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ch11

VIEWS: 4 PAGES: 103

									Aggregate Demand II: Applying
      the IS-LM Model
  Chapter 11 of Macroeconomics, 7th
    edition, by N. Gregory Mankiw
          ECO62 Udayan Roy
      Applying the IS-LM Model
• Section 11-1 shows how the IS-LM model that
  we studied in chapter 10 can be applied to
  understand how an economy copes with
  disturbances (or, shocks) in the short run
• Section 11-3 extends section 11-1 by looking
  closely at
  – The Great Depression of the 1930s, and
  – The Great recession of 2008-09
• Warning: I will skip section 11-2! Very sorry!
The IS-LM Model: Ch. 10 Assumptions
• Y=C+I+G
  – C = Co + Cy ✕ (Y – T)
  – I = Io − Irr
  – G and T are exogenous
• M = Md = L(i)PY
  • L(i) = Lo – Lii
  – i = r + Eπ
  – M, P and Eπ are exogenous
The IS-LM Model: Ch. 10 Summary
• Y=C+I+G                   Y
                                   1
                                        (Co  I o  G) 
                                                           Cy         I
                                                                T  r  r
                                 1 Cy                    1 Cy     1 Cy
  – C = Co + Cy ✕ (Y – T)
  – I = Io − Irr
  – G and T are exogenous
• M = Md = L(i)PY                                 M        1
                                        r   L0             E
  • L(i) = Lo – Lii                               PY       Li
  – i = r + Eπ
  – M, P and Eπ are exogenous
The IS-LM Model: Ch. 10 Summary
• Short-run equilibrium in the goods market is represented
  by a downward-sloping IS curve linking Y and r.
• Short-run equilibrium in the money market is represented
  by an upward-sloping LM curve linking Y and r.
• The intersection of the IS and LM curves determine the
  short-run equilibrium values of Y and r.
• The IS curve shifts right if there is: r
   – an increase in Co + Io + G, or                  LM
   – a decrease in T.
• The LM curve shifts right if:
   – M/P or Eπ increases, or
   – Lo decreases
                                                     IS
                                                             Y
            Equilibrium in the IS-LM model
The IS curve represents       r
equilibrium in the goods                     LM
market.
       Y
Y  C (  T )  I (r )  G
                             r1
The LM curve represents
money market equilibrium.
                                             IS
M  L(r  E )  P  Y
                                    Y1            Y
                Shifts of the IS curve
                                      r
• Recall from chapter 10 that                  LM
   – the consumption function is
     C(Y – T) = Co + Cy ✕ (Y – T),
     and
   – The investment function is r1
     I(r) = Io – Irr
• Recall also that the IS curve
  shifts right if there is:                    IS
   – an increase in Co + Io + G, or       Y1        Y
   – a decrease in T.
• As a result, both Y and r
  increase
              Shifts of the IS curve
                                 r
• Similarly, the IS curve                 LM
  shifts left if there is:
   – a decrease in Co + Io + G,
     or                         r1
   – an increase in T.
• As a result, both Y and r               IS
  decrease                           Y1        Y
                  Shifts of the IS curve
                                 r
• In other words, we can                   LM
  make the following
  predictions:
        IS-LM Predictions
                                r1
                 Y          r
  Co + Io + G    +          +
                                           IS
  T              −          −
                                     Y1         Y
  Ch. 10: Comparing fiscal policy in the
   Keynesian Cross and in the IS Curve
In the Keynesian Cross model, expansionary fiscal policy boosts GDP by an amount
dictated by the multipliers.
                                                          Keynesian Cross
      1                       Cy
 Y        (Co  I o  G)        T
    1 Cy                    1 Cy
    K.C. Spending Multiplier                  K.C. Tax-Cut Multiplier


In the IS-LM model, expansionary fiscal policy also raises the real interest rate,
thereby weakening the effect of fiscal policy on GDP. (Crowding-out effect)
       1                       Cy          Ir
  Y        (Co  I o  G)        T        r
     1 Cy                    1 Cy      1 Cy
                                                            IS Curve
     Fiscal Policy is Weakened by the
            Crowding-Out Effect
• We have just seen that, in the IS-LM model,
  expansionary fiscal policy (G↑ or T↓)
   – leads to higher interest rates, which
   – exerts downward pressure on investment spending, which
   – exerts downward pressure on GDP and jobs.
• This negative aspect of expansionary fiscal policy is
  called the crowding-out effect
• This effect was absent in the Keynesian Cross model
• Thus, fiscal policy is less effective in the IS-LM model
  than in the Keynesian Cross model
   An increase in government purchases: graph
1. IS curve shifts right            r
           1
   by          G                                       LM
        1 MPC
   causing GDP to rise.            r2
                             2.
                                   r1
2. This raises money
    demand, causing the                            1.         IS2
    interest rate to rise…                              IS1
3. …which reduces investment, so                                    Y
                                        Y1        Y2
   the final increase in Y
                                             3.
                           1
   is smaller than           G
                      1 MPC
                      A tax cut
Consumers save (1MPC) of          r
the tax cut, so the initial                        LM
boost in spending is smaller
for T than for an equal
G…                             r2
                             2.
                                r1
and the IS curve shifts by
                                              1.
         MPC                                            IS2
   1.          T                                  IS1
        1 MPC
                                       Y1 Y2                   Y
2. …so the effects on r
                                         2.
    and Y are smaller for T
    than for an equal G.
             Shifts of the LM curve
                                  r
• Recall from chapter 10                   LM
  that M = L(i)PY = (Lo –
  Lii)PY = (Lo – Lir – LiEπ)PY.
• Recall also that the LM r1
  curve shifts right if there
  is:                                      IS
   – an increase in M or Eπ, or                 Y
                                      Y1
   – a decrease in Lo or P.
• As a result, Y increases
  and r decreases
           Shifts of the LM curve
                              r
• Similarly, the LM curve              LM
  shifts left if there is:
  – a decrease in M/P or Eπ,
    or                       r1
  – an increase in Lo.
• As a result, Y decreases             IS
  and r increases                 Y1        Y
           Shifts of the LM curve
                            r
• Recall from Ch. 10 that, if        LM
  expected inflation (Eπ)
  increases (decreases),
  the LM curve shifts down
  (up) by the exact same r1
  amount!
• Therefore, if Eπ                   IS
  decreases, r will increase,   Y1        Y
  but by a smaller amount.
• Therefore, i = r + Eπ will
  decrease.
                         IS-LM Predictions
                                       IS-LM Predictions
                    IS Curve       LM Curve          Y     r   i
Co + Io + G            →                              +    +   +
T                      ←                              −    −   −
M/P                                    →              +    −   −
Eπ                                     →              +    −   +
Lo                                     ←              −    +   +




    At this point, you should be able to
    do problems 1, 2, 3 (a) – (f), 4, and 5
    on pages 336 – 337 of the textbook.
    Please try them.
             Monetary Policy
• The practice of changing the quantity of
  money (M) in order to affect the
  macroeconomic outcome is called monetary
  policy
  – an increase in the quantity of money (M↑) is
    called expansionary monetary policy, and
  – A decrease in the quantity of money (M↓) is
    called contractionary monetary policy
              Shifts of the LM curve
                                     r
• When the central bank of a
                                              LM
  country makes changes to
  the quantity of money (M),
   – only the LM curve changes,
     and
                                    r1
   – the real interest rate (r)
     changes in the opposite
     direction
   – As expected inflation (Eπ) is            IS
     assumed exogenous in the                      Y
     IS-LM model, when the real          Y1
     interest rate (r) changes, the
     nominal interest rate (i = r +
     Eπ) changes in the same
     direction.
           Shifts of the LM curve
                              r
• One can think of the                 LM
  central bank as
  – targeting M and
    affecting r and i in the r1
    process, or as
  – targeting r and/or i and           IS
    adjusting M to achieve                  Y
                                  Y1
    the target
     Monetary Policy Re-defined
• Therefore, one can re-define expansionary
  and contractionary monetary policy as
  follows:
  – Monetary policy is expansionary when the central
    bank attempts to reduce interest rates (real and
    nominal), and
  – Monetary policy is contractionary when the
    central bank attempts to increase the interest
    rates (real and nominal)
        The Federal Funds Rate
• In the United States, the central bank (the
  Federal Reserve) formally describes its
  monetary policy by periodically announcing its
  desired or target level for a nominal interest
  rate called the Federal Funds Rate
• Having announced its target level for the FFR,
  the Fed then adjusts the money supply to
  steer the actual FFR as close to its target level
  as it can
        The Federal Funds Rate
• The Federal Funds Rate is the interest rate
  that banks charge each other for overnight
  loans
• If the Fed wishes the FFR to be 1.8%, all it has
  to do is to announce that
  – it will lend money to any bank at 1.8% interest and
  – will pay 1.8% interest on deposits received from
    any bank
         The Federal Funds Rate
• Given that the Fed expresses its monetary policy
  in terms of the target value of the Federal Funds
  Rate, we can re-define monetary policy as
  follows:
  – Monetary policy is expansionary when the Fed seeks
    to reduce the federal funds rate, and
  – Monetary policy is contractionary when the Fed
    seeks to increase the federal funds rate
• Keep in mind that, when expected inflation (Eπ) is
  exogenous, changes in nominal interest rates
  (such as the FFR) lead to equal changes in real
  interest rates
   The Zero Lower Bound on Nominal
             Interest Rates
                                   r
• We have seen that, when
                                            LM
  faced with a recession, the
  central bank can
   – Increase the money supply
     (M↑)
                                  r1
   – Thereby shifting the LM
     curve right
   – Thereby reducing the real
     interest rate (r = i − Eπ ↓)           IS
     and the nominal interest                    Y
     rate (i = r + Eπ↓) and            Y1
     increasing GDP (Y↑) to drag
     the economy out of the
     recession
     The Zero Lower Bound on Nominal
               Interest Rates
                                   r
• The problem is that there is a
  limit to how low the nominal              LM
  interest rate can be
• Nominal interest rates (such
  as the federal funds rate)
  cannot be negative             r1
• To deal with the 2008
  economic crisis, the Fed
  reduced the FFR to zero                   IS
• But the recession persisted                    Y
                                       Y1
• Unfortunately, the Fed could
  not reduce interest rates
  below zero: monetary policy
  had reached its limit
The Zero Lower Bound on Nominal
  Interest Rates: Crisis 2008-09
    The Zero Lower Bound on Nominal
              Interest Rates
                              r
• r = i − Eπ                           LM
• iminimum = 0
• Therefore, rminimum =
                             r1
  iminimum − Eπ = 0 − Eπ
                          2.1%
• Therefore, rminimum = −              IS
  Eπ
                                  Y1        Y
• For example, if Eπ =
  −3%, then rminimum = −
  Eπ = 3%
     The Zero Lower Bound on Nominal
               Interest Rates
                                  r
• For example, in the                                         LM
  diagram, the central bank
  will have to reduce the real
  interest rate to r = 2.1% in
  order to end the recession r1
• But suppose expected         2.1%
  inflation is Eπ = − 3%
                                                             IS
• Then, the nominal interest
  rate would have to be                           Y1                     Y
  brought down to i = r + Eπ          This example also shows how
  = 2.1 – 3.0 = – 0.9%                dangerous it can be if we have
• Which, alas, is impossible          deflation and people begin to expect
                                      the deflation to continue
  The Zero Lower Bound on Nominal
            Interest Rates
• If the nominal interest rate has been reduced
  all the way down to zero, and the economy is
  still stuck in a recession, the economy is said
  to be
  – at the zero lower bound, or
  – in a liquidity trap
     • See page 334 of the textbook
  The Zero Lower Bound on Nominal
       Interest Rates: Solutions
• When an economy is in a liquidity trap, monetary
  policy cannot be used to reduce interest rates any
  further
• But is there nothing else that can be done to
  bring the economy back to life?
• Yes, there is!
• Expansionary fiscal policy can be used
• And there’s something else that the monetary
  authorities (the central bank) can do: make a
  credible promise to be irresponsible!
      The Zero Lower Bound on Nominal
           Interest Rates: Solutions
• In my example,
                                               r
    – the central bank needs to reduce                                LM
      the real interest rate to r = 2.1% to
      end the recession
    – But expected inflation is Eπ = − 3%
    – So, the nominal interest rate would
      have to be brought down to i = –        r1
      0.9%, which, alas, is impossible
• Recall that the LM curve shifts right2.1%
  if either M or Eπ increases
• If the central bank promises to be                                 IS
  irresponsible and to create rapid
  inflation in the future, and if people                                         Y
  believe its promise, then Eπ will                      Y1
  increase, say from − 3% to +1%
• Then the nominal interest rate            The zero-lower-bound problem can be
  required for full-employment will be      solved if the central bank can credibly
  i = r + Eπ = 2.1 + 1.0 = 3.1%, which is
  definitely attainable                     promise to be irresponsible!
  The Zero Lower Bound on Nominal
       Interest Rates: Solutions
• Although this chapter assumes a closed
  economy, in reality foreign trade does matter.
• So, the central bank can
  – print domestic currency, and
  – use it to buy foreign currency,
  – thereby making the domestic currency cheaper
    relative to the foreign currency,
  – thereby stimulating exports,
  – thereby ending the recession!
  The Zero Lower Bound on Nominal
       Interest Rates: Solutions
• Even when short-term interest rates such as the
  federal funds rate are at zero percent, the central
  bank can print money and make long-term loans
  to the government, to businesses, to home-
  buyers who need mortgages, etc.
• This would reduce long-term interest rates
  directly, thereby stimulating spending by the
  borrowers
• This strategy—called quantitative easing—may
  also end a recession
         Interaction between
       monetary and fiscal policy
• IS-LM Model:
  Monetary and fiscal policy variables
  (M, G, and T) are exogenous.
• Real world:
  Monetary policymakers may adjust M
  in response to changes in fiscal policy,
  or vice versa.
• Such responses by the central bank may affect
  the effectiveness of fiscal policy
         The Fed’s response to G > 0

• Suppose the government increases G.
• Possible Fed responses:
   1. hold M constant
   2. hold r constant
   3. hold Y constant
• In each case, the effects of G on Y
  are different…
      Response 1: Hold M constant

When G increases,              r
the IS curve shifts right.                  LM

If Fed holds M constant,
                              r2
then LM curve does not        r1
shift.
                                              IS2
As a result, interest rates
                                            IS1
rise. This has a crowding-
out effect. Consequently,           Y1 Y2           Y
GDP increases, but not a
lot.
      Response 2: Hold r constant

If Congress raises G,         r
the IS curve shifts right.                     LM1
                                                       LM2
To keep r constant, Fed
                             r2
increases M                  r1
to shift LM curve right.
                                                 IS2
Results:                                       IS1
    Y  Y 3  Y 1                  Y1 Y2 Y3            Y

     r  0
      Response 3: Hold Y constant

If Congress raises G,         r                      LM2
the IS curve shifts right.                             LM1

                             r3
To keep Y constant, Fed
                             r2
reduces M                    r1
to shift LM curve left.
                                                            IS2
Results:                                                 IS1
     Y  0                                 Y1 Y2
                                                                   Y

     r  r3  r1
                             At this point, you should be able to do
                             problem 7 on page 337 of the
                             textbook. Please try it.
          Estimates of fiscal policy multipliers
                from the DRI macroeconometric model


                                          Estimated             Estimated
  Assumption about                         value of              value of
  monetary policy                          Y/G                 Y/T

  Fed holds money
                                              0.60                 0.26
  supply constant
  Fed holds nominal
                                              1.93                 1.19
  interest rate constant

A macroeconometric model is a more elaborate version of our IS-LM model, with
the parameters given the numerical values that they are estimated to have, based
on historical data.
     Shocks in the IS-LM model
IS shocks: exogenous changes in the
demand for goods & services.
Examples:
 – stock market boom or crash
      change in households’ wealth
      C
 – change in business or consumer
   confidence or expectations
      I and/or C
     Shocks in the IS-LM model
LM shocks: exogenous changes in the
demand for money.
Examples:
 – a wave of credit card fraud increases demand
   for money.
 – more ATMs or the Internet reduce money
   demand.
                      NOW YOU TRY:
      Analyze shocks with the IS-LM Model
Use the IS-LM model to analyze the effects of
 1. a boom in the stock market that makes consumers
     wealthier.
 2. after a wave of credit card fraud, consumers using
     cash more frequently in transactions.
For each shock,
  a. use the IS-LM diagram to show the effects of the shock
     on Y and r.
  b. determine what happens to C, I, and the
     unemployment rate.
CASE STUDY:
THE U.S. RECESSION OF 2001
       The U.S. Recession of 2001
•   3.9% on 9/00   7.0
                         Unemployment


•   4.9% on 8/01   6.0



•   6.3% on 6/03   5.0



•   5.0% on 7/05   4.0


                   3.0


                   2.0


                   1.0


                   0.0
      The U.S. Recession of 2001
• Growth of             GDP growth rate

  GDP was
                 10.0




  negative in     8.0



  the 1st and     6.0

  3rd quarters    4.0
  of 2001
• That’s          2.0




  essentially     0.0


  before 9/11    -2.0
              Recall: IS-LM Predictions
                            IS-LM Predictions
               IS Curve   LM Curve        Y     r   i
Co + Io + G      →                         +    +   +
T                ←                         −    −   −
M/P                          →             +    −   −
Eπ                           →             +    −   +
Lo                           ←             −    +   +
          The U.S. Recession of 2001
                                          r
• Why?
• Demand shocks moved the IS                       LM
  curve left
   – The “tech bubble” ended and
     stocks fell 25% between 8/00
     and 8/01
   – 9/11 attacks led to a 12% fall in
                                         r1
     stock prices in one week and a
     huge rise in uncertainty
   – Scandals at Enron, WorldCom                   IS
     and other corporations led to
     stock price declines and a
     decline in trust and a rise in           Y1        Y
     uncertainty
   – Lower household wealth
     reduced Co and higher
     uncertainty reduced Io
                                             CASE STUDY:
                            The U.S. recession of 2001
Causes: 1) Stock market decline  C

                     1500
                               Standard & Poor’s
Index (1942 = 100)




                     1200            500

                      900

                      600

                      300
                        1995   1996   1997    1998   1999   2000   2001   2002   2003
       The U.S. Recession of 2001
                                             r
• Fiscal stimulus moved IS curve
                                                                      LM1
  right
   – Major tax cuts were enacted in                                           LM2
     2001 and 2003
   – Government spending was
     boosted                       r1
      • to rebuild NYC, and
      • to bail out the airline industry                                IS2
• Fed printed money and                                               IS1
  moved LM curve right                                    Y1     Y3            Y
   – Interest rate on 3-month
     Treasury bills fell
      • 6.4% in 11/00
      • 3.3% in 8/01                       All three tools—G, T and M—were used
      • 0.9% in 7/03
                      CASE STUDY:
         The U.S. recession of 2001
• Monetary policy response: shifted LM curve right
     7
     6
                              Three-month
                               T-Bill Rate
     5
     4
     3
     2
     1
     0
THE GREAT DEPRESSION
                                    The Great Depression
                           240                                             30
                                                      Unemployment
                           220                         (right scale)       25
billions of 1958 dollars




                                                                                percent of labor force
                           200                                             20

                           180                                             15

                           160                                             10

                           140                       Real GNP              5
                                                     (left scale)
                           120                                             0
                             1929    1931   1933   1935    1937     1939
               THE SPENDING HYPOTHESIS:
            Shocks to the IS curve
• asserts that the               r
  Depression was largely                       LM
  due to an exogenous fall
  in the demand for goods
  and services – a leftward     r1
  shift of the IS curve.
• evidence: output and                         IS
  interest rates both fell in
  early 1930s, which is                   Y1        Y
  what a leftward IS shift
  would cause.
                 THE SPENDING HYPOTHESIS:
            Reasons for the IS shift
• Stock market crash  exogenous C
   – Oct-Dec 1929: S&P 500 fell 17%
   – Oct 1929-Dec 1933: S&P 500 fell 71%
• Drop in investment
   – “correction” after overbuilding in the 1920s
   – widespread bank failures in early 1930s made it harder
     to obtain financing for investment
• Contractionary fiscal policy
   – Politicians raised tax rates in 1932 and cut spending to
     combat increasing deficits.
                THE MONEY HYPOTHESIS:
         A shock to the LM curve
• asserts that the Depression was largely due to
  huge fall in the money supply.
• evidence: M1 fell 25% during 1929-33.
• But, two problems with this hypothesis:
  – P fell even more, so M/P actually rose slightly
    during 1929-31.
  – nominal interest rates fell, which is the opposite
    of what a leftward LM shift would cause.
            THE MONEY HYPOTHESIS AGAIN:
       The effects of falling prices
• asserts that the severity of the Depression
  was due to a huge deflation:
  – P fell 25% during 1929-33.
• This deflation was probably caused by the fall
  in M, so perhaps money played an important
  role after all.
• In what ways does a deflation affect the
  economy?
            THE MONEY HYPOTHESIS AGAIN:
         The effects of falling prices
• The stabilizing effects of deflation:
• P  (M/P)  LM shifts right  Y
• Pigou effect:
    P      (M/P)
            consumers’ wealth 
            C
            IS shifts right
            Y
                  IS-LM Predictions
                           IS-LM Predictions
              IS Curve   LM Curve        Y     r   i
Co + Io + G     →                         +    +   +
T               ←                         −    −   −
M/P                         →             +    −   −
Eπ                          →             +    −   +
Lo                          ←             −    +   +
             THE MONEY HYPOTHESIS AGAIN:
        The effects of falling prices
• The destabilizing effects       r
                                            LM
  of expected deflation: E
• LM curve shifts left
  r  and I (r )               r1
   planned expenditure 
  income and output 
                                            IS
• Also, the nominal interest                     Y
                                       Y1
  rate decreases (i↓):
  – see IS-LM predictions grid
             THE MONEY HYPOTHESIS AGAIN:
        The effects of falling prices
• The destabilizing effects of unexpected deflation:
  debt-deflation theory
P (if unexpected)
    transfers purchasing power from borrowers to
        lenders
    borrowers spend less, lenders spend more
    if borrowers’ propensity to spend is larger than
        lenders’, then aggregate spending falls,
        the IS curve shifts left, and Y falls
 The evidence on output and nominal
            interest rates
• Note that, other than the money hypothesis, all the other
  hypotheses—the spending hypothesis, the debt-deflation
  hypothesis, and the deflationary expectations hypothesis—
  predict falling real GDP and falling nominal interest rates
• This is exactly what happened in the early stages of the
  Great Depression
• The spending hypothesis and the debt-deflation hypothesis
  both predict falling real interest rates, whereas the
  deflationary expectations hypothesis predicts rising real
  interest rates
• Therefore, evidence on real interest rates is crucial in
  identifying suitable explanations for the Great Depression
Why another Depression is unlikely
• Policymakers (or their advisors) now know much more
  about macroeconomics:
   – The Fed knows better than to let M fall so much,
     especially during a contraction.
   – Fiscal policymakers know better than to raise
     taxes or cut spending during a contraction.
• Federal deposit insurance makes widespread bank
  failures very unlikely.
• Automatic stabilizers make fiscal policy expansionary
  during an economic downturn.
THE FINANCIAL CRISIS AND ECONOMIC
DOWNTURN OF 2008 AND 2009
                       CASE STUDY
        The 2008-09 Financial Crisis & Recession
• 2009: Real GDP fell, u-rate approached 10%
• Important factors in the crisis:
   – early 2000s Federal Reserve interest rate policy
   – sub-prime mortgage crisis
   – bursting of house price bubble,
     rising foreclosure rates
   – falling stock prices
   – failing financial institutions
   – declining consumer confidence, drop in spending on
     consumer durables and investment goods
       A Too-Brief and Too-Simple
              Explanation
• The price of housing had risen to
  unsustainable levels.
• When home prices inevitably crashed, people
  suddenly felt poor and cut back their spending
  plans.
• This fall in planned expenditure brought about
  the Great Recession of 2008-09.
   The Housing Bubble Inflates, then
               Deflates
• The S&P Case-Shiller 20-City Home Price Index
  went from
  – 100 in Jan 2000, to
  – 206.54 in April 2006, to
  – 140.95 in May 2009, to
  – 142.16 in Dec 2010
• Why did the housing bubble inflate?
    The Housing Bubble: Reasons
• The Fed kept the interest rates too low for too
  long
• Securitization technology got a lot fancier in
  the mortgage bond market
• The government regulators were sleeping
• Pretty much everybody believed that home
  prices could never fall
    The Housing Bubble: Low FFR
• The Fed had reduced the Federal Funds Rate
  to fight the Recession of 2001.
• After that recession ended, the Fed continued
  to keep interest rates low until 2004
  – The Fed was watching inflation, which remained
    tame. Consequently, the Fed saw little reason to
    raise interest rates.
  – The Fed did not believe that housing prices had
    formed a bubble … until it was blindingly obvious
The Housing Bubble: Securitization
• In the past, people with money did not like to
  lend money to home buyers because such
  loans were risky and had unreliable returns
• But the advent of new financial technologies
  called securitization and tranching made
  people with money suddenly eager to lend to
  home buyers
The Housing Bubble: Weak Regulators
• The financial sector was regulated by people
  who were ideologically opposed to regulation
• They turned a blind eye to even the worst
  lending practices
     The Housing Bubble Inflates
• The Fed’s low-interest policy and financial
  innovation made it easy for home buyers to
  borrow money
• Lax regulation allowed subprime lending
  – That is, lending to people who had few assets and/or
    prospects that would make repayment likely
• The belief that home prices would keep rising
  made it unnecessary to worry about the credit
  worthiness of borrowers
    The Housing Bubble Deflates
• After mid-2006, home prices started to fall
  – Home owners began to default on their loans
  – Foreclosures increased
  – This flooded the market with more homes for sale
  – Which led to further declines in home prices
  – These cascading and self-reinforcing home price
    declines made people feel poor
  – Consumption spending fell
    The Housing Bubble Deflates
• After mid-2006, home prices started to fall
  – The financial institutions that had made mortgage
    loans faced huge losses when borrowers began to
    default
  – These institutions began to second guess their ability
    to spot good borrowers. So, they reduced lending
  – Even financial institutions that had not made bad
    loans were scared to lend because they feared that
    the borrower may have made bad investments and
    would soon go bankrupt
  – Business investment spending collapsed
    The Housing Bubble Deflates
• After mid-2006, home prices started to fall
  – Financial institutions were revealed to have suffered
    huge losses
  – Non-financial businesses were not getting loans and
    were shutting down
  – But a lack of transparency meant that it was not
    possible to figure out which companies would collapse
    next
  – This caused great uncertainty
  – People with money sold off their stocks and bonds
  – The decline in stock prices made people feel poor
  – Consumption spending fell
     The Housing Bubble Deflates
• The collapse of the housing bubble led,
  through a complex chain of causation, to
  major declines in consumption and
  investment spending
• One can think of all this as a shift of the IS
  curve to the left
• This brings about a recession, with falling
  output and rising unemployment
           The Fed’s Response
• The Federal Reserve reduced the Federal
  Funds Rate
  – from 5.25% in Sept 2007
  – to essentially zero in Dec 2008
     • The Fed had reached the zero lower bound and could
       not go any further
• The Fed is now trying less orthodox measures,
  called quantitative easing, to reduce long-
  term interest rates
 The Federal Government’s Response
• In October 2008, the outgoing Bush
  administration enacted the Troubled Assets
  Recovery Program (TARP) that spent $700
  billion to revive Wall Street
• In January 2009, the incoming Obama
  administration enacted the American
  Recovery and Reinvestment Act (ARRA), which
  consisted of $800 billion in tax cuts and
  spending initiatives to spread over two years
              Slow Recovery
• The Great Recession officially ended in June
  2009
• But the recovery has been very slow
• Real GDP grew at 3.1% in the fourth quarter of
  2010
• The unemployment rate was at 8.9% in
  February 2011
THE GREAT RECESSION CHARTBOOK
                             Interest rates and house prices
                                    Federal Funds rate
                    9               30-year mortgage rate
                                                                                190
                                    Case-Shiller 20-city composite house price index
                    8




                                                                                       House price index, 2000=100
                                                                               170
                    7
interest rate (%)




                    6                                                          150

                    5
                                                                               130

                    4
                                                                               110
                    3
                                                                               90
                    2

                                                                               70
                    1

                    0                                                          50
                     2000   2001    2002         2003         2004         2005
                                              Change in U.S. house price index
                                           and rate of new foreclosures, 1999-2009
                                 14%
                                            US house price index                        1.4
                                 12%
                                            New foreclosures
Percent change in house prices




                                 10%                                                    1.2
    (from 4 quarters earlier)




                                                                                              New foreclosure starts
                                                                                              (% of total mortgages)
                                 8%
                                                                                        1.0
                                 6%
                                                                                        0.8
                                 4%

                                 2%                                                     0.6

                                 0%
                                                                                        0.4
                                 -2%
                                                                                        0.2
                                 -4%

                                 -6%                                                    0.0
                                    1999     2001       2003       2005   2007   2009
          House price change and new foreclosures, 2006:Q3 – 2009Q1

                     20%

                     18%      Nevada
                                             Florida         Illinois
                     16%
                                                                        Ohio
% of all mortgages




                                                    Michigan
New foreclosures,




                     14%
                              California                                        Georgia
                     12%

                     10%               Arizona                                    Colorado

                     8%            Rhode Island
                                                                                      Texas
                                     New Jersey
                     6%
                                                 Hawaii                               S. Dakota
                     4%
                                                          Oregon
                     2%                                                               Wyoming
                                                               Alaska
                                                                             N. Dakota
                     0%
                       -40%       -30%       -20%         -10%          0%      10%       20%
                                     Cumulative change in house price index
U.S. bank failures by year, 2000-2009




                                                  *

                                * as of July 24, 2009.
                                         0%
                                              20%
                                                    40%
                                                          60%
                                                                80%




                    -60%
                           -40%
                                  -20%




             -80%
                                                                      100%
                                                                                120%
                                                                                            140%
 12/6/1999

 8/13/2000

 4/21/2001

12/28/2001

  9/5/2002

 5/14/2003

 1/20/2004

 9/27/2004

  6/5/2005

 2/11/2006
                                                                                                                                      Major U.S. stock indexes
                                                                                                   (% change from 52 weeks earlier)




10/20/2006

 6/28/2007
                                                                                              DJIA




  3/5/2008
                                                                                  S&P 500
                                                                       NASDAQ




11/11/2008

 7/20/2009
                                      Consumer sentiment and growth in consumer durables and
                                                      investment spending
                                      20%
                                                                                                   110




                                                                                                         Consumer Sentiment Index, 1966=100
                                      15%
% change from four quarters earlier




                                      10%                                                          100

                                       5%
                                                                                                   90
                                       0%

                                      -5%                                                          80


                                      -10%
                                                                                                   70

                                      -15%
                                               Durables
                                                                                                   60
                                      -20%     Investment
                                               UM Consumer Sentiment Index
                                      -25%                                                         50
                                          1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
                                            Real GDP growth and Unemployment
                                  10%                                                                 10
                                             Real GDP growth rate (left scale)
                                                                                                      9
                                  8%         Unemployment rate (right scale)
% change from 4 quaters earlier




                                                                                                      8

                                  6%                                                                  7




                                                                                                           % of labor force
                                                                                                      6
                                  4%
                                                                                                      5
                                  2%
                                                                                                      4

                                  0%                                                                  3

                                                                                                      2
                                  -2%
                                                                                                      1

                                  -4%                                                                 0
                                     1995    1997     1999     2001     2003     2005   2007   2009
The Fed Tried: M/P Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped

         Mortgage rates were very low   Note that there is a
         between ‘04 and ‘06. They      link between the two
         may have contributed to the    rates, though weak
         housing bubble



   In hindsight, the FFR
   should have been
   higher in 2003-06.
   But inflation was low.
Record low mortgage rates

                                    Mortgage rates are
                                    even lower now. But
          The unusually low         credit standards have
          mortgage rates may have   been tightened. In
          helped to inflate the     any case, the
          housing bubble.           economy is still
                                    weak. So, don’t
                                    expect another
                                    housing bubble.
The Housing Bubble Inflates, and then
             Deflates
       The Stock Market Tanks

In 2007, it becomes
clear that banks would
get hit by the collapse
of the housing bubble
The “Fear Index” Spikes
The “Fear Index” Spikes
Consumption Spending Falls




          In 2007, the growth
          rate of consumption
          slowed faster than
          GDP did. This was
          unusual.
Business Investment Tanks




         From 2007,
         investment, which
         includes new housing,
         absolutely crashed.
Unemployment Shot Up




    Remember Okun’s Law?
Unemployment Shot Up




            Remember Okun’s Law?
            Because GDP growth has
            remained below 3%,
            unemployment has remained
            stubbornly high.
             Inflation Fell Sharply




The Fed pays more attention to the “core
inflation rate,” which ignores food and energy.
Now you see why. The downward trend in core
inflation is a worry: we don’t need deflation.
   A Yawning Budget Deficit!

Has government spending risen at an
unusually rapid rate? Not really.

The main budgetary problem has
been caused by the crashing tax
revenues.
       A Yawning Budget Deficit!




Has government spending
risen at an unusually rapid
rate? Not really.

The main budgetary problem has
been caused by the crashing tax
revenues.
      A Yawning Budget Deficit!




Has government spending risen at an
unusually rapid rate? Not really.

The main budgetary problem has been
caused by the crashing tax revenues.

								
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