(1) Given the current price level, the long-term real risky interest rate must be such that total planned nominal spending is equal to the full employment level. In general the lower the long-term real risky interest rate, the higher is total planned nominal spending--this is the "IS" curve: the curve that corresponds to equilibrium in the market for "bonds".
(2) Given the current price level, the short-term nominal safe interest rate must be such that when nominal spending and incomes are at their full-employment level that planned holdings of liquid cash money are equal to the existing money stock--this is the "LM" curve: the curve that corresponds to equilibrium in the market for "money".
(3) The expected inflation rate, expectations of future shifts in short-term nominal safe interest rates, the amount of financial risk in the economy, and the financial risk tolerance of wealth holders must be such that the spread between the long-term risky real interest rate and the short-term nominal interest rate is equal to the gap between those respective interest rates' full-employment values. The spread corresponds to equilibrium in the market for "quality."
Recessions happen when:
(1) A shortage of savings vehicles to transfer purchasing power from the present into the future induces spenders to cut back spending and save more. Even if the money stock (and thus the LM curve) and the spread remain at their appropriate full-employment balanced-macroeconomic values, spending will fall and unemployment rise.
(2) A shortage of liquid cash money leads spenders to cut back spending to try to build up their liquid cash money balances. Even if the relationship between spending and real interest rates (and thus the IS curve) and the spread remain at their appropriate full-employment balanced-macroeconomic values, spending will fall and unemployment rise.
(3) A shortage of high-quality assets or expected deflation or expected future monetary contraction leads the spread between the short-term nominal safe interest rate and the long-term real risky interest rate to rise. Even if propensities to spend, to hold money, and the money stock remain at their appropriate full-employment balanced-macroeconomic values, spending will fall and unemployment rise.
And, of course, a shortage of any of these three classes of financial assets--savings vehicles ("bonds"), liquid cash ("money"), or high-quality assets ("quality")--relative to its full-employment balanced macroeconomic level can arise ither becasue of a reduction in the supply of such assets or an increase in the demand for such assets. In 2008 we had a fall in the supply and a rise in the demand for high-quality assets with the financial crisis. In 2001 we had a fall in the supply of savings vehicles with the collapse of the dot-com boom. In 1982 we had a fall in the real supply of liquid cash with the Volcker disinflation.
Is there a presumption that a recession that arises out of derangement in any of these three financial markets--for bonds, for money, or for quality--is best cured by a strategic government intervention to repair the supply-demand full-employment imbalance in that particular market? Yes, if you thought that the macroeconomy was in balance before the recession--that the long-term risky real interest rate and the spread were at their right value before. Otherwise? It is pretty clear to me that you do not want to reattain full employment with spreads that are 'too low' or 'too high', or with a long-term real risky rate of interest that is either 'too low' or 'too high'. But what the appropriate values are of those variables is not something I would claim to have strong evidence-based views on.
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