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Housing and GDP

New federal housing data shows that the nation's most overheated local housing markets make up such a large share of the total US market that a sharp fall in their value could stall or slow economic growth. If worst case is true, and a sharp fall in real estate values leads to a decline in GDP, assess:

1. how this situation would be depicted using an IS-LM diagram where the equilibrium and interest rate before the fall in real estate values are Y0 and r0 (Y subzero and r subzero for income and interest rates). Include/show any new equilibrium values.

2. how could a sharp fall in real estate values affect the GDP?

Now assume that even after a fall in real estate values and decline in GPS, the fed continues with its interest rate increase campaign and increases the federal funds target rate:

3. using the same IS-LM diagram from 1, show this new situation depicted.

Now suppose the fed decides not to change the federal funds target rate after the fall in real estate values and decline in GDP:

4. what policy options are available to the government to counter the effect of a sharp fall in real estate values on the economy? Again, using the same IS-LM diagram from 1, show the effect of these policy options.

5. would these policy options affect the government budget deficit? How?

Solution Preview

You should see the attachment.

STEP 1
There is a sharp fall in real estate values and this leads to a decline in the GDP. On the IS-LM diagram this would mean that the IS curve would shift to the left. If the interest rate before the fall in real estate values are Y0 and r0. The new values that is Y1 and r1 will be lower than the original Y0 and r0. This situation is depicted in the IS-LM diagram given below.

In other words this means that if there is a ...

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