By early 2008, most economists believed we were heading towards recession. Congress and the...

Question

By early 2008, most economists believed we were heading towards recession. Congress and the President passed an Economic Stimulus Package (Expansionary Fiscal Policy) and the Federal Reserve cut interest rates (Expansionary Monetary Policy). Explain what was happening to the economy in terms of the AS/AD model, including what would need to happen to bring us out of the "recessionary gap". In other words, using the AS/AD model as a starting point, explain the economic situation of 2008.

Robert · Accepted Answer

Introduction: 
The financial crisis of 2008 –often deemed to be the worst since The Great Depression – came about 
after the collapse of the housing bubble. Investment banks – Lehman Brothers, JP Morgan Chase, 
Morgan Stanley etc.  – has made huge loans to finance the rise of the housing sector but due to the 
massive overvaluations ,  the real-estate sector collapsed and the loans went bad. The crisis , which 
started at Wall Street,  started to spill over to the main economy . The symptoms of a crisis are mostly 
similar : availability of easy credit , a boom in a particular sector  , and an eventual collapse . This spreads 
panic in the economy making people wary of investments in financial assets which affects investment 
and thus Aggregate Demand. People starting hoarding money (considered to be a riskless asset) ,

By early 2008, most economists believed we were heading towards recession. Congress and the President passed an Economic Stimulus Package (Expansionary Fiscal Policy) and the Federal Reserve cut...

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