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Economics: Theory Through Applications

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USA

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Chapter 30The Global Financial Crisis

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Learning Objectives

• What was the role of coordination games in the crisis?

• What was the monetary policy response to the crisis?

• What was the fiscal policy response to the crisis?

• How did the financial crisis spread to the aggregate economy?

• What was the fiscal policy response?

• What was the monetary policy response?

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Learning Objectives

• What are the ways the crisis spread from the United States to the rest of the world?

• In what ways did the institutional structure of the European Union (EU) hamper Europe’s ability to cope with the crisis?

• What are the causes of a currency crisis?

• How is a currency crisis related to a financial crisis?

Crisis in the United States

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nominal value of service flow from the house over the next yearvalue of the house this year

nominal interest factorprice of the house next year

nominal interest factor

Figure 30.1 - The Payoffs in a Bank-run Game with and without Deposit Insurance

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Table 30.1 - The Federal Funds Rate: Target and Realized Rates

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Lowering Interest Rates

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loan rate probability of loan repayment cost of funds to the bank

A $700 Billion Bailout

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government deficit change in government debt change in money supply

From Housing to the Aggregate Economy

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real GDP planned spending autonomous spending marginal propensity to spend real GDP

autonomous spendingreal GDP

1 marginal propensity to spend

Table 30.2 - State of the Economy: Growth Rates in 2006–2010

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Figure 30.2 - The Foreign Sector in the Circular Flow

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Figure 30.3 - Stock Markets around the World Crashed Together

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Key Terms

• Coordination game: A coordination game is a strategic situation where there are multiple equilibria

• Nash equilibria: Nash equilibrium is used to predict outcomes in strategic situations

– In a Nash equilibrium, (a) each player chooses the action that gives him the highest payoff, based on his predictions of the other players; and (b) each player’s predictions of the actions of the other players are correct

• Coordination failure: A coordination failure occurs if the outcome of the coordination game is one of the equilibria outcomes which are worse than other equilibria

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Key Terms

• Discounted present value: Discounted present value is a device for measuring flows that occur over time

– It tells you the value of something you will receive in the future, discounted back to the present

• Deposit insurance: Deposit insurance is a government program which insures the deposits (subject to some limits) of individuals at banks

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Key Terms

• Aggregate expenditure model: The aggregate expenditure framework studies the relationship between planned spending and output

• Circular flow of income: The circular flow of income measures the money flows among the different sectors of the economy as individuals and firms buy and sell goods and services

• Multiplier: The multiplier equals one divided by one minus the marginal propensity to spend and is key to understanding how a change in autonomous spending effects output in the aggregate expenditures model

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Key Terms

• Contagion effect: A contagion effect arises when outcome in one market effects the beliefs and thus the behavior of participants in other markets, perhaps in another country

• Comparative advantage: A person has a comparative advantage in the production of one good if the opportunity cost, measured by the lost output of the other good, is lower for that person than for the other

• Commitment problem: A government suffers from a commitment problem when it is not able to make credible promises to pursue actions regardless of how others respond to those actions

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Key Terms

• Currency board: Under a currency board, one country maintains a fixed exchange rate by backing its currency completely with another currency.

• Inflation tax: An inflation tax occurs when the government prints money to finance its deficit

• Currency crisis: A currency crisis is a sudden and unexpected rapid fall in the value of a currency

• Fixed exchange rate: In a fixed exchange rate regime, a central bank uses it tools to target the value of the domestic currency in terms of a foreign currency

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Key Terms

• Flexible exchange rates: Under a flexible exchange rate system, market forces determine exchange rates

• Devaluation: A devaluation is a decrease in the value of a currency in a fixed exchange rate

• Coordination game: A coordination game is a strategic situation where there are multiple equilibria

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Key Takeaways

• Though there were no bank runs in the U.S. during the recent crisis, the structure of coordination games is useful for thinking about instability of the housing sector, the interactions of banks within the financial system and the interaction between income and spending

• During the crisis, the Fed moved aggressively to lower interest rates and provide liquidity to the system

• The Bush administration created a $700 billion program to purchase or guarantee troubled assets, such as mortgages and shares of financial firms

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Key Takeaways

• Disruptions in the financial system led to reductions in consumption and investment and this led to a fall in real GDP

• An $800 billion stimulus package was passed in February 2009 to offset the recessionary effects of the financial crisis

• From December 2008 through (at least) the summer of 2010, the target federal funds rate was near zero

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Key Takeaways

• The United States and the rest of the world are linked through many channels

– Key channels that allowed the crisis to spread were financial links due to both holdings of assets across borders and the spread of pessimism across markets

– In addition, links across countries due to trade flows meant that as real GDP fell in some countries, exports and thus real GDP fell in others

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Key Takeaways

• Within the EMU, individual countries were limited in fiscal policy responses due to restrictions on debt outstanding

– Further, the ECB supposedly follows an inflation target rule and thus is not able to directly intervene to stabilize outcome

– In the end, countries did take fiscal actions and the ECB ultimately did provide needed liquidity to Europe

– But this experience highlighted some of the costs of a monetary union

• A currency crisis can occur for a number of reasons including being a consequence of a financial crisis or of a fiscal crisis or, in some cases, just driven by expectations like a bank run

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Key Takeaways

• A financial crisis can lead to a currency crisis if depositors in one country, seeing the collapse of a financial system, rush to convert home into foreign currencies

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