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Macroeconomics 2 Essay ECO2004S European Debt Crisis and IS-LM Model Since the Lehman Brothers filed for bankruptcy in September 2008 the ensuing financial crisis has led to a worldwide recession. The 2008 -2009 recession has been arguably the deepest collapse of economic trade and activity since the Great Depression. Policymakers from across the globe have responded with various policy mixes –automatic stabilisers, fiscal policies and policies on the monetary front –with varying degrees of success. Europe has been hit particularly hard, due mainly in part to the structural make-up of the European Union. In the aftermath of the recession another crisis has emerged in Europe: The Sovereign Debt Crisis. This has forced the EU to reconsider their approach to combating the debt crisis within the Euro region (Matheron, Mojon, & Sahuc, 2012). The original policy of fiscal austerity has come in for a lot of criticism in the aftermath of its implementation. The aim of this paper is to firstly critically analyse the effectiveness of the austerity fiscal policy, specifically within the European context, through the use of the IS-LM macroeconomic model. I will then extend the focus of the discussion to the potential role monetary policy can play, looking forward, while finally concluding that according to the evidence the most efficient policy in the current environment is an expansionary fiscal policy. The focus of this essay will revolve around the use of the IS-LM model and it is therefore important to establish what this model is. The IS/LM model stands for: Investment—Saving / Liquidity preference—Money supply) and it is a macroeconomic tool that illustrates the relationship between interest rates and real output in the goods and services market and the money market. Important to this model is the intersection of the IS curve –showing how interest rate affects output–and the LM curve –showing how output affects the interest rate. This is the "general equilibrium" where there is simultaneous equilibrium in both markets (Krugman, 2011). These ideas will be important in discussing the effects of fiscal and monetary policies on the Euro debt crisis. The Sovereign Debt Crisis is an ongoing financial crisis in the Euro Area that has made it difficult for some countries to refinance their government debt, bar the assistance of third parties. The biggest concern is that public indebtedness has reached unprecedented levels,
leading to concerns over the sustainability and solvency of these countries and in effect leading to a “confidence crisis”within the entire Euro region (Matheron, Mojon, & Sahuc, 2012). Greece, Ireland and Portugal and Italy all have Debt to GDP ratios of over 100% (Saler, 2012). The fear is that one of these countries will potentially default and throw the entire region into widespread financial crisis. There have been scattered signs of improvement in the worlds’ economic situation in more recent times; however despite