Part of this is to help keep my Macroeconomics students sharp in the run-up to the AP exam in May, and part of this is to help me figure out how the economy’s going to turn out this year.

We start right now with current demand well short of full-employment output. That means we’re in a recession. If you want to draw an AD/AS graph, make that Aggregate Demand (AD) line well to the left of the Long-Run Aggregate Supply (LRAS) line. For the uninitiated, the LRAS line shows where the economy needs to be for unemployment to be around 3-5%. We’re at 10% unemployment, so things are grim right now, but they could get better.

All right… there’s some indication to show we’ve hit bottom and that things have to rebound. Imports, for example, are down. That moves the AD line to the right, closer to full-employment output, which is where we want it to be to be out of this dadgum recession. Consumer confidence is on the long road back up, so things could get better if that leads to more spending. But we don’t know for sure if it will.

The Bush tax cuts of 2001 are set to expire this year. That would mean a de facto increase in taxes. Increases in taxes move the AD line to the left. The stimulus spending is set to end this year. Less government spending also moves AD to the left. Democrats are considering a tax increase on persons earning over $200,000 in a year – that would cut their ability to purchase additional capital stock, which would reduce investment spending this year, which would be another left shift for AD. I don’t see the decrease in imports equaling the negatives above, so that means a deepening of the recession in 2010.

Since 2008 was so bad, there’s a chance at having GDP go positive sometime in 2010, but only in comparison to the raging badness of 2008. We’d still need to see improvement elsewhere to really be out of a recession. If Congress chooses to take the deficit to stratospheric levels and postpone the tax hikes, we could see demand move up, ever so slightly.

The Fed probably won’t raise interest rates, as that move would reduce both firms’ purchases of capital stock and interest-sensitive consumer spending (think: HOUSES), both of which would reduce AD. Bernanke claims to be a scholar of the Great Depression, so he doesn’t want to have a repeat of the collapse of 1937 on his watch. But these record-low interest rates will likely fuel another asset bubble or two, so look for the stock market to gyrate wildly somewhere next year and then make a mess when that bubble pops. The same people that caused the Panic of 2008 are still in charge of the banks that are too big to fail, and they’re dead set on doing exactly what they did for as long as possible. There are no meaningful regulations to restrict their activities, so we’re as exposed to catastrophe now as we were back when this thing started to come apart several years ago.

Now I know that I said Bernanke doesn’t want to hike up interest rates… but he’s also said the Fed will stop monetizing the debt. That means interest rates will have to go up when that happens. Oops. If the US runs a $1.4 trillion deficit in 2010, foreigners are likely to kick in $300 billion, as they did last year. Where will the other $1.1 trillion come from if the Fed doesn’t buy it outright?

If the Fed cuts off the government totally, then the US government will essentially have no buyers for its debt. There are no good solutions for that problem. India just purchased 200 tons of gold, so one wonders if that’s the direction things are going. Back to the macro problems, if there’s nothing to back US debt purchases, they don’t really happen in a way to stimulate the economy. If we see suddenly higher prices due to the Treasury just printing money, we’ll see a contraction in Aggregate Supply (AS), with even more potential misery as prices take off like a jet along with unemployment… and future growth prospects would also be diminished in that scenario.

Because this recession came about as a result of way too much borrowing and speculation, it’s not a normal business cycle recession that fixes itself in a few quarters. This current recession may take 6-7 years to unwind, according to McKinsey Global Institute. (Click that link to get to the executive summary of their report.) Recovery in this kind of recession will be slower and uglier than recovery in other recessions.

Things are set already for the recession to deepen this year. Come March when the Fed stops buying debt directly, we’ll see if the recession plunges or we find some other way to keep the wolf from the door. Things will eventually get better, but the macro indicators point to not just yet.