The Investment and Savings curve (IS) represents the commodity market equilibrium, with the national savings (S) being determined by national output (Y) - (Private Consumption (C) + Government Expenditure (E). Y is a function of the tax policy, economic expectations and interest rates etc, while E is dependent of government policy (Krugman, 2009).
Figure 1: IS Curve Derivation
The 2007 recession started in the sub-prime mortgage market, due to the expansion of liquidity derived from the bond markets, which was unmatched increases in real assets. The risky loans amounted to $1.3 trillion in 2007, with the subprime market accounting for 18% of total originations. Increased securitization, credit, coupled by high default rates, foreclosures and less regulation etc, which forced savers to move their savings into other assets. Reduced savings leads to increased interest rates. The high rates of interest reduce consumption spending by the US economy. This causes the reduction of the GDP from Y2 to Y1. With the decline in savings, high interest rates and reduced consumption triggered off reduced investments into the housing market, which burst the housing bubble. The investments curve I, is derived in the left graph in figure 1(Eicher, Mutti, & Turnovsky, 2009). The important of the real estate industry in altering investment interest rates, lower economic expectations, which caused the recession. In return, the recession exacerbated consumption, credit availability and real interest rates. The decline in consumption means that the demand for products across the US declined. The importance of the US economy, and due to globalization, the global financial system is inter-connected, made even stronger by the international bond markets.
Figure 2: Capital Flows
The real rate of interest is determined by the demand and supply of loanable funds, where the supply equals the national savings, while the demand comprises of the net capital outflows and the domestic investments. A decline in domestic investments, reduces the demand on loanable funds, and given a fixed level of savings, then the excess supply results in a decline in the real interest rates, represented by a leftward shift of the Investment Curve. A reduction in real interest rates relative to the rest of the world causes an increase to investments outside the United States in search of higher returns on the capital (Krugman, 2009). This causes an increase in foreign direct investments and bonds etc in the external markets shown in figure 2.
An increase in capital outflows, lead to an increase in the demand for foreign currency as against the dollar. This is exacerbated by the increased demand for consumer goods due to low real rates of interest on the market for loanable funds, which when coupled with reduced domestic investments, drives up the demand for imports. Increased capital outflows and imports leads to increased supply of dollars, and does a decline in the real exchange rate. This causes a trade deficit in the United States. However, the low real exchange rate causes US exports to be relatively cheaper than the rest of the world, which drives up demand for US exports. This drives up domestic investments in the US to meet the growing demand, which should tend towards the restoration of the level of domestic investments and the BOP.
Banks rely on the fractional banking model, where they retain only a fraction of the deposits (monetary base), which is expanded by the multiplier to form part of the reserve monetary base, which is invested in loans and securities with varied maturity times. Effectively, banks don’t have enough cash reserves to meet all withdrawals. Banks intermediate between depositors, who prefer liquid cash and borrowers, who desire longer-term loans, which presents several Nash equilibriums. If depositors believe whether by rumours or otherwise that a bank is in crisis, then they will rush to take out their deposits. This will force the banks to call in their advances to the borrowers. However, since it is impossible for all the debtors to repay the loans, coupled with the fact that the loans may not be mature, then the banks will be unable to meet the depositors request for money (Eicher, Mutti, & Turnovsky, 2009).
The reduced depositors’ confidence stemming from frequent bank crises, coupled by lack of deposit insurance, will breed panic and even more depositors, to seek to withdraw their deposits from the bank. The reserve base will multiply contract, but since the monetary base is a measure of the total amount of liquid cash in an economy, it remains essentially the same. Even is some, or the majority of the depositors in a bank know that the rumoured banking crisis is only a rumour, they would also want to take out their deposits on the fear that the rumour will cause a bank run anyway. Effectively, any rumours would result into a bank run, and the bank will inevitably go into bankruptcy (Krugman, 2009).
Eicher, T. S., Mutti, J., & Turnovsky, M. (2009). International Economics. London: Taylor & Francis.
Krugman, p. (2009). he Return of Depression Economics and the Crisis of 2008. New York: W.W. Norton Company Limited.