The Macroeconomics of Financial Crises for Undergraduates

Article excerpt

JEL A20 * E63 * F01

The current financial crisis is also a challenge for undergraduate macroeconomics instruction (The Economist, March 2010). We show that workhorse models of undergraduate macroeconomics, creatively applied and properly enriched with elements introduced back in Keynes' time, teach us a great deal about the current crisis and help prepare for future financial crises.

The tools needed for this endeavour are crisis versions of the IS-LM and Mundcll-Fleming models that distinguish between money and capital markets, introduce risk premiums, and show how these interact with a dormant liquidity trap. IS-LM and Mundell-Fleming models have well-known limitations. They do not explain what started the crisis in the first place, how to prevent bubbles, or what regulations the financial industry needs. But they offer a useful bird's-eye perspective of the macroeconomic consequences of financial crises, and help to sort out the main policy issues.

We emphasize that high calibre financial crises often come in conjunction with a liquidity trap that cannot be easily identified when banks are part of the problem. Such traps lack the characteristic feature of zero interest rates. In addition, conventional policy recommendations may be misleading. Expansionary fiscal policy may be the sole remedy, given that there is no more crowding out in small open economies via exchange rate appreciation. But this is only true up to a certain point because liquidity traps may morph into perfect traps. …