Macroeconomics Case Study

Global Financial Crisis and ITS Impact on Real and Financial Sectors in India

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Abstract:
This case is intended to introduce students to the fundamentals of macroeconomic management using the IS-LM model. The name of this model originates from the basic equilibrium conditions of income determination: investment (I) must equal saving (S); money demanded (L) must equal money supplied (M). General equilibrium is a situation of simultaneous equilibrium in both the goods market (IS) and the money market (LM). The IS-LM model was developed in 1937 by Nobel laureate Sir John Hicks, who intended it as a graphical representation of the ideas presented by Keynes during the Great Depression of the 1930s in his famous book, The General Theory of Employment, Interest, and Money. Since Hicks, several economists have refined the IS-LM model, and have been widely applied in understanding cyclical fluctuations in economic activity and macroeconomic policy. The recession that began in December 2007 in the U. S. grew steadily worse, and the unemployment rate increased dramatically. During the financial crisis of 2008, U.S stock prices plunged. Investors feared that a depression was around the corner because of the breakdown of the financial sector. The result was that the world witnessed the largest and sharpest drop in global economic activity since the Great Depression of the 1930s. In 2009, most developed economies found themselves in deep recession. However, India, one of the prominent emerging economies of the world, was resilient to the sharp decline in national output. The Indian stock market crashed in 2008, resulting in a destructive impact on household wealth, business confidence, credit crunch, and a decline in consumer spending and private investment spending.

The global crisis impacted India’s financial and real sectors due to demand shock. Private demand and external demand were quickly affected and further resulted in a reduction in gross domestic output. The real GDP growth rate declined to 6.7 percent in 2008-09 from 9 percent in 2007-08. The Reserve Bank of India, the Central Bank, and government responded with easy monetary and fiscal policies that in turn had their effects on real output, interest rate, budget deficit, the general price level, and on crowding out of private investment.

The case offers students several opportunities for analysis. They can begin by analyzing the impact of the global financial crisis on aggregate demand in India and identify the factors that shifted the IS curve. The case contains information and data on various components of aggregate demand and data on the real and financial sectors. It has sufficient details about the fiscal and monetary policy measures taken during the crisis period in India. Finally, students can analyze the effects of massive policy (both fiscal and monetary) responses using the IS-LM framework. The case has been developed using secondary data and information. The case enables the students to analyze the dynamics of the closed economy IS-LM model using the data on the Indian economy.

Pedagogical Objectives:

• Establish a link between the goods market and the money market
• Analyze how the financial and real sectors are affected by a demand shock
• Analyze how the IS-LM model can be applied to understand how an economy copes with disturbances (or, shocks) in the short run
• Analyze the influence of monetary and fiscal policies on the money market and the goods market
• Analyze policy responses and understand the related dynamics such as increase in fiscal deficit, rise in general price level, rise in interest rate, crowding out of private investment etc.
• Infer the effect of the policies on the economy so as to restore simultaneous equilibrium both in the goods market and the money market.

Keywords : Global Financial Crisis, Indian Economy, Nature and Implications of Global Financial Crisis on Indian Economy, Real Sector Impacts, Financial Sector Impacts, Goods Market & Money Market, Business Cycles, Closed Economy IS-LM Model, Fiscal and Monetary Policies, Crowding-Out, Business Cycles, Closed Economy IS-LM Model, Fiscal and Monetary Policies, Business Environment, Inflation, Fiscal Deficit, GDP Growth in India, Aggregate Demand, Saving & Investment, RBI