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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 (1MPC) 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.