginning of 2006.

Furthermore, monetary policy tools have been used as well to counteract the crisis. The central bank decided for monetary expansion which resulted in a lowered short-term interest rate from at the beginning of 2008 4.6% to 1.2% at the beginning of 2009. From 2009 on the interest rate was still decreasing but at a much slower rate.

Fig. 10. Nominal Short-Term Interest Rate in Germany from 2006-2010. Data from amecoselect.dta

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Speaking in terms of the IS-LM-model, the central bank increased nominal money M and with that real money M/P through an open market operation. This increase in money supply then shifts the LM-curve down.

Fig. 11. IS-LM-relation 2 (Blanchard 97).

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Putting the two policy tools together, it can be concluded that the initial decrease in output which resulted in a leftward shift of the IS-curve was counteracted by fiscal expansion and by monetary expansion which effected both the LM- and the IS-curve. At the beginning of 2010, budget balance and the short-term interest rate were still declining however confidence, consumption, investment, stock market prices, housing prices and real GDP all show an increase from 2009 on again which is a sign that the economy started to recover from the beginning of 2009 again. In 2010, the IS-curve is almost back at its starting point from 2006 though the LM-curve moved even a bit further down which results in the new equilibrium A' with a higher output but a lowered interest rate compared to 2006.

Now that the economic intuition and the relations became clearer, it is time to look at another important variable which has been ignored so far: unemployment.

Fig. 12. Unemployment in Germany from 2006-2010. Data from amecoselect.dta.

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Unemployment sharply decreased from 2006 onwards from over 10% to 7.5% at the beginning of 2008. Till the beginning of 2009 it increases to approximately 7.9% and then falls at the beginning of 2010 even under the rate from 2008. Even though real GDP dropped from 2275 to 2170 in 2008, the increase in the unemployment rate in 2008 is surprisingly small. The reason for this is a change in policy: On 5 November 2008, the German federal government passed the “business activity support programme 1” (“Konjunkturpaket 1 - Maßnahmenpaket Beschäftigungssicherung durch Wachstumsstärkung”; Lau) which amongst others extended the period in which short-time work (Kurzarbeit) money can be received and allowed for the development of a special programme for older and less qualified wage earners. Together with the “business activity support programme 2” (“Konjunkturpaket 2”; “Beschlüsse”), these two programmes include the main actions the German government undertook to avert the damage of the global crisis and to overcome the recession (“Schlaglichter”). As already examined earlier, most of them had the goal to increase government spending and decrease taxes to stimulate growth.

In conclusion it can be said that even though Germany experienced a recession in 2008 due to the global crisis, the effects were reduced with the help of a fiscal-monetary policy mix and the economy quickly recovered in one year.

Word Count: 1710

Works Cited

“Beschlüsse der Koalition zum Download.” General-Anzeiger, 13 Jan. 2009. Web. 11 Dec. 2011.

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Excerpt out of 12 pages

Details

Title
Germany and the Global Crisis 2006-2010
Subtitle
The Global Crisis explained in the AS/LM framework
College
Utrecht University
Grade
A
Author
Year
2011
Pages
12
Catalog Number
V184343
ISBN (eBook)
9783656091028
ISBN (Book)
9783656090885
File size
821 KB
Language
English
Tags
germany, global crisis, is-lm-model, financial crisis, 2006-2010
Quote paper
Nora Görne (Author), 2011, Germany and the Global Crisis 2006-2010, Munich, GRIN Verlag, https://www.grin.com/document/184343

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