aggregate demand ii: applying the is-lm model chapter 12 of macroeconomics, 8 th edition, by n....
TRANSCRIPT
Aggregate Demand II Applying the IS-LM Model
Chapter 12 of Macroeconomics 8th edition by N Gregory Mankiw
ECO62 Udayan Roy
Applying the IS-LM Model
bull Section 12-1 shows how the IS-LM model that we studied in Chapter 11 can be applied to understand how an economy copes with disturbances (or shocks) in the short run
bull Section 12-3 extends section 12-1 by looking closely at ndash The Great Depression of the 1930s andndash The Great recession of 2008-09
bull Warning I will skip section 12-2 Very sorry
The IS-LM Model Ch 11 Assumptions
bull Y = C + I + Gndash C = Co + Cy (Y ndash T)
ndash I = Io minus Irr
ndash G and T are exogenous
bull M = Md = L(i) P Ybull L(i) = Lo ndash Li i
ndash i = r + Eπndash M P and Eπ are exogenous
The IS-LM Model Ch 11 Summary
bull Y = C + I + Gndash C = Co + Cy (Y ndash T)
ndash I = Io minus Irr
ndash G and T are exogenous
bull M = Md = L(i) P Ybull L(i) = Lo ndash Li i
ndash i = r + Eπndash M P and Eπ are exogenous
rC
IT
C
CGIC
CY
y
r
y
yoo
y
11
)(1
1
The IS-LM Model Ch 11 Summarybull Short-run equilibrium in the goods market is represented
by a downward-sloping IS curve linking Y and rbull Short-run equilibrium in the money market is represented
by an upward-sloping LM curve linking Y and rbull The intersection of the IS and LM curves determine the
short-run equilibrium values of Y and rbull The IS curve shifts right if there is
ndash an increase in Co + Io + G orndash a decrease in T
bull The LM curve shifts right ifndash MP or Eπ increases orndash Lo decreases
Y
r
IS
LM
The LM curve represents money market equilibrium
Equilibrium in the IS -LM model
The IS curve represents equilibrium in the goods market
( ) ( )Y C Y T I r G
IS
Y
rLM
r1
Y1
YPErLM )(
Shifts of the IS curve
bull Recall from Chapter 11 that ndash the consumption function is
C(Y ndash T) = Co + Cy ( Y ndash T) and
ndash The investment function is I(r) = Io ndash Ir r
bull Recall also that the IS curve shifts right if there isndash an increase in Co + Io + G orndash a decrease in T
bull As a result both Y and r increase
IS
Y
rLM
r1
Y1
Shifts of the IS curve
bull Similarly the IS curve shifts left if there isndash a decrease in Co + Io + G
orndash an increase in T
bull As a result both Y and r decrease
IS
Y
rLM
r1
Y1
Shifts of the IS curve
bull In other words we can make the following predictions
IS
Y
rLM
r1
Y1
IS-LM Predictions
Y r
Co + Io + G + +
T minus minus
Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
rC
IT
C
CGIC
CY
y
r
y
yoo
y
11
)(1
1
TC
CGIC
CY
y
yoo
y
1
)(1
1Keynesian Cross
IS Curve
In the Keynesian Cross model expansionary fiscal policy boosts GDP by an amount dictated by the multipliers
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)
KC Spending Multiplier KC Tax-Cut Multiplier
Fiscal Policy is Weakened by the Crowding-Out Effect
bull We have just seen that in the IS-LM model expansionary fiscal policy (Guarr or Tdarr) ndash leads to higher interest rates whichndash exerts downward pressure on investment spending whichndash exerts downward pressure on GDP and jobs
bull This negative aspect of expansionary fiscal policy is called the crowding-out effect
bull This effect was absent in the Keynesian Cross modelbull Thus fiscal policy is less effective in the IS-LM model
than in the Keynesian Cross model
causing GDP to rise
IS1
An increase in government purchases graph
1 IS curve shifts right
Y
rLM
r1
Y1
1by
1 MPCG
IS2
Y2
r2
12 This raises money
demand causing the interest rate to risehellip
2
3 hellipwhich reduces investment so the final increase in Y
1is smaller than
1 MPCG
3
IS1
1
A tax cut
Y
rLM
r1
Y1
IS2
Y2
r2
Consumers save (1MPC) of the tax cut so the initial boost in spending is smaller for T than for an equal Ghellip
and the IS curve shifts by
MPC
1 MPCT
1
2
2hellipso the effects on r and Y are smaller for T than for an equal G
2
Shifts of the LM curve
IS
Y
rLM
r1
Y1
Shifts of the LM curve
bull Similarly the LM curve shifts left if there isndash a decrease in MP or Eπ
orndash an increase in Lo
bull As a result Y decreases and r increases
IS
Y
rLM
r1
Y1
Shifts of the LM curve
Shifts of the LM curve
bull Recall from Ch 11 that if expected inflation (Eπ) increases (decreases) the LM curve shifts down (up) by the exact same amount
bull Therefore if Eπ decreases r will increase but by a smaller amount
bull Therefore i = r + Eπ will decrease
IS
Y
rLM
r1
Y1
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
At this point you should be able to do problems 1 2 3 (a) ndash (f) 4 and 5 on pages 352 ndash 353 of the textbook Please try them
Monetary Policy
bull The practice of changing the quantity of money (M) in order to affect the macroeconomic outcome is called monetary policyndash an increase in the quantity of money (Muarr) is
called expansionary monetary policy andndash A decrease in the quantity of money (Mdarr) is
called contractionary monetary policy
Shifts of the LM curvebull When the central bank of a
country makes changes to the quantity of money (M)ndash only the LM curve changes
and ndash the real interest rate (r)
changes in the opposite direction
ndash As expected inflation (Eπ) is assumed exogenous in the IS-LM model when the real interest rate (r) changes the nominal interest rate (i = r + Eπ) changes in the same direction
IS
Y
rLM
r1
Y1
Shifts of the LM curve
bull One can think of the central bank as ndash targeting M and
affecting r and i in the process or as
ndash targeting r andor i and adjusting M to achieve the target
IS
Y
rLM
r1
Y1
Monetary Policy Re-defined
bull Therefore one can re-define expansionary and contractionary monetary policy as followsndash Monetary policy is expansionary when the central
bank attempts to reduce interest rates (real and nominal) and
ndash Monetary policy is contractionary when the central bank attempts to increase the interest rates (real and nominal)
The Federal Funds Rate
bull 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
bull 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
bull The Federal Funds Rate is the interest rate that banks charge each other for overnight loans
bull If the Fed wishes the FFR to be 18 all it has to do is to announce that ndash it will lend money to any bank at 18 interest
andndash will pay 18 interest on deposits received from
any bank
The Federal Funds Ratebull 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 followsndash Monetary policy is expansionary when the Fed seeks
to reduce the federal funds rate andndash Monetary policy is contractionary when the Fed
seeks to increase the federal funds ratebull 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
bull We have seen that when faced with a recession the central bank can ndash Increase the money supply
(Muarr)ndash Thereby shifting the LM
curve rightndash Thereby reducing the real
interest rate (r = i minus Eπ darr) and the nominal interest rate (i = r + Eπdarr) and increasing GDP (Yuarr) to drag the economy out of the recession
IS
Y
rLM
r1
Y1
The Zero Lower Bound on Nominal Interest Rates
bull The problem is that there is a limit to how low the nominal interest rate can be
bull Nominal interest rates (such as the federal funds rate) cannot be negative
bull To deal with the 2008 economic crisis the Fed reduced the FFR to zero
bull But the recession persistedbull Unfortunately the Fed could
not reduce interest rates below zero monetary policy had reached its limit
IS
Y
rLM
r1
Y1
The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
The Zero Lower Bound on Nominal Interest Rates
bull r = i minus Eπbull iminimum = 0
bull Therefore rminimum = iminimum minus Eπ = 0 minus Eπ
bull Therefore rminimum = minus Eπ
bull For example if Eπ = minus3 then rminimum = minus Eπ = 3
IS
Y
rLM
r1
Y1
21
The Zero Lower Bound on Nominal Interest Rates
bull For example in the diagram the central bank will have to reduce the real interest rate to r = 21 in order to end the recession
bull But suppose expected inflation is Eπ = minus 3
bull Then the nominal interest rate would have to be brought down to i = r + Eπ = 21 ndash 30 = ndash 09
bull Which alas is impossible
IS
Y
rLM
r1
Y1
21
This example also shows how dangerous it can be if we have deflation and people begin to expect the deflation to continue
The Zero Lower Bound on Nominal Interest Rates
bull 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 bendash at the zero lower bound orndash in a liquidity trap
bull See page 350 of the textbook
The Zero Lower Bound on Nominal Interest Rates Solutions
bull When an economy is in a liquidity trap monetary policy cannot be used to reduce interest rates any further
bull But is there nothing else that can be done to bring the economy back to life
bull Yes there isbull Expansionary fiscal policy can be usedbull And therersquos 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
bull In my example ndash the central bank needs to reduce
the real interest rate to r = 21 to end the recession
ndash But expected inflation is Eπ = minus 3 ndash So the nominal interest rate would
have to be brought down to i = ndash 09 which alas is impossible
bull Recall that the LM curve shifts right if either M or Eπ increases
bull If the central bank promises to be irresponsible and to create rapid inflation in the future and if people believe its promise then Eπ will increase say from minus 3 to +1
bull Then the nominal interest rate required for full-employment will be i = r + Eπ = 21 + 10 = 31 which is definitely attainable
IS
Y
rLM
r1
Y1
21
The zero-lower-bound problem can be solved if the central bank can credibly promise to be irresponsible
The Zero Lower Bound on Nominal Interest Rates Solutions
bull Although this chapter assumes a closed economy in reality foreign trade does matter
bull So the central bank can ndash print domestic currency and ndash use it to buy foreign currency ndash thereby making the domestic currency cheaper
relative to the foreign currencyndash thereby stimulating exportsndash thereby ending the recession
The Zero Lower Bound on Nominal Interest Rates Solutions
bull 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
bull This would reduce long-term interest rates directly thereby stimulating spending by the borrowers
bull This strategymdashcalled quantitative easingmdashmay also end a recession
Interaction between monetary and fiscal policy
bull IS-LM Model Monetary and fiscal policy variables (M G and T ) are exogenous
bull Real world Monetary policymakers may adjust M in response to changes in fiscal policy or vice versa
bull Such responses by the central bank may affect the effectiveness of fiscal policy
The Fedrsquos response to G gt 0
bull Suppose the government increases Gbull Possible Fed responses
1 hold M constant2 hold r constant3 hold Y constant
bull In each case the effects of G on Yare differenthellip
When G increases the IS curve shifts right
IS1
Response 1 Hold M constant
Y
rLM
r1
Y1
IS2
Y2
r2
If Fed holds M constant then LM curve does not shift
As a result interest rates rise This has a crowding-out effect Consequently GDP increases but not a lot
If Congress raises G the IS curve shifts right
IS1
Response 2 Hold r constant
Y
rLM1
r1
Y1
IS2
Y2
r2
To keep r constant Fed increases M to shift LM curve right
3 1Y Y Y
0r
LM2
Y3
Results
IS1
Response 3 Hold Y constant
Y
rLM1
r1
IS2
Y2
r2
To keep Y constant Fed reduces M to shift LM curve left
0Y
3 1r r r
LM2
Results
Y1
r3
If Congress raises G the IS curve shifts right
At this point you should be able to do problem 7 on page 353 of the textbook Please try it
Estimates of fiscal policy multipliersfrom the DRI macroeconometric model
Assumption about monetary policy
Estimated value of Y G
Fed holds nominal interest rate constant
Fed holds money supply constant
193
060
Estimated value of Y T
119
026
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 amp services
Examples ndash stock market boom or crash
change in householdsrsquo wealth C
ndash change in business or consumer confidence or expectations I andor C
Shocks in the IS -LM model
LM shocks exogenous changes in the demand for money
Examplesndash a wave of credit card fraud increases demand
for moneyndash 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 of1 a boom in the stock market that makes consumers
wealthier2 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 rb determine what happens to C I and the
unemployment rate
CASE STUDY
THE US RECESSION OF 2001
The US Recession of 2001
bull 39 on 900bull 49 on 801bull 63 on 603bull 50 on 705
The US Recession of 2001
bull Growth of GDP was negative in the 1st and 3rd quarters of 2001
bull Thatrsquos essentially before 911
Recall IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
The US Recession of 2001bull Whybull Demand shocks moved the IS
curve leftndash The ldquotech bubblerdquo ended and
stocks fell 25 between 800 and 801
ndash 911 attacks led to a 12 fall in stock prices in one week and a huge rise in uncertainty
ndash Scandals at Enron WorldCom and other corporations led to stock price declines and a decline in trust and a rise in uncertainty
ndash Lower household wealth reduced Co and higher uncertainty reduced Io
IS
Y
rLM
r1
Y1
CASE STUDY
The US recession of 2001Causes 1) Stock market decline C
300
600
900
1200
1500
1995 1996 1997 1998 1999 2000 2001 2002 2003
Ind
ex
(19
42
= 1
00
) Standard amp Poorrsquos 500
The US Recession of 2001bull Fiscal stimulus moved IS curve
rightndash Major tax cuts were enacted in
2001 and 2003ndash Government spending was
boostedbull to rebuild NYC andbull to bail out the airline industry
bull Fed printed money and moved LM curve rightndash Interest rate on 3-month
Treasury bills fellbull 64 in 1100bull 33 in 801bull 09 in 703
IS1
Y
rLM1
r1
Y1
IS2
LM2
Y3
All three toolsmdashG T and Mmdashwere used
CASE STUDY
The US recession of 2001bull Monetary policy response shifted LM curve right
Three-month T-Bill Rate
Three-month T-Bill Rate
0
1
2
3
4
5
6
7
010
120
0004
02
2000
070
320
0010
03
2000
010
320
0104
05
2001
070
620
0110
06
2001
010
620
0204
08
2002
070
920
0210
09
2002
010
920
0304
11
2003
Skip
bull I am skipping section 11-2
THE GREAT DEPRESSION
The Great Depression
Unemployment (right scale)
Real GNP(left scale)
120
140
160
180
200
220
240
1929 1931 1933 1935 1937 1939
billi
ons
of 1
958
dolla
rs
0
5
10
15
20
25
30
perc
ent o
f lab
or fo
rce
THE SPENDING HYPOTHESIS
Shocks to the IS curvebull asserts that the
Depression was largely due to an exogenous fall in the demand for goods and services ndash a leftward shift of the IS curve
bull evidence output and interest rates both fell in early 1930s which is what a leftward IS shift would cause
IS
Y
rLM
r1
Y1
THE SPENDING HYPOTHESIS
Reasons for the IS shiftbull Stock market crash exogenous C
ndash Oct-Dec 1929 SampP 500 fell 17ndash Oct 1929-Dec 1933 SampP 500 fell 71
bull Drop in investmentndash ldquocorrectionrdquo after overbuilding in the 1920sndash widespread bank failures in early 1930s made it harder
to obtain financing for investmentbull Contractionary fiscal policy
ndash Politicians raised tax rates in 1932 and cut spending to combat increasing deficits
THE MONEY HYPOTHESIS
A shock to the LM curvebull asserts that the Depression was largely due to
huge fall in the money supplybull evidence M1 fell 25 during 1929-33 bull But two problems with this hypothesis
ndash P fell even more so MP actually rose slightly during 1929-31
ndash nominal interest rates fell which is the opposite of what a leftward LM shift would cause
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull asserts that the severity of the Depression
was due to a huge deflation ndash P fell 25 during 1929-33
bull This deflation was probably caused by the fall in M so perhaps money played an important role after all
bull In what ways does a deflation affect the economy
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The stabilizing effects of deflationbull P (MP ) LM shifts right Ybull Pigou effect
P (MP )
consumersrsquo wealth
C
IS shifts right
Y
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects
of expected deflation E
bull LM curve shifts leftr and I (r ) planned expenditure income and output
bull Also the nominal interest rate decreases (idarr) ndash see IS-LM predictions grid
IS
Y
rLM
r1
Y1
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects of unexpected deflation
debt-deflation theoryP (if unexpected)
transfers purchasing power from borrowers to lenders
borrowers spend less lenders spend more if borrowersrsquo propensity to spend is larger than
lendersrsquo then aggregate spending falls the IS curve shifts left and Y falls
The evidence on output and nominal interest rates
bull Note that other than the money hypothesis all the other hypothesesmdashthe spending hypothesis the debt-deflation hypothesis and the deflationary expectations hypothesismdashpredict falling real GDP and falling nominal interest rates
bull This is exactly what happened in the early stages of the Great Depression
bull The spending hypothesis and the debt-deflation hypothesis both predict falling real interest rates whereas the deflationary expectations hypothesis predicts rising real interest rates
bull Therefore evidence on real interest rates is crucial in identifying suitable explanations for the Great Depression
Why another Depression is unlikelybull Policymakers (or their advisors) now know much more
about macroeconomicsndash The Fed knows better than to let M fall so much
especially during a contractionndash Fiscal policymakers know better than to raise
taxes or cut spending during a contractionbull Federal deposit insurance makes widespread bank
failures very unlikely
bull Automatic stabilizers make fiscal policy expansionary during an economic downturn
THE FINANCIAL CRISIS AND ECONOMIC DOWNTURN OF 2008 AND 2009
CASE STUDYThe 2008-09 Financial Crisis amp Recession
bull 2009 Real GDP fell unemployment rate approached 10
bull Important factors in the crisisndash early 2000s Federal Reserve interest rate policy ndash sub-prime mortgage crisisndash bursting of house price bubble rising foreclosure
ratesndash falling stock pricesndash failing financial institutionsndash declining consumer confidence drop in spending on
consumer durables and investment goods
A Too-Brief and Too-Simple Explanation
bull The price of housing had risen to unsustainable levels
bull When home prices inevitably crashed people suddenly felt poor and cut back their spending plans
bull This fall in planned expenditure brought about the Great Recession of 2008-09
The Housing Bubble Inflates then Deflates
bull The SampP Case-Shiller 20-City Home Price Index went from ndash 100 in Jan 2000 tondash 20654 in April 2006 tondash 14095 in May 2009 tondash 14216 in Dec 2010
bull Why did the housing bubble inflate
The Housing Bubble Reasons
bull The Fed kept the interest rates too low for too long
bull Securitization technology got a lot fancier in the mortgage bond market
bull The government regulators were sleepingbull Pretty much everybody believed that home
prices could never fall
The Housing Bubble Low FFR
bull The Fed had reduced the Federal Funds Rate to fight the Recession of 2001
bull After that recession ended the Fed continued to keep interest rates low until 2004ndash The Fed was watching inflation which remained
tame Consequently the Fed saw little reason to raise interest rates
ndash The Fed did not believe that housing prices had formed a bubble hellip until it was blindingly obvious
The Housing Bubble Securitization
bull In the past people with money did not like to lend money to home buyers because such loans were risky and had unreliable returns
bull 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
bull The financial sector was regulated by people who were ideologically opposed to regulation
bull They turned a blind eye to even the worst lending practices
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
Applying the IS-LM Model
bull Section 12-1 shows how the IS-LM model that we studied in Chapter 11 can be applied to understand how an economy copes with disturbances (or shocks) in the short run
bull Section 12-3 extends section 12-1 by looking closely at ndash The Great Depression of the 1930s andndash The Great recession of 2008-09
bull Warning I will skip section 12-2 Very sorry
The IS-LM Model Ch 11 Assumptions
bull Y = C + I + Gndash C = Co + Cy (Y ndash T)
ndash I = Io minus Irr
ndash G and T are exogenous
bull M = Md = L(i) P Ybull L(i) = Lo ndash Li i
ndash i = r + Eπndash M P and Eπ are exogenous
The IS-LM Model Ch 11 Summary
bull Y = C + I + Gndash C = Co + Cy (Y ndash T)
ndash I = Io minus Irr
ndash G and T are exogenous
bull M = Md = L(i) P Ybull L(i) = Lo ndash Li i
ndash i = r + Eπndash M P and Eπ are exogenous
rC
IT
C
CGIC
CY
y
r
y
yoo
y
11
)(1
1
The IS-LM Model Ch 11 Summarybull Short-run equilibrium in the goods market is represented
by a downward-sloping IS curve linking Y and rbull Short-run equilibrium in the money market is represented
by an upward-sloping LM curve linking Y and rbull The intersection of the IS and LM curves determine the
short-run equilibrium values of Y and rbull The IS curve shifts right if there is
ndash an increase in Co + Io + G orndash a decrease in T
bull The LM curve shifts right ifndash MP or Eπ increases orndash Lo decreases
Y
r
IS
LM
The LM curve represents money market equilibrium
Equilibrium in the IS -LM model
The IS curve represents equilibrium in the goods market
( ) ( )Y C Y T I r G
IS
Y
rLM
r1
Y1
YPErLM )(
Shifts of the IS curve
bull Recall from Chapter 11 that ndash the consumption function is
C(Y ndash T) = Co + Cy ( Y ndash T) and
ndash The investment function is I(r) = Io ndash Ir r
bull Recall also that the IS curve shifts right if there isndash an increase in Co + Io + G orndash a decrease in T
bull As a result both Y and r increase
IS
Y
rLM
r1
Y1
Shifts of the IS curve
bull Similarly the IS curve shifts left if there isndash a decrease in Co + Io + G
orndash an increase in T
bull As a result both Y and r decrease
IS
Y
rLM
r1
Y1
Shifts of the IS curve
bull In other words we can make the following predictions
IS
Y
rLM
r1
Y1
IS-LM Predictions
Y r
Co + Io + G + +
T minus minus
Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
rC
IT
C
CGIC
CY
y
r
y
yoo
y
11
)(1
1
TC
CGIC
CY
y
yoo
y
1
)(1
1Keynesian Cross
IS Curve
In the Keynesian Cross model expansionary fiscal policy boosts GDP by an amount dictated by the multipliers
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)
KC Spending Multiplier KC Tax-Cut Multiplier
Fiscal Policy is Weakened by the Crowding-Out Effect
bull We have just seen that in the IS-LM model expansionary fiscal policy (Guarr or Tdarr) ndash leads to higher interest rates whichndash exerts downward pressure on investment spending whichndash exerts downward pressure on GDP and jobs
bull This negative aspect of expansionary fiscal policy is called the crowding-out effect
bull This effect was absent in the Keynesian Cross modelbull Thus fiscal policy is less effective in the IS-LM model
than in the Keynesian Cross model
causing GDP to rise
IS1
An increase in government purchases graph
1 IS curve shifts right
Y
rLM
r1
Y1
1by
1 MPCG
IS2
Y2
r2
12 This raises money
demand causing the interest rate to risehellip
2
3 hellipwhich reduces investment so the final increase in Y
1is smaller than
1 MPCG
3
IS1
1
A tax cut
Y
rLM
r1
Y1
IS2
Y2
r2
Consumers save (1MPC) of the tax cut so the initial boost in spending is smaller for T than for an equal Ghellip
and the IS curve shifts by
MPC
1 MPCT
1
2
2hellipso the effects on r and Y are smaller for T than for an equal G
2
Shifts of the LM curve
IS
Y
rLM
r1
Y1
Shifts of the LM curve
bull Similarly the LM curve shifts left if there isndash a decrease in MP or Eπ
orndash an increase in Lo
bull As a result Y decreases and r increases
IS
Y
rLM
r1
Y1
Shifts of the LM curve
Shifts of the LM curve
bull Recall from Ch 11 that if expected inflation (Eπ) increases (decreases) the LM curve shifts down (up) by the exact same amount
bull Therefore if Eπ decreases r will increase but by a smaller amount
bull Therefore i = r + Eπ will decrease
IS
Y
rLM
r1
Y1
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
At this point you should be able to do problems 1 2 3 (a) ndash (f) 4 and 5 on pages 352 ndash 353 of the textbook Please try them
Monetary Policy
bull The practice of changing the quantity of money (M) in order to affect the macroeconomic outcome is called monetary policyndash an increase in the quantity of money (Muarr) is
called expansionary monetary policy andndash A decrease in the quantity of money (Mdarr) is
called contractionary monetary policy
Shifts of the LM curvebull When the central bank of a
country makes changes to the quantity of money (M)ndash only the LM curve changes
and ndash the real interest rate (r)
changes in the opposite direction
ndash As expected inflation (Eπ) is assumed exogenous in the IS-LM model when the real interest rate (r) changes the nominal interest rate (i = r + Eπ) changes in the same direction
IS
Y
rLM
r1
Y1
Shifts of the LM curve
bull One can think of the central bank as ndash targeting M and
affecting r and i in the process or as
ndash targeting r andor i and adjusting M to achieve the target
IS
Y
rLM
r1
Y1
Monetary Policy Re-defined
bull Therefore one can re-define expansionary and contractionary monetary policy as followsndash Monetary policy is expansionary when the central
bank attempts to reduce interest rates (real and nominal) and
ndash Monetary policy is contractionary when the central bank attempts to increase the interest rates (real and nominal)
The Federal Funds Rate
bull 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
bull 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
bull The Federal Funds Rate is the interest rate that banks charge each other for overnight loans
bull If the Fed wishes the FFR to be 18 all it has to do is to announce that ndash it will lend money to any bank at 18 interest
andndash will pay 18 interest on deposits received from
any bank
The Federal Funds Ratebull 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 followsndash Monetary policy is expansionary when the Fed seeks
to reduce the federal funds rate andndash Monetary policy is contractionary when the Fed
seeks to increase the federal funds ratebull 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
bull We have seen that when faced with a recession the central bank can ndash Increase the money supply
(Muarr)ndash Thereby shifting the LM
curve rightndash Thereby reducing the real
interest rate (r = i minus Eπ darr) and the nominal interest rate (i = r + Eπdarr) and increasing GDP (Yuarr) to drag the economy out of the recession
IS
Y
rLM
r1
Y1
The Zero Lower Bound on Nominal Interest Rates
bull The problem is that there is a limit to how low the nominal interest rate can be
bull Nominal interest rates (such as the federal funds rate) cannot be negative
bull To deal with the 2008 economic crisis the Fed reduced the FFR to zero
bull But the recession persistedbull Unfortunately the Fed could
not reduce interest rates below zero monetary policy had reached its limit
IS
Y
rLM
r1
Y1
The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
The Zero Lower Bound on Nominal Interest Rates
bull r = i minus Eπbull iminimum = 0
bull Therefore rminimum = iminimum minus Eπ = 0 minus Eπ
bull Therefore rminimum = minus Eπ
bull For example if Eπ = minus3 then rminimum = minus Eπ = 3
IS
Y
rLM
r1
Y1
21
The Zero Lower Bound on Nominal Interest Rates
bull For example in the diagram the central bank will have to reduce the real interest rate to r = 21 in order to end the recession
bull But suppose expected inflation is Eπ = minus 3
bull Then the nominal interest rate would have to be brought down to i = r + Eπ = 21 ndash 30 = ndash 09
bull Which alas is impossible
IS
Y
rLM
r1
Y1
21
This example also shows how dangerous it can be if we have deflation and people begin to expect the deflation to continue
The Zero Lower Bound on Nominal Interest Rates
bull 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 bendash at the zero lower bound orndash in a liquidity trap
bull See page 350 of the textbook
The Zero Lower Bound on Nominal Interest Rates Solutions
bull When an economy is in a liquidity trap monetary policy cannot be used to reduce interest rates any further
bull But is there nothing else that can be done to bring the economy back to life
bull Yes there isbull Expansionary fiscal policy can be usedbull And therersquos 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
bull In my example ndash the central bank needs to reduce
the real interest rate to r = 21 to end the recession
ndash But expected inflation is Eπ = minus 3 ndash So the nominal interest rate would
have to be brought down to i = ndash 09 which alas is impossible
bull Recall that the LM curve shifts right if either M or Eπ increases
bull If the central bank promises to be irresponsible and to create rapid inflation in the future and if people believe its promise then Eπ will increase say from minus 3 to +1
bull Then the nominal interest rate required for full-employment will be i = r + Eπ = 21 + 10 = 31 which is definitely attainable
IS
Y
rLM
r1
Y1
21
The zero-lower-bound problem can be solved if the central bank can credibly promise to be irresponsible
The Zero Lower Bound on Nominal Interest Rates Solutions
bull Although this chapter assumes a closed economy in reality foreign trade does matter
bull So the central bank can ndash print domestic currency and ndash use it to buy foreign currency ndash thereby making the domestic currency cheaper
relative to the foreign currencyndash thereby stimulating exportsndash thereby ending the recession
The Zero Lower Bound on Nominal Interest Rates Solutions
bull 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
bull This would reduce long-term interest rates directly thereby stimulating spending by the borrowers
bull This strategymdashcalled quantitative easingmdashmay also end a recession
Interaction between monetary and fiscal policy
bull IS-LM Model Monetary and fiscal policy variables (M G and T ) are exogenous
bull Real world Monetary policymakers may adjust M in response to changes in fiscal policy or vice versa
bull Such responses by the central bank may affect the effectiveness of fiscal policy
The Fedrsquos response to G gt 0
bull Suppose the government increases Gbull Possible Fed responses
1 hold M constant2 hold r constant3 hold Y constant
bull In each case the effects of G on Yare differenthellip
When G increases the IS curve shifts right
IS1
Response 1 Hold M constant
Y
rLM
r1
Y1
IS2
Y2
r2
If Fed holds M constant then LM curve does not shift
As a result interest rates rise This has a crowding-out effect Consequently GDP increases but not a lot
If Congress raises G the IS curve shifts right
IS1
Response 2 Hold r constant
Y
rLM1
r1
Y1
IS2
Y2
r2
To keep r constant Fed increases M to shift LM curve right
3 1Y Y Y
0r
LM2
Y3
Results
IS1
Response 3 Hold Y constant
Y
rLM1
r1
IS2
Y2
r2
To keep Y constant Fed reduces M to shift LM curve left
0Y
3 1r r r
LM2
Results
Y1
r3
If Congress raises G the IS curve shifts right
At this point you should be able to do problem 7 on page 353 of the textbook Please try it
Estimates of fiscal policy multipliersfrom the DRI macroeconometric model
Assumption about monetary policy
Estimated value of Y G
Fed holds nominal interest rate constant
Fed holds money supply constant
193
060
Estimated value of Y T
119
026
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 amp services
Examples ndash stock market boom or crash
change in householdsrsquo wealth C
ndash change in business or consumer confidence or expectations I andor C
Shocks in the IS -LM model
LM shocks exogenous changes in the demand for money
Examplesndash a wave of credit card fraud increases demand
for moneyndash 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 of1 a boom in the stock market that makes consumers
wealthier2 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 rb determine what happens to C I and the
unemployment rate
CASE STUDY
THE US RECESSION OF 2001
The US Recession of 2001
bull 39 on 900bull 49 on 801bull 63 on 603bull 50 on 705
The US Recession of 2001
bull Growth of GDP was negative in the 1st and 3rd quarters of 2001
bull Thatrsquos essentially before 911
Recall IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
The US Recession of 2001bull Whybull Demand shocks moved the IS
curve leftndash The ldquotech bubblerdquo ended and
stocks fell 25 between 800 and 801
ndash 911 attacks led to a 12 fall in stock prices in one week and a huge rise in uncertainty
ndash Scandals at Enron WorldCom and other corporations led to stock price declines and a decline in trust and a rise in uncertainty
ndash Lower household wealth reduced Co and higher uncertainty reduced Io
IS
Y
rLM
r1
Y1
CASE STUDY
The US recession of 2001Causes 1) Stock market decline C
300
600
900
1200
1500
1995 1996 1997 1998 1999 2000 2001 2002 2003
Ind
ex
(19
42
= 1
00
) Standard amp Poorrsquos 500
The US Recession of 2001bull Fiscal stimulus moved IS curve
rightndash Major tax cuts were enacted in
2001 and 2003ndash Government spending was
boostedbull to rebuild NYC andbull to bail out the airline industry
bull Fed printed money and moved LM curve rightndash Interest rate on 3-month
Treasury bills fellbull 64 in 1100bull 33 in 801bull 09 in 703
IS1
Y
rLM1
r1
Y1
IS2
LM2
Y3
All three toolsmdashG T and Mmdashwere used
CASE STUDY
The US recession of 2001bull Monetary policy response shifted LM curve right
Three-month T-Bill Rate
Three-month T-Bill Rate
0
1
2
3
4
5
6
7
010
120
0004
02
2000
070
320
0010
03
2000
010
320
0104
05
2001
070
620
0110
06
2001
010
620
0204
08
2002
070
920
0210
09
2002
010
920
0304
11
2003
Skip
bull I am skipping section 11-2
THE GREAT DEPRESSION
The Great Depression
Unemployment (right scale)
Real GNP(left scale)
120
140
160
180
200
220
240
1929 1931 1933 1935 1937 1939
billi
ons
of 1
958
dolla
rs
0
5
10
15
20
25
30
perc
ent o
f lab
or fo
rce
THE SPENDING HYPOTHESIS
Shocks to the IS curvebull asserts that the
Depression was largely due to an exogenous fall in the demand for goods and services ndash a leftward shift of the IS curve
bull evidence output and interest rates both fell in early 1930s which is what a leftward IS shift would cause
IS
Y
rLM
r1
Y1
THE SPENDING HYPOTHESIS
Reasons for the IS shiftbull Stock market crash exogenous C
ndash Oct-Dec 1929 SampP 500 fell 17ndash Oct 1929-Dec 1933 SampP 500 fell 71
bull Drop in investmentndash ldquocorrectionrdquo after overbuilding in the 1920sndash widespread bank failures in early 1930s made it harder
to obtain financing for investmentbull Contractionary fiscal policy
ndash Politicians raised tax rates in 1932 and cut spending to combat increasing deficits
THE MONEY HYPOTHESIS
A shock to the LM curvebull asserts that the Depression was largely due to
huge fall in the money supplybull evidence M1 fell 25 during 1929-33 bull But two problems with this hypothesis
ndash P fell even more so MP actually rose slightly during 1929-31
ndash nominal interest rates fell which is the opposite of what a leftward LM shift would cause
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull asserts that the severity of the Depression
was due to a huge deflation ndash P fell 25 during 1929-33
bull This deflation was probably caused by the fall in M so perhaps money played an important role after all
bull In what ways does a deflation affect the economy
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The stabilizing effects of deflationbull P (MP ) LM shifts right Ybull Pigou effect
P (MP )
consumersrsquo wealth
C
IS shifts right
Y
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects
of expected deflation E
bull LM curve shifts leftr and I (r ) planned expenditure income and output
bull Also the nominal interest rate decreases (idarr) ndash see IS-LM predictions grid
IS
Y
rLM
r1
Y1
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects of unexpected deflation
debt-deflation theoryP (if unexpected)
transfers purchasing power from borrowers to lenders
borrowers spend less lenders spend more if borrowersrsquo propensity to spend is larger than
lendersrsquo then aggregate spending falls the IS curve shifts left and Y falls
The evidence on output and nominal interest rates
bull Note that other than the money hypothesis all the other hypothesesmdashthe spending hypothesis the debt-deflation hypothesis and the deflationary expectations hypothesismdashpredict falling real GDP and falling nominal interest rates
bull This is exactly what happened in the early stages of the Great Depression
bull The spending hypothesis and the debt-deflation hypothesis both predict falling real interest rates whereas the deflationary expectations hypothesis predicts rising real interest rates
bull Therefore evidence on real interest rates is crucial in identifying suitable explanations for the Great Depression
Why another Depression is unlikelybull Policymakers (or their advisors) now know much more
about macroeconomicsndash The Fed knows better than to let M fall so much
especially during a contractionndash Fiscal policymakers know better than to raise
taxes or cut spending during a contractionbull Federal deposit insurance makes widespread bank
failures very unlikely
bull Automatic stabilizers make fiscal policy expansionary during an economic downturn
THE FINANCIAL CRISIS AND ECONOMIC DOWNTURN OF 2008 AND 2009
CASE STUDYThe 2008-09 Financial Crisis amp Recession
bull 2009 Real GDP fell unemployment rate approached 10
bull Important factors in the crisisndash early 2000s Federal Reserve interest rate policy ndash sub-prime mortgage crisisndash bursting of house price bubble rising foreclosure
ratesndash falling stock pricesndash failing financial institutionsndash declining consumer confidence drop in spending on
consumer durables and investment goods
A Too-Brief and Too-Simple Explanation
bull The price of housing had risen to unsustainable levels
bull When home prices inevitably crashed people suddenly felt poor and cut back their spending plans
bull This fall in planned expenditure brought about the Great Recession of 2008-09
The Housing Bubble Inflates then Deflates
bull The SampP Case-Shiller 20-City Home Price Index went from ndash 100 in Jan 2000 tondash 20654 in April 2006 tondash 14095 in May 2009 tondash 14216 in Dec 2010
bull Why did the housing bubble inflate
The Housing Bubble Reasons
bull The Fed kept the interest rates too low for too long
bull Securitization technology got a lot fancier in the mortgage bond market
bull The government regulators were sleepingbull Pretty much everybody believed that home
prices could never fall
The Housing Bubble Low FFR
bull The Fed had reduced the Federal Funds Rate to fight the Recession of 2001
bull After that recession ended the Fed continued to keep interest rates low until 2004ndash The Fed was watching inflation which remained
tame Consequently the Fed saw little reason to raise interest rates
ndash The Fed did not believe that housing prices had formed a bubble hellip until it was blindingly obvious
The Housing Bubble Securitization
bull In the past people with money did not like to lend money to home buyers because such loans were risky and had unreliable returns
bull 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
bull The financial sector was regulated by people who were ideologically opposed to regulation
bull They turned a blind eye to even the worst lending practices
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
The IS-LM Model Ch 11 Assumptions
bull Y = C + I + Gndash C = Co + Cy (Y ndash T)
ndash I = Io minus Irr
ndash G and T are exogenous
bull M = Md = L(i) P Ybull L(i) = Lo ndash Li i
ndash i = r + Eπndash M P and Eπ are exogenous
The IS-LM Model Ch 11 Summary
bull Y = C + I + Gndash C = Co + Cy (Y ndash T)
ndash I = Io minus Irr
ndash G and T are exogenous
bull M = Md = L(i) P Ybull L(i) = Lo ndash Li i
ndash i = r + Eπndash M P and Eπ are exogenous
rC
IT
C
CGIC
CY
y
r
y
yoo
y
11
)(1
1
The IS-LM Model Ch 11 Summarybull Short-run equilibrium in the goods market is represented
by a downward-sloping IS curve linking Y and rbull Short-run equilibrium in the money market is represented
by an upward-sloping LM curve linking Y and rbull The intersection of the IS and LM curves determine the
short-run equilibrium values of Y and rbull The IS curve shifts right if there is
ndash an increase in Co + Io + G orndash a decrease in T
bull The LM curve shifts right ifndash MP or Eπ increases orndash Lo decreases
Y
r
IS
LM
The LM curve represents money market equilibrium
Equilibrium in the IS -LM model
The IS curve represents equilibrium in the goods market
( ) ( )Y C Y T I r G
IS
Y
rLM
r1
Y1
YPErLM )(
Shifts of the IS curve
bull Recall from Chapter 11 that ndash the consumption function is
C(Y ndash T) = Co + Cy ( Y ndash T) and
ndash The investment function is I(r) = Io ndash Ir r
bull Recall also that the IS curve shifts right if there isndash an increase in Co + Io + G orndash a decrease in T
bull As a result both Y and r increase
IS
Y
rLM
r1
Y1
Shifts of the IS curve
bull Similarly the IS curve shifts left if there isndash a decrease in Co + Io + G
orndash an increase in T
bull As a result both Y and r decrease
IS
Y
rLM
r1
Y1
Shifts of the IS curve
bull In other words we can make the following predictions
IS
Y
rLM
r1
Y1
IS-LM Predictions
Y r
Co + Io + G + +
T minus minus
Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
rC
IT
C
CGIC
CY
y
r
y
yoo
y
11
)(1
1
TC
CGIC
CY
y
yoo
y
1
)(1
1Keynesian Cross
IS Curve
In the Keynesian Cross model expansionary fiscal policy boosts GDP by an amount dictated by the multipliers
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)
KC Spending Multiplier KC Tax-Cut Multiplier
Fiscal Policy is Weakened by the Crowding-Out Effect
bull We have just seen that in the IS-LM model expansionary fiscal policy (Guarr or Tdarr) ndash leads to higher interest rates whichndash exerts downward pressure on investment spending whichndash exerts downward pressure on GDP and jobs
bull This negative aspect of expansionary fiscal policy is called the crowding-out effect
bull This effect was absent in the Keynesian Cross modelbull Thus fiscal policy is less effective in the IS-LM model
than in the Keynesian Cross model
causing GDP to rise
IS1
An increase in government purchases graph
1 IS curve shifts right
Y
rLM
r1
Y1
1by
1 MPCG
IS2
Y2
r2
12 This raises money
demand causing the interest rate to risehellip
2
3 hellipwhich reduces investment so the final increase in Y
1is smaller than
1 MPCG
3
IS1
1
A tax cut
Y
rLM
r1
Y1
IS2
Y2
r2
Consumers save (1MPC) of the tax cut so the initial boost in spending is smaller for T than for an equal Ghellip
and the IS curve shifts by
MPC
1 MPCT
1
2
2hellipso the effects on r and Y are smaller for T than for an equal G
2
Shifts of the LM curve
IS
Y
rLM
r1
Y1
Shifts of the LM curve
bull Similarly the LM curve shifts left if there isndash a decrease in MP or Eπ
orndash an increase in Lo
bull As a result Y decreases and r increases
IS
Y
rLM
r1
Y1
Shifts of the LM curve
Shifts of the LM curve
bull Recall from Ch 11 that if expected inflation (Eπ) increases (decreases) the LM curve shifts down (up) by the exact same amount
bull Therefore if Eπ decreases r will increase but by a smaller amount
bull Therefore i = r + Eπ will decrease
IS
Y
rLM
r1
Y1
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
At this point you should be able to do problems 1 2 3 (a) ndash (f) 4 and 5 on pages 352 ndash 353 of the textbook Please try them
Monetary Policy
bull The practice of changing the quantity of money (M) in order to affect the macroeconomic outcome is called monetary policyndash an increase in the quantity of money (Muarr) is
called expansionary monetary policy andndash A decrease in the quantity of money (Mdarr) is
called contractionary monetary policy
Shifts of the LM curvebull When the central bank of a
country makes changes to the quantity of money (M)ndash only the LM curve changes
and ndash the real interest rate (r)
changes in the opposite direction
ndash As expected inflation (Eπ) is assumed exogenous in the IS-LM model when the real interest rate (r) changes the nominal interest rate (i = r + Eπ) changes in the same direction
IS
Y
rLM
r1
Y1
Shifts of the LM curve
bull One can think of the central bank as ndash targeting M and
affecting r and i in the process or as
ndash targeting r andor i and adjusting M to achieve the target
IS
Y
rLM
r1
Y1
Monetary Policy Re-defined
bull Therefore one can re-define expansionary and contractionary monetary policy as followsndash Monetary policy is expansionary when the central
bank attempts to reduce interest rates (real and nominal) and
ndash Monetary policy is contractionary when the central bank attempts to increase the interest rates (real and nominal)
The Federal Funds Rate
bull 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
bull 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
bull The Federal Funds Rate is the interest rate that banks charge each other for overnight loans
bull If the Fed wishes the FFR to be 18 all it has to do is to announce that ndash it will lend money to any bank at 18 interest
andndash will pay 18 interest on deposits received from
any bank
The Federal Funds Ratebull 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 followsndash Monetary policy is expansionary when the Fed seeks
to reduce the federal funds rate andndash Monetary policy is contractionary when the Fed
seeks to increase the federal funds ratebull 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
bull We have seen that when faced with a recession the central bank can ndash Increase the money supply
(Muarr)ndash Thereby shifting the LM
curve rightndash Thereby reducing the real
interest rate (r = i minus Eπ darr) and the nominal interest rate (i = r + Eπdarr) and increasing GDP (Yuarr) to drag the economy out of the recession
IS
Y
rLM
r1
Y1
The Zero Lower Bound on Nominal Interest Rates
bull The problem is that there is a limit to how low the nominal interest rate can be
bull Nominal interest rates (such as the federal funds rate) cannot be negative
bull To deal with the 2008 economic crisis the Fed reduced the FFR to zero
bull But the recession persistedbull Unfortunately the Fed could
not reduce interest rates below zero monetary policy had reached its limit
IS
Y
rLM
r1
Y1
The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
The Zero Lower Bound on Nominal Interest Rates
bull r = i minus Eπbull iminimum = 0
bull Therefore rminimum = iminimum minus Eπ = 0 minus Eπ
bull Therefore rminimum = minus Eπ
bull For example if Eπ = minus3 then rminimum = minus Eπ = 3
IS
Y
rLM
r1
Y1
21
The Zero Lower Bound on Nominal Interest Rates
bull For example in the diagram the central bank will have to reduce the real interest rate to r = 21 in order to end the recession
bull But suppose expected inflation is Eπ = minus 3
bull Then the nominal interest rate would have to be brought down to i = r + Eπ = 21 ndash 30 = ndash 09
bull Which alas is impossible
IS
Y
rLM
r1
Y1
21
This example also shows how dangerous it can be if we have deflation and people begin to expect the deflation to continue
The Zero Lower Bound on Nominal Interest Rates
bull 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 bendash at the zero lower bound orndash in a liquidity trap
bull See page 350 of the textbook
The Zero Lower Bound on Nominal Interest Rates Solutions
bull When an economy is in a liquidity trap monetary policy cannot be used to reduce interest rates any further
bull But is there nothing else that can be done to bring the economy back to life
bull Yes there isbull Expansionary fiscal policy can be usedbull And therersquos 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
bull In my example ndash the central bank needs to reduce
the real interest rate to r = 21 to end the recession
ndash But expected inflation is Eπ = minus 3 ndash So the nominal interest rate would
have to be brought down to i = ndash 09 which alas is impossible
bull Recall that the LM curve shifts right if either M or Eπ increases
bull If the central bank promises to be irresponsible and to create rapid inflation in the future and if people believe its promise then Eπ will increase say from minus 3 to +1
bull Then the nominal interest rate required for full-employment will be i = r + Eπ = 21 + 10 = 31 which is definitely attainable
IS
Y
rLM
r1
Y1
21
The zero-lower-bound problem can be solved if the central bank can credibly promise to be irresponsible
The Zero Lower Bound on Nominal Interest Rates Solutions
bull Although this chapter assumes a closed economy in reality foreign trade does matter
bull So the central bank can ndash print domestic currency and ndash use it to buy foreign currency ndash thereby making the domestic currency cheaper
relative to the foreign currencyndash thereby stimulating exportsndash thereby ending the recession
The Zero Lower Bound on Nominal Interest Rates Solutions
bull 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
bull This would reduce long-term interest rates directly thereby stimulating spending by the borrowers
bull This strategymdashcalled quantitative easingmdashmay also end a recession
Interaction between monetary and fiscal policy
bull IS-LM Model Monetary and fiscal policy variables (M G and T ) are exogenous
bull Real world Monetary policymakers may adjust M in response to changes in fiscal policy or vice versa
bull Such responses by the central bank may affect the effectiveness of fiscal policy
The Fedrsquos response to G gt 0
bull Suppose the government increases Gbull Possible Fed responses
1 hold M constant2 hold r constant3 hold Y constant
bull In each case the effects of G on Yare differenthellip
When G increases the IS curve shifts right
IS1
Response 1 Hold M constant
Y
rLM
r1
Y1
IS2
Y2
r2
If Fed holds M constant then LM curve does not shift
As a result interest rates rise This has a crowding-out effect Consequently GDP increases but not a lot
If Congress raises G the IS curve shifts right
IS1
Response 2 Hold r constant
Y
rLM1
r1
Y1
IS2
Y2
r2
To keep r constant Fed increases M to shift LM curve right
3 1Y Y Y
0r
LM2
Y3
Results
IS1
Response 3 Hold Y constant
Y
rLM1
r1
IS2
Y2
r2
To keep Y constant Fed reduces M to shift LM curve left
0Y
3 1r r r
LM2
Results
Y1
r3
If Congress raises G the IS curve shifts right
At this point you should be able to do problem 7 on page 353 of the textbook Please try it
Estimates of fiscal policy multipliersfrom the DRI macroeconometric model
Assumption about monetary policy
Estimated value of Y G
Fed holds nominal interest rate constant
Fed holds money supply constant
193
060
Estimated value of Y T
119
026
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 amp services
Examples ndash stock market boom or crash
change in householdsrsquo wealth C
ndash change in business or consumer confidence or expectations I andor C
Shocks in the IS -LM model
LM shocks exogenous changes in the demand for money
Examplesndash a wave of credit card fraud increases demand
for moneyndash 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 of1 a boom in the stock market that makes consumers
wealthier2 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 rb determine what happens to C I and the
unemployment rate
CASE STUDY
THE US RECESSION OF 2001
The US Recession of 2001
bull 39 on 900bull 49 on 801bull 63 on 603bull 50 on 705
The US Recession of 2001
bull Growth of GDP was negative in the 1st and 3rd quarters of 2001
bull Thatrsquos essentially before 911
Recall IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
The US Recession of 2001bull Whybull Demand shocks moved the IS
curve leftndash The ldquotech bubblerdquo ended and
stocks fell 25 between 800 and 801
ndash 911 attacks led to a 12 fall in stock prices in one week and a huge rise in uncertainty
ndash Scandals at Enron WorldCom and other corporations led to stock price declines and a decline in trust and a rise in uncertainty
ndash Lower household wealth reduced Co and higher uncertainty reduced Io
IS
Y
rLM
r1
Y1
CASE STUDY
The US recession of 2001Causes 1) Stock market decline C
300
600
900
1200
1500
1995 1996 1997 1998 1999 2000 2001 2002 2003
Ind
ex
(19
42
= 1
00
) Standard amp Poorrsquos 500
The US Recession of 2001bull Fiscal stimulus moved IS curve
rightndash Major tax cuts were enacted in
2001 and 2003ndash Government spending was
boostedbull to rebuild NYC andbull to bail out the airline industry
bull Fed printed money and moved LM curve rightndash Interest rate on 3-month
Treasury bills fellbull 64 in 1100bull 33 in 801bull 09 in 703
IS1
Y
rLM1
r1
Y1
IS2
LM2
Y3
All three toolsmdashG T and Mmdashwere used
CASE STUDY
The US recession of 2001bull Monetary policy response shifted LM curve right
Three-month T-Bill Rate
Three-month T-Bill Rate
0
1
2
3
4
5
6
7
010
120
0004
02
2000
070
320
0010
03
2000
010
320
0104
05
2001
070
620
0110
06
2001
010
620
0204
08
2002
070
920
0210
09
2002
010
920
0304
11
2003
Skip
bull I am skipping section 11-2
THE GREAT DEPRESSION
The Great Depression
Unemployment (right scale)
Real GNP(left scale)
120
140
160
180
200
220
240
1929 1931 1933 1935 1937 1939
billi
ons
of 1
958
dolla
rs
0
5
10
15
20
25
30
perc
ent o
f lab
or fo
rce
THE SPENDING HYPOTHESIS
Shocks to the IS curvebull asserts that the
Depression was largely due to an exogenous fall in the demand for goods and services ndash a leftward shift of the IS curve
bull evidence output and interest rates both fell in early 1930s which is what a leftward IS shift would cause
IS
Y
rLM
r1
Y1
THE SPENDING HYPOTHESIS
Reasons for the IS shiftbull Stock market crash exogenous C
ndash Oct-Dec 1929 SampP 500 fell 17ndash Oct 1929-Dec 1933 SampP 500 fell 71
bull Drop in investmentndash ldquocorrectionrdquo after overbuilding in the 1920sndash widespread bank failures in early 1930s made it harder
to obtain financing for investmentbull Contractionary fiscal policy
ndash Politicians raised tax rates in 1932 and cut spending to combat increasing deficits
THE MONEY HYPOTHESIS
A shock to the LM curvebull asserts that the Depression was largely due to
huge fall in the money supplybull evidence M1 fell 25 during 1929-33 bull But two problems with this hypothesis
ndash P fell even more so MP actually rose slightly during 1929-31
ndash nominal interest rates fell which is the opposite of what a leftward LM shift would cause
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull asserts that the severity of the Depression
was due to a huge deflation ndash P fell 25 during 1929-33
bull This deflation was probably caused by the fall in M so perhaps money played an important role after all
bull In what ways does a deflation affect the economy
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The stabilizing effects of deflationbull P (MP ) LM shifts right Ybull Pigou effect
P (MP )
consumersrsquo wealth
C
IS shifts right
Y
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects
of expected deflation E
bull LM curve shifts leftr and I (r ) planned expenditure income and output
bull Also the nominal interest rate decreases (idarr) ndash see IS-LM predictions grid
IS
Y
rLM
r1
Y1
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects of unexpected deflation
debt-deflation theoryP (if unexpected)
transfers purchasing power from borrowers to lenders
borrowers spend less lenders spend more if borrowersrsquo propensity to spend is larger than
lendersrsquo then aggregate spending falls the IS curve shifts left and Y falls
The evidence on output and nominal interest rates
bull Note that other than the money hypothesis all the other hypothesesmdashthe spending hypothesis the debt-deflation hypothesis and the deflationary expectations hypothesismdashpredict falling real GDP and falling nominal interest rates
bull This is exactly what happened in the early stages of the Great Depression
bull The spending hypothesis and the debt-deflation hypothesis both predict falling real interest rates whereas the deflationary expectations hypothesis predicts rising real interest rates
bull Therefore evidence on real interest rates is crucial in identifying suitable explanations for the Great Depression
Why another Depression is unlikelybull Policymakers (or their advisors) now know much more
about macroeconomicsndash The Fed knows better than to let M fall so much
especially during a contractionndash Fiscal policymakers know better than to raise
taxes or cut spending during a contractionbull Federal deposit insurance makes widespread bank
failures very unlikely
bull Automatic stabilizers make fiscal policy expansionary during an economic downturn
THE FINANCIAL CRISIS AND ECONOMIC DOWNTURN OF 2008 AND 2009
CASE STUDYThe 2008-09 Financial Crisis amp Recession
bull 2009 Real GDP fell unemployment rate approached 10
bull Important factors in the crisisndash early 2000s Federal Reserve interest rate policy ndash sub-prime mortgage crisisndash bursting of house price bubble rising foreclosure
ratesndash falling stock pricesndash failing financial institutionsndash declining consumer confidence drop in spending on
consumer durables and investment goods
A Too-Brief and Too-Simple Explanation
bull The price of housing had risen to unsustainable levels
bull When home prices inevitably crashed people suddenly felt poor and cut back their spending plans
bull This fall in planned expenditure brought about the Great Recession of 2008-09
The Housing Bubble Inflates then Deflates
bull The SampP Case-Shiller 20-City Home Price Index went from ndash 100 in Jan 2000 tondash 20654 in April 2006 tondash 14095 in May 2009 tondash 14216 in Dec 2010
bull Why did the housing bubble inflate
The Housing Bubble Reasons
bull The Fed kept the interest rates too low for too long
bull Securitization technology got a lot fancier in the mortgage bond market
bull The government regulators were sleepingbull Pretty much everybody believed that home
prices could never fall
The Housing Bubble Low FFR
bull The Fed had reduced the Federal Funds Rate to fight the Recession of 2001
bull After that recession ended the Fed continued to keep interest rates low until 2004ndash The Fed was watching inflation which remained
tame Consequently the Fed saw little reason to raise interest rates
ndash The Fed did not believe that housing prices had formed a bubble hellip until it was blindingly obvious
The Housing Bubble Securitization
bull In the past people with money did not like to lend money to home buyers because such loans were risky and had unreliable returns
bull 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
bull The financial sector was regulated by people who were ideologically opposed to regulation
bull They turned a blind eye to even the worst lending practices
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
The IS-LM Model Ch 11 Summary
bull Y = C + I + Gndash C = Co + Cy (Y ndash T)
ndash I = Io minus Irr
ndash G and T are exogenous
bull M = Md = L(i) P Ybull L(i) = Lo ndash Li i
ndash i = r + Eπndash M P and Eπ are exogenous
rC
IT
C
CGIC
CY
y
r
y
yoo
y
11
)(1
1
The IS-LM Model Ch 11 Summarybull Short-run equilibrium in the goods market is represented
by a downward-sloping IS curve linking Y and rbull Short-run equilibrium in the money market is represented
by an upward-sloping LM curve linking Y and rbull The intersection of the IS and LM curves determine the
short-run equilibrium values of Y and rbull The IS curve shifts right if there is
ndash an increase in Co + Io + G orndash a decrease in T
bull The LM curve shifts right ifndash MP or Eπ increases orndash Lo decreases
Y
r
IS
LM
The LM curve represents money market equilibrium
Equilibrium in the IS -LM model
The IS curve represents equilibrium in the goods market
( ) ( )Y C Y T I r G
IS
Y
rLM
r1
Y1
YPErLM )(
Shifts of the IS curve
bull Recall from Chapter 11 that ndash the consumption function is
C(Y ndash T) = Co + Cy ( Y ndash T) and
ndash The investment function is I(r) = Io ndash Ir r
bull Recall also that the IS curve shifts right if there isndash an increase in Co + Io + G orndash a decrease in T
bull As a result both Y and r increase
IS
Y
rLM
r1
Y1
Shifts of the IS curve
bull Similarly the IS curve shifts left if there isndash a decrease in Co + Io + G
orndash an increase in T
bull As a result both Y and r decrease
IS
Y
rLM
r1
Y1
Shifts of the IS curve
bull In other words we can make the following predictions
IS
Y
rLM
r1
Y1
IS-LM Predictions
Y r
Co + Io + G + +
T minus minus
Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
rC
IT
C
CGIC
CY
y
r
y
yoo
y
11
)(1
1
TC
CGIC
CY
y
yoo
y
1
)(1
1Keynesian Cross
IS Curve
In the Keynesian Cross model expansionary fiscal policy boosts GDP by an amount dictated by the multipliers
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)
KC Spending Multiplier KC Tax-Cut Multiplier
Fiscal Policy is Weakened by the Crowding-Out Effect
bull We have just seen that in the IS-LM model expansionary fiscal policy (Guarr or Tdarr) ndash leads to higher interest rates whichndash exerts downward pressure on investment spending whichndash exerts downward pressure on GDP and jobs
bull This negative aspect of expansionary fiscal policy is called the crowding-out effect
bull This effect was absent in the Keynesian Cross modelbull Thus fiscal policy is less effective in the IS-LM model
than in the Keynesian Cross model
causing GDP to rise
IS1
An increase in government purchases graph
1 IS curve shifts right
Y
rLM
r1
Y1
1by
1 MPCG
IS2
Y2
r2
12 This raises money
demand causing the interest rate to risehellip
2
3 hellipwhich reduces investment so the final increase in Y
1is smaller than
1 MPCG
3
IS1
1
A tax cut
Y
rLM
r1
Y1
IS2
Y2
r2
Consumers save (1MPC) of the tax cut so the initial boost in spending is smaller for T than for an equal Ghellip
and the IS curve shifts by
MPC
1 MPCT
1
2
2hellipso the effects on r and Y are smaller for T than for an equal G
2
Shifts of the LM curve
IS
Y
rLM
r1
Y1
Shifts of the LM curve
bull Similarly the LM curve shifts left if there isndash a decrease in MP or Eπ
orndash an increase in Lo
bull As a result Y decreases and r increases
IS
Y
rLM
r1
Y1
Shifts of the LM curve
Shifts of the LM curve
bull Recall from Ch 11 that if expected inflation (Eπ) increases (decreases) the LM curve shifts down (up) by the exact same amount
bull Therefore if Eπ decreases r will increase but by a smaller amount
bull Therefore i = r + Eπ will decrease
IS
Y
rLM
r1
Y1
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
At this point you should be able to do problems 1 2 3 (a) ndash (f) 4 and 5 on pages 352 ndash 353 of the textbook Please try them
Monetary Policy
bull The practice of changing the quantity of money (M) in order to affect the macroeconomic outcome is called monetary policyndash an increase in the quantity of money (Muarr) is
called expansionary monetary policy andndash A decrease in the quantity of money (Mdarr) is
called contractionary monetary policy
Shifts of the LM curvebull When the central bank of a
country makes changes to the quantity of money (M)ndash only the LM curve changes
and ndash the real interest rate (r)
changes in the opposite direction
ndash As expected inflation (Eπ) is assumed exogenous in the IS-LM model when the real interest rate (r) changes the nominal interest rate (i = r + Eπ) changes in the same direction
IS
Y
rLM
r1
Y1
Shifts of the LM curve
bull One can think of the central bank as ndash targeting M and
affecting r and i in the process or as
ndash targeting r andor i and adjusting M to achieve the target
IS
Y
rLM
r1
Y1
Monetary Policy Re-defined
bull Therefore one can re-define expansionary and contractionary monetary policy as followsndash Monetary policy is expansionary when the central
bank attempts to reduce interest rates (real and nominal) and
ndash Monetary policy is contractionary when the central bank attempts to increase the interest rates (real and nominal)
The Federal Funds Rate
bull 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
bull 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
bull The Federal Funds Rate is the interest rate that banks charge each other for overnight loans
bull If the Fed wishes the FFR to be 18 all it has to do is to announce that ndash it will lend money to any bank at 18 interest
andndash will pay 18 interest on deposits received from
any bank
The Federal Funds Ratebull 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 followsndash Monetary policy is expansionary when the Fed seeks
to reduce the federal funds rate andndash Monetary policy is contractionary when the Fed
seeks to increase the federal funds ratebull 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
bull We have seen that when faced with a recession the central bank can ndash Increase the money supply
(Muarr)ndash Thereby shifting the LM
curve rightndash Thereby reducing the real
interest rate (r = i minus Eπ darr) and the nominal interest rate (i = r + Eπdarr) and increasing GDP (Yuarr) to drag the economy out of the recession
IS
Y
rLM
r1
Y1
The Zero Lower Bound on Nominal Interest Rates
bull The problem is that there is a limit to how low the nominal interest rate can be
bull Nominal interest rates (such as the federal funds rate) cannot be negative
bull To deal with the 2008 economic crisis the Fed reduced the FFR to zero
bull But the recession persistedbull Unfortunately the Fed could
not reduce interest rates below zero monetary policy had reached its limit
IS
Y
rLM
r1
Y1
The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
The Zero Lower Bound on Nominal Interest Rates
bull r = i minus Eπbull iminimum = 0
bull Therefore rminimum = iminimum minus Eπ = 0 minus Eπ
bull Therefore rminimum = minus Eπ
bull For example if Eπ = minus3 then rminimum = minus Eπ = 3
IS
Y
rLM
r1
Y1
21
The Zero Lower Bound on Nominal Interest Rates
bull For example in the diagram the central bank will have to reduce the real interest rate to r = 21 in order to end the recession
bull But suppose expected inflation is Eπ = minus 3
bull Then the nominal interest rate would have to be brought down to i = r + Eπ = 21 ndash 30 = ndash 09
bull Which alas is impossible
IS
Y
rLM
r1
Y1
21
This example also shows how dangerous it can be if we have deflation and people begin to expect the deflation to continue
The Zero Lower Bound on Nominal Interest Rates
bull 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 bendash at the zero lower bound orndash in a liquidity trap
bull See page 350 of the textbook
The Zero Lower Bound on Nominal Interest Rates Solutions
bull When an economy is in a liquidity trap monetary policy cannot be used to reduce interest rates any further
bull But is there nothing else that can be done to bring the economy back to life
bull Yes there isbull Expansionary fiscal policy can be usedbull And therersquos 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
bull In my example ndash the central bank needs to reduce
the real interest rate to r = 21 to end the recession
ndash But expected inflation is Eπ = minus 3 ndash So the nominal interest rate would
have to be brought down to i = ndash 09 which alas is impossible
bull Recall that the LM curve shifts right if either M or Eπ increases
bull If the central bank promises to be irresponsible and to create rapid inflation in the future and if people believe its promise then Eπ will increase say from minus 3 to +1
bull Then the nominal interest rate required for full-employment will be i = r + Eπ = 21 + 10 = 31 which is definitely attainable
IS
Y
rLM
r1
Y1
21
The zero-lower-bound problem can be solved if the central bank can credibly promise to be irresponsible
The Zero Lower Bound on Nominal Interest Rates Solutions
bull Although this chapter assumes a closed economy in reality foreign trade does matter
bull So the central bank can ndash print domestic currency and ndash use it to buy foreign currency ndash thereby making the domestic currency cheaper
relative to the foreign currencyndash thereby stimulating exportsndash thereby ending the recession
The Zero Lower Bound on Nominal Interest Rates Solutions
bull 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
bull This would reduce long-term interest rates directly thereby stimulating spending by the borrowers
bull This strategymdashcalled quantitative easingmdashmay also end a recession
Interaction between monetary and fiscal policy
bull IS-LM Model Monetary and fiscal policy variables (M G and T ) are exogenous
bull Real world Monetary policymakers may adjust M in response to changes in fiscal policy or vice versa
bull Such responses by the central bank may affect the effectiveness of fiscal policy
The Fedrsquos response to G gt 0
bull Suppose the government increases Gbull Possible Fed responses
1 hold M constant2 hold r constant3 hold Y constant
bull In each case the effects of G on Yare differenthellip
When G increases the IS curve shifts right
IS1
Response 1 Hold M constant
Y
rLM
r1
Y1
IS2
Y2
r2
If Fed holds M constant then LM curve does not shift
As a result interest rates rise This has a crowding-out effect Consequently GDP increases but not a lot
If Congress raises G the IS curve shifts right
IS1
Response 2 Hold r constant
Y
rLM1
r1
Y1
IS2
Y2
r2
To keep r constant Fed increases M to shift LM curve right
3 1Y Y Y
0r
LM2
Y3
Results
IS1
Response 3 Hold Y constant
Y
rLM1
r1
IS2
Y2
r2
To keep Y constant Fed reduces M to shift LM curve left
0Y
3 1r r r
LM2
Results
Y1
r3
If Congress raises G the IS curve shifts right
At this point you should be able to do problem 7 on page 353 of the textbook Please try it
Estimates of fiscal policy multipliersfrom the DRI macroeconometric model
Assumption about monetary policy
Estimated value of Y G
Fed holds nominal interest rate constant
Fed holds money supply constant
193
060
Estimated value of Y T
119
026
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 amp services
Examples ndash stock market boom or crash
change in householdsrsquo wealth C
ndash change in business or consumer confidence or expectations I andor C
Shocks in the IS -LM model
LM shocks exogenous changes in the demand for money
Examplesndash a wave of credit card fraud increases demand
for moneyndash 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 of1 a boom in the stock market that makes consumers
wealthier2 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 rb determine what happens to C I and the
unemployment rate
CASE STUDY
THE US RECESSION OF 2001
The US Recession of 2001
bull 39 on 900bull 49 on 801bull 63 on 603bull 50 on 705
The US Recession of 2001
bull Growth of GDP was negative in the 1st and 3rd quarters of 2001
bull Thatrsquos essentially before 911
Recall IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
The US Recession of 2001bull Whybull Demand shocks moved the IS
curve leftndash The ldquotech bubblerdquo ended and
stocks fell 25 between 800 and 801
ndash 911 attacks led to a 12 fall in stock prices in one week and a huge rise in uncertainty
ndash Scandals at Enron WorldCom and other corporations led to stock price declines and a decline in trust and a rise in uncertainty
ndash Lower household wealth reduced Co and higher uncertainty reduced Io
IS
Y
rLM
r1
Y1
CASE STUDY
The US recession of 2001Causes 1) Stock market decline C
300
600
900
1200
1500
1995 1996 1997 1998 1999 2000 2001 2002 2003
Ind
ex
(19
42
= 1
00
) Standard amp Poorrsquos 500
The US Recession of 2001bull Fiscal stimulus moved IS curve
rightndash Major tax cuts were enacted in
2001 and 2003ndash Government spending was
boostedbull to rebuild NYC andbull to bail out the airline industry
bull Fed printed money and moved LM curve rightndash Interest rate on 3-month
Treasury bills fellbull 64 in 1100bull 33 in 801bull 09 in 703
IS1
Y
rLM1
r1
Y1
IS2
LM2
Y3
All three toolsmdashG T and Mmdashwere used
CASE STUDY
The US recession of 2001bull Monetary policy response shifted LM curve right
Three-month T-Bill Rate
Three-month T-Bill Rate
0
1
2
3
4
5
6
7
010
120
0004
02
2000
070
320
0010
03
2000
010
320
0104
05
2001
070
620
0110
06
2001
010
620
0204
08
2002
070
920
0210
09
2002
010
920
0304
11
2003
Skip
bull I am skipping section 11-2
THE GREAT DEPRESSION
The Great Depression
Unemployment (right scale)
Real GNP(left scale)
120
140
160
180
200
220
240
1929 1931 1933 1935 1937 1939
billi
ons
of 1
958
dolla
rs
0
5
10
15
20
25
30
perc
ent o
f lab
or fo
rce
THE SPENDING HYPOTHESIS
Shocks to the IS curvebull asserts that the
Depression was largely due to an exogenous fall in the demand for goods and services ndash a leftward shift of the IS curve
bull evidence output and interest rates both fell in early 1930s which is what a leftward IS shift would cause
IS
Y
rLM
r1
Y1
THE SPENDING HYPOTHESIS
Reasons for the IS shiftbull Stock market crash exogenous C
ndash Oct-Dec 1929 SampP 500 fell 17ndash Oct 1929-Dec 1933 SampP 500 fell 71
bull Drop in investmentndash ldquocorrectionrdquo after overbuilding in the 1920sndash widespread bank failures in early 1930s made it harder
to obtain financing for investmentbull Contractionary fiscal policy
ndash Politicians raised tax rates in 1932 and cut spending to combat increasing deficits
THE MONEY HYPOTHESIS
A shock to the LM curvebull asserts that the Depression was largely due to
huge fall in the money supplybull evidence M1 fell 25 during 1929-33 bull But two problems with this hypothesis
ndash P fell even more so MP actually rose slightly during 1929-31
ndash nominal interest rates fell which is the opposite of what a leftward LM shift would cause
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull asserts that the severity of the Depression
was due to a huge deflation ndash P fell 25 during 1929-33
bull This deflation was probably caused by the fall in M so perhaps money played an important role after all
bull In what ways does a deflation affect the economy
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The stabilizing effects of deflationbull P (MP ) LM shifts right Ybull Pigou effect
P (MP )
consumersrsquo wealth
C
IS shifts right
Y
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects
of expected deflation E
bull LM curve shifts leftr and I (r ) planned expenditure income and output
bull Also the nominal interest rate decreases (idarr) ndash see IS-LM predictions grid
IS
Y
rLM
r1
Y1
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects of unexpected deflation
debt-deflation theoryP (if unexpected)
transfers purchasing power from borrowers to lenders
borrowers spend less lenders spend more if borrowersrsquo propensity to spend is larger than
lendersrsquo then aggregate spending falls the IS curve shifts left and Y falls
The evidence on output and nominal interest rates
bull Note that other than the money hypothesis all the other hypothesesmdashthe spending hypothesis the debt-deflation hypothesis and the deflationary expectations hypothesismdashpredict falling real GDP and falling nominal interest rates
bull This is exactly what happened in the early stages of the Great Depression
bull The spending hypothesis and the debt-deflation hypothesis both predict falling real interest rates whereas the deflationary expectations hypothesis predicts rising real interest rates
bull Therefore evidence on real interest rates is crucial in identifying suitable explanations for the Great Depression
Why another Depression is unlikelybull Policymakers (or their advisors) now know much more
about macroeconomicsndash The Fed knows better than to let M fall so much
especially during a contractionndash Fiscal policymakers know better than to raise
taxes or cut spending during a contractionbull Federal deposit insurance makes widespread bank
failures very unlikely
bull Automatic stabilizers make fiscal policy expansionary during an economic downturn
THE FINANCIAL CRISIS AND ECONOMIC DOWNTURN OF 2008 AND 2009
CASE STUDYThe 2008-09 Financial Crisis amp Recession
bull 2009 Real GDP fell unemployment rate approached 10
bull Important factors in the crisisndash early 2000s Federal Reserve interest rate policy ndash sub-prime mortgage crisisndash bursting of house price bubble rising foreclosure
ratesndash falling stock pricesndash failing financial institutionsndash declining consumer confidence drop in spending on
consumer durables and investment goods
A Too-Brief and Too-Simple Explanation
bull The price of housing had risen to unsustainable levels
bull When home prices inevitably crashed people suddenly felt poor and cut back their spending plans
bull This fall in planned expenditure brought about the Great Recession of 2008-09
The Housing Bubble Inflates then Deflates
bull The SampP Case-Shiller 20-City Home Price Index went from ndash 100 in Jan 2000 tondash 20654 in April 2006 tondash 14095 in May 2009 tondash 14216 in Dec 2010
bull Why did the housing bubble inflate
The Housing Bubble Reasons
bull The Fed kept the interest rates too low for too long
bull Securitization technology got a lot fancier in the mortgage bond market
bull The government regulators were sleepingbull Pretty much everybody believed that home
prices could never fall
The Housing Bubble Low FFR
bull The Fed had reduced the Federal Funds Rate to fight the Recession of 2001
bull After that recession ended the Fed continued to keep interest rates low until 2004ndash The Fed was watching inflation which remained
tame Consequently the Fed saw little reason to raise interest rates
ndash The Fed did not believe that housing prices had formed a bubble hellip until it was blindingly obvious
The Housing Bubble Securitization
bull In the past people with money did not like to lend money to home buyers because such loans were risky and had unreliable returns
bull 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
bull The financial sector was regulated by people who were ideologically opposed to regulation
bull They turned a blind eye to even the worst lending practices
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
The IS-LM Model Ch 11 Summarybull Short-run equilibrium in the goods market is represented
by a downward-sloping IS curve linking Y and rbull Short-run equilibrium in the money market is represented
by an upward-sloping LM curve linking Y and rbull The intersection of the IS and LM curves determine the
short-run equilibrium values of Y and rbull The IS curve shifts right if there is
ndash an increase in Co + Io + G orndash a decrease in T
bull The LM curve shifts right ifndash MP or Eπ increases orndash Lo decreases
Y
r
IS
LM
The LM curve represents money market equilibrium
Equilibrium in the IS -LM model
The IS curve represents equilibrium in the goods market
( ) ( )Y C Y T I r G
IS
Y
rLM
r1
Y1
YPErLM )(
Shifts of the IS curve
bull Recall from Chapter 11 that ndash the consumption function is
C(Y ndash T) = Co + Cy ( Y ndash T) and
ndash The investment function is I(r) = Io ndash Ir r
bull Recall also that the IS curve shifts right if there isndash an increase in Co + Io + G orndash a decrease in T
bull As a result both Y and r increase
IS
Y
rLM
r1
Y1
Shifts of the IS curve
bull Similarly the IS curve shifts left if there isndash a decrease in Co + Io + G
orndash an increase in T
bull As a result both Y and r decrease
IS
Y
rLM
r1
Y1
Shifts of the IS curve
bull In other words we can make the following predictions
IS
Y
rLM
r1
Y1
IS-LM Predictions
Y r
Co + Io + G + +
T minus minus
Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
rC
IT
C
CGIC
CY
y
r
y
yoo
y
11
)(1
1
TC
CGIC
CY
y
yoo
y
1
)(1
1Keynesian Cross
IS Curve
In the Keynesian Cross model expansionary fiscal policy boosts GDP by an amount dictated by the multipliers
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)
KC Spending Multiplier KC Tax-Cut Multiplier
Fiscal Policy is Weakened by the Crowding-Out Effect
bull We have just seen that in the IS-LM model expansionary fiscal policy (Guarr or Tdarr) ndash leads to higher interest rates whichndash exerts downward pressure on investment spending whichndash exerts downward pressure on GDP and jobs
bull This negative aspect of expansionary fiscal policy is called the crowding-out effect
bull This effect was absent in the Keynesian Cross modelbull Thus fiscal policy is less effective in the IS-LM model
than in the Keynesian Cross model
causing GDP to rise
IS1
An increase in government purchases graph
1 IS curve shifts right
Y
rLM
r1
Y1
1by
1 MPCG
IS2
Y2
r2
12 This raises money
demand causing the interest rate to risehellip
2
3 hellipwhich reduces investment so the final increase in Y
1is smaller than
1 MPCG
3
IS1
1
A tax cut
Y
rLM
r1
Y1
IS2
Y2
r2
Consumers save (1MPC) of the tax cut so the initial boost in spending is smaller for T than for an equal Ghellip
and the IS curve shifts by
MPC
1 MPCT
1
2
2hellipso the effects on r and Y are smaller for T than for an equal G
2
Shifts of the LM curve
IS
Y
rLM
r1
Y1
Shifts of the LM curve
bull Similarly the LM curve shifts left if there isndash a decrease in MP or Eπ
orndash an increase in Lo
bull As a result Y decreases and r increases
IS
Y
rLM
r1
Y1
Shifts of the LM curve
Shifts of the LM curve
bull Recall from Ch 11 that if expected inflation (Eπ) increases (decreases) the LM curve shifts down (up) by the exact same amount
bull Therefore if Eπ decreases r will increase but by a smaller amount
bull Therefore i = r + Eπ will decrease
IS
Y
rLM
r1
Y1
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
At this point you should be able to do problems 1 2 3 (a) ndash (f) 4 and 5 on pages 352 ndash 353 of the textbook Please try them
Monetary Policy
bull The practice of changing the quantity of money (M) in order to affect the macroeconomic outcome is called monetary policyndash an increase in the quantity of money (Muarr) is
called expansionary monetary policy andndash A decrease in the quantity of money (Mdarr) is
called contractionary monetary policy
Shifts of the LM curvebull When the central bank of a
country makes changes to the quantity of money (M)ndash only the LM curve changes
and ndash the real interest rate (r)
changes in the opposite direction
ndash As expected inflation (Eπ) is assumed exogenous in the IS-LM model when the real interest rate (r) changes the nominal interest rate (i = r + Eπ) changes in the same direction
IS
Y
rLM
r1
Y1
Shifts of the LM curve
bull One can think of the central bank as ndash targeting M and
affecting r and i in the process or as
ndash targeting r andor i and adjusting M to achieve the target
IS
Y
rLM
r1
Y1
Monetary Policy Re-defined
bull Therefore one can re-define expansionary and contractionary monetary policy as followsndash Monetary policy is expansionary when the central
bank attempts to reduce interest rates (real and nominal) and
ndash Monetary policy is contractionary when the central bank attempts to increase the interest rates (real and nominal)
The Federal Funds Rate
bull 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
bull 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
bull The Federal Funds Rate is the interest rate that banks charge each other for overnight loans
bull If the Fed wishes the FFR to be 18 all it has to do is to announce that ndash it will lend money to any bank at 18 interest
andndash will pay 18 interest on deposits received from
any bank
The Federal Funds Ratebull 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 followsndash Monetary policy is expansionary when the Fed seeks
to reduce the federal funds rate andndash Monetary policy is contractionary when the Fed
seeks to increase the federal funds ratebull 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
bull We have seen that when faced with a recession the central bank can ndash Increase the money supply
(Muarr)ndash Thereby shifting the LM
curve rightndash Thereby reducing the real
interest rate (r = i minus Eπ darr) and the nominal interest rate (i = r + Eπdarr) and increasing GDP (Yuarr) to drag the economy out of the recession
IS
Y
rLM
r1
Y1
The Zero Lower Bound on Nominal Interest Rates
bull The problem is that there is a limit to how low the nominal interest rate can be
bull Nominal interest rates (such as the federal funds rate) cannot be negative
bull To deal with the 2008 economic crisis the Fed reduced the FFR to zero
bull But the recession persistedbull Unfortunately the Fed could
not reduce interest rates below zero monetary policy had reached its limit
IS
Y
rLM
r1
Y1
The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
The Zero Lower Bound on Nominal Interest Rates
bull r = i minus Eπbull iminimum = 0
bull Therefore rminimum = iminimum minus Eπ = 0 minus Eπ
bull Therefore rminimum = minus Eπ
bull For example if Eπ = minus3 then rminimum = minus Eπ = 3
IS
Y
rLM
r1
Y1
21
The Zero Lower Bound on Nominal Interest Rates
bull For example in the diagram the central bank will have to reduce the real interest rate to r = 21 in order to end the recession
bull But suppose expected inflation is Eπ = minus 3
bull Then the nominal interest rate would have to be brought down to i = r + Eπ = 21 ndash 30 = ndash 09
bull Which alas is impossible
IS
Y
rLM
r1
Y1
21
This example also shows how dangerous it can be if we have deflation and people begin to expect the deflation to continue
The Zero Lower Bound on Nominal Interest Rates
bull 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 bendash at the zero lower bound orndash in a liquidity trap
bull See page 350 of the textbook
The Zero Lower Bound on Nominal Interest Rates Solutions
bull When an economy is in a liquidity trap monetary policy cannot be used to reduce interest rates any further
bull But is there nothing else that can be done to bring the economy back to life
bull Yes there isbull Expansionary fiscal policy can be usedbull And therersquos 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
bull In my example ndash the central bank needs to reduce
the real interest rate to r = 21 to end the recession
ndash But expected inflation is Eπ = minus 3 ndash So the nominal interest rate would
have to be brought down to i = ndash 09 which alas is impossible
bull Recall that the LM curve shifts right if either M or Eπ increases
bull If the central bank promises to be irresponsible and to create rapid inflation in the future and if people believe its promise then Eπ will increase say from minus 3 to +1
bull Then the nominal interest rate required for full-employment will be i = r + Eπ = 21 + 10 = 31 which is definitely attainable
IS
Y
rLM
r1
Y1
21
The zero-lower-bound problem can be solved if the central bank can credibly promise to be irresponsible
The Zero Lower Bound on Nominal Interest Rates Solutions
bull Although this chapter assumes a closed economy in reality foreign trade does matter
bull So the central bank can ndash print domestic currency and ndash use it to buy foreign currency ndash thereby making the domestic currency cheaper
relative to the foreign currencyndash thereby stimulating exportsndash thereby ending the recession
The Zero Lower Bound on Nominal Interest Rates Solutions
bull 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
bull This would reduce long-term interest rates directly thereby stimulating spending by the borrowers
bull This strategymdashcalled quantitative easingmdashmay also end a recession
Interaction between monetary and fiscal policy
bull IS-LM Model Monetary and fiscal policy variables (M G and T ) are exogenous
bull Real world Monetary policymakers may adjust M in response to changes in fiscal policy or vice versa
bull Such responses by the central bank may affect the effectiveness of fiscal policy
The Fedrsquos response to G gt 0
bull Suppose the government increases Gbull Possible Fed responses
1 hold M constant2 hold r constant3 hold Y constant
bull In each case the effects of G on Yare differenthellip
When G increases the IS curve shifts right
IS1
Response 1 Hold M constant
Y
rLM
r1
Y1
IS2
Y2
r2
If Fed holds M constant then LM curve does not shift
As a result interest rates rise This has a crowding-out effect Consequently GDP increases but not a lot
If Congress raises G the IS curve shifts right
IS1
Response 2 Hold r constant
Y
rLM1
r1
Y1
IS2
Y2
r2
To keep r constant Fed increases M to shift LM curve right
3 1Y Y Y
0r
LM2
Y3
Results
IS1
Response 3 Hold Y constant
Y
rLM1
r1
IS2
Y2
r2
To keep Y constant Fed reduces M to shift LM curve left
0Y
3 1r r r
LM2
Results
Y1
r3
If Congress raises G the IS curve shifts right
At this point you should be able to do problem 7 on page 353 of the textbook Please try it
Estimates of fiscal policy multipliersfrom the DRI macroeconometric model
Assumption about monetary policy
Estimated value of Y G
Fed holds nominal interest rate constant
Fed holds money supply constant
193
060
Estimated value of Y T
119
026
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 amp services
Examples ndash stock market boom or crash
change in householdsrsquo wealth C
ndash change in business or consumer confidence or expectations I andor C
Shocks in the IS -LM model
LM shocks exogenous changes in the demand for money
Examplesndash a wave of credit card fraud increases demand
for moneyndash 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 of1 a boom in the stock market that makes consumers
wealthier2 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 rb determine what happens to C I and the
unemployment rate
CASE STUDY
THE US RECESSION OF 2001
The US Recession of 2001
bull 39 on 900bull 49 on 801bull 63 on 603bull 50 on 705
The US Recession of 2001
bull Growth of GDP was negative in the 1st and 3rd quarters of 2001
bull Thatrsquos essentially before 911
Recall IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
The US Recession of 2001bull Whybull Demand shocks moved the IS
curve leftndash The ldquotech bubblerdquo ended and
stocks fell 25 between 800 and 801
ndash 911 attacks led to a 12 fall in stock prices in one week and a huge rise in uncertainty
ndash Scandals at Enron WorldCom and other corporations led to stock price declines and a decline in trust and a rise in uncertainty
ndash Lower household wealth reduced Co and higher uncertainty reduced Io
IS
Y
rLM
r1
Y1
CASE STUDY
The US recession of 2001Causes 1) Stock market decline C
300
600
900
1200
1500
1995 1996 1997 1998 1999 2000 2001 2002 2003
Ind
ex
(19
42
= 1
00
) Standard amp Poorrsquos 500
The US Recession of 2001bull Fiscal stimulus moved IS curve
rightndash Major tax cuts were enacted in
2001 and 2003ndash Government spending was
boostedbull to rebuild NYC andbull to bail out the airline industry
bull Fed printed money and moved LM curve rightndash Interest rate on 3-month
Treasury bills fellbull 64 in 1100bull 33 in 801bull 09 in 703
IS1
Y
rLM1
r1
Y1
IS2
LM2
Y3
All three toolsmdashG T and Mmdashwere used
CASE STUDY
The US recession of 2001bull Monetary policy response shifted LM curve right
Three-month T-Bill Rate
Three-month T-Bill Rate
0
1
2
3
4
5
6
7
010
120
0004
02
2000
070
320
0010
03
2000
010
320
0104
05
2001
070
620
0110
06
2001
010
620
0204
08
2002
070
920
0210
09
2002
010
920
0304
11
2003
Skip
bull I am skipping section 11-2
THE GREAT DEPRESSION
The Great Depression
Unemployment (right scale)
Real GNP(left scale)
120
140
160
180
200
220
240
1929 1931 1933 1935 1937 1939
billi
ons
of 1
958
dolla
rs
0
5
10
15
20
25
30
perc
ent o
f lab
or fo
rce
THE SPENDING HYPOTHESIS
Shocks to the IS curvebull asserts that the
Depression was largely due to an exogenous fall in the demand for goods and services ndash a leftward shift of the IS curve
bull evidence output and interest rates both fell in early 1930s which is what a leftward IS shift would cause
IS
Y
rLM
r1
Y1
THE SPENDING HYPOTHESIS
Reasons for the IS shiftbull Stock market crash exogenous C
ndash Oct-Dec 1929 SampP 500 fell 17ndash Oct 1929-Dec 1933 SampP 500 fell 71
bull Drop in investmentndash ldquocorrectionrdquo after overbuilding in the 1920sndash widespread bank failures in early 1930s made it harder
to obtain financing for investmentbull Contractionary fiscal policy
ndash Politicians raised tax rates in 1932 and cut spending to combat increasing deficits
THE MONEY HYPOTHESIS
A shock to the LM curvebull asserts that the Depression was largely due to
huge fall in the money supplybull evidence M1 fell 25 during 1929-33 bull But two problems with this hypothesis
ndash P fell even more so MP actually rose slightly during 1929-31
ndash nominal interest rates fell which is the opposite of what a leftward LM shift would cause
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull asserts that the severity of the Depression
was due to a huge deflation ndash P fell 25 during 1929-33
bull This deflation was probably caused by the fall in M so perhaps money played an important role after all
bull In what ways does a deflation affect the economy
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The stabilizing effects of deflationbull P (MP ) LM shifts right Ybull Pigou effect
P (MP )
consumersrsquo wealth
C
IS shifts right
Y
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects
of expected deflation E
bull LM curve shifts leftr and I (r ) planned expenditure income and output
bull Also the nominal interest rate decreases (idarr) ndash see IS-LM predictions grid
IS
Y
rLM
r1
Y1
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects of unexpected deflation
debt-deflation theoryP (if unexpected)
transfers purchasing power from borrowers to lenders
borrowers spend less lenders spend more if borrowersrsquo propensity to spend is larger than
lendersrsquo then aggregate spending falls the IS curve shifts left and Y falls
The evidence on output and nominal interest rates
bull Note that other than the money hypothesis all the other hypothesesmdashthe spending hypothesis the debt-deflation hypothesis and the deflationary expectations hypothesismdashpredict falling real GDP and falling nominal interest rates
bull This is exactly what happened in the early stages of the Great Depression
bull The spending hypothesis and the debt-deflation hypothesis both predict falling real interest rates whereas the deflationary expectations hypothesis predicts rising real interest rates
bull Therefore evidence on real interest rates is crucial in identifying suitable explanations for the Great Depression
Why another Depression is unlikelybull Policymakers (or their advisors) now know much more
about macroeconomicsndash The Fed knows better than to let M fall so much
especially during a contractionndash Fiscal policymakers know better than to raise
taxes or cut spending during a contractionbull Federal deposit insurance makes widespread bank
failures very unlikely
bull Automatic stabilizers make fiscal policy expansionary during an economic downturn
THE FINANCIAL CRISIS AND ECONOMIC DOWNTURN OF 2008 AND 2009
CASE STUDYThe 2008-09 Financial Crisis amp Recession
bull 2009 Real GDP fell unemployment rate approached 10
bull Important factors in the crisisndash early 2000s Federal Reserve interest rate policy ndash sub-prime mortgage crisisndash bursting of house price bubble rising foreclosure
ratesndash falling stock pricesndash failing financial institutionsndash declining consumer confidence drop in spending on
consumer durables and investment goods
A Too-Brief and Too-Simple Explanation
bull The price of housing had risen to unsustainable levels
bull When home prices inevitably crashed people suddenly felt poor and cut back their spending plans
bull This fall in planned expenditure brought about the Great Recession of 2008-09
The Housing Bubble Inflates then Deflates
bull The SampP Case-Shiller 20-City Home Price Index went from ndash 100 in Jan 2000 tondash 20654 in April 2006 tondash 14095 in May 2009 tondash 14216 in Dec 2010
bull Why did the housing bubble inflate
The Housing Bubble Reasons
bull The Fed kept the interest rates too low for too long
bull Securitization technology got a lot fancier in the mortgage bond market
bull The government regulators were sleepingbull Pretty much everybody believed that home
prices could never fall
The Housing Bubble Low FFR
bull The Fed had reduced the Federal Funds Rate to fight the Recession of 2001
bull After that recession ended the Fed continued to keep interest rates low until 2004ndash The Fed was watching inflation which remained
tame Consequently the Fed saw little reason to raise interest rates
ndash The Fed did not believe that housing prices had formed a bubble hellip until it was blindingly obvious
The Housing Bubble Securitization
bull In the past people with money did not like to lend money to home buyers because such loans were risky and had unreliable returns
bull 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
bull The financial sector was regulated by people who were ideologically opposed to regulation
bull They turned a blind eye to even the worst lending practices
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
The LM curve represents money market equilibrium
Equilibrium in the IS -LM model
The IS curve represents equilibrium in the goods market
( ) ( )Y C Y T I r G
IS
Y
rLM
r1
Y1
YPErLM )(
Shifts of the IS curve
bull Recall from Chapter 11 that ndash the consumption function is
C(Y ndash T) = Co + Cy ( Y ndash T) and
ndash The investment function is I(r) = Io ndash Ir r
bull Recall also that the IS curve shifts right if there isndash an increase in Co + Io + G orndash a decrease in T
bull As a result both Y and r increase
IS
Y
rLM
r1
Y1
Shifts of the IS curve
bull Similarly the IS curve shifts left if there isndash a decrease in Co + Io + G
orndash an increase in T
bull As a result both Y and r decrease
IS
Y
rLM
r1
Y1
Shifts of the IS curve
bull In other words we can make the following predictions
IS
Y
rLM
r1
Y1
IS-LM Predictions
Y r
Co + Io + G + +
T minus minus
Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
rC
IT
C
CGIC
CY
y
r
y
yoo
y
11
)(1
1
TC
CGIC
CY
y
yoo
y
1
)(1
1Keynesian Cross
IS Curve
In the Keynesian Cross model expansionary fiscal policy boosts GDP by an amount dictated by the multipliers
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)
KC Spending Multiplier KC Tax-Cut Multiplier
Fiscal Policy is Weakened by the Crowding-Out Effect
bull We have just seen that in the IS-LM model expansionary fiscal policy (Guarr or Tdarr) ndash leads to higher interest rates whichndash exerts downward pressure on investment spending whichndash exerts downward pressure on GDP and jobs
bull This negative aspect of expansionary fiscal policy is called the crowding-out effect
bull This effect was absent in the Keynesian Cross modelbull Thus fiscal policy is less effective in the IS-LM model
than in the Keynesian Cross model
causing GDP to rise
IS1
An increase in government purchases graph
1 IS curve shifts right
Y
rLM
r1
Y1
1by
1 MPCG
IS2
Y2
r2
12 This raises money
demand causing the interest rate to risehellip
2
3 hellipwhich reduces investment so the final increase in Y
1is smaller than
1 MPCG
3
IS1
1
A tax cut
Y
rLM
r1
Y1
IS2
Y2
r2
Consumers save (1MPC) of the tax cut so the initial boost in spending is smaller for T than for an equal Ghellip
and the IS curve shifts by
MPC
1 MPCT
1
2
2hellipso the effects on r and Y are smaller for T than for an equal G
2
Shifts of the LM curve
IS
Y
rLM
r1
Y1
Shifts of the LM curve
bull Similarly the LM curve shifts left if there isndash a decrease in MP or Eπ
orndash an increase in Lo
bull As a result Y decreases and r increases
IS
Y
rLM
r1
Y1
Shifts of the LM curve
Shifts of the LM curve
bull Recall from Ch 11 that if expected inflation (Eπ) increases (decreases) the LM curve shifts down (up) by the exact same amount
bull Therefore if Eπ decreases r will increase but by a smaller amount
bull Therefore i = r + Eπ will decrease
IS
Y
rLM
r1
Y1
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
At this point you should be able to do problems 1 2 3 (a) ndash (f) 4 and 5 on pages 352 ndash 353 of the textbook Please try them
Monetary Policy
bull The practice of changing the quantity of money (M) in order to affect the macroeconomic outcome is called monetary policyndash an increase in the quantity of money (Muarr) is
called expansionary monetary policy andndash A decrease in the quantity of money (Mdarr) is
called contractionary monetary policy
Shifts of the LM curvebull When the central bank of a
country makes changes to the quantity of money (M)ndash only the LM curve changes
and ndash the real interest rate (r)
changes in the opposite direction
ndash As expected inflation (Eπ) is assumed exogenous in the IS-LM model when the real interest rate (r) changes the nominal interest rate (i = r + Eπ) changes in the same direction
IS
Y
rLM
r1
Y1
Shifts of the LM curve
bull One can think of the central bank as ndash targeting M and
affecting r and i in the process or as
ndash targeting r andor i and adjusting M to achieve the target
IS
Y
rLM
r1
Y1
Monetary Policy Re-defined
bull Therefore one can re-define expansionary and contractionary monetary policy as followsndash Monetary policy is expansionary when the central
bank attempts to reduce interest rates (real and nominal) and
ndash Monetary policy is contractionary when the central bank attempts to increase the interest rates (real and nominal)
The Federal Funds Rate
bull 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
bull 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
bull The Federal Funds Rate is the interest rate that banks charge each other for overnight loans
bull If the Fed wishes the FFR to be 18 all it has to do is to announce that ndash it will lend money to any bank at 18 interest
andndash will pay 18 interest on deposits received from
any bank
The Federal Funds Ratebull 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 followsndash Monetary policy is expansionary when the Fed seeks
to reduce the federal funds rate andndash Monetary policy is contractionary when the Fed
seeks to increase the federal funds ratebull 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
bull We have seen that when faced with a recession the central bank can ndash Increase the money supply
(Muarr)ndash Thereby shifting the LM
curve rightndash Thereby reducing the real
interest rate (r = i minus Eπ darr) and the nominal interest rate (i = r + Eπdarr) and increasing GDP (Yuarr) to drag the economy out of the recession
IS
Y
rLM
r1
Y1
The Zero Lower Bound on Nominal Interest Rates
bull The problem is that there is a limit to how low the nominal interest rate can be
bull Nominal interest rates (such as the federal funds rate) cannot be negative
bull To deal with the 2008 economic crisis the Fed reduced the FFR to zero
bull But the recession persistedbull Unfortunately the Fed could
not reduce interest rates below zero monetary policy had reached its limit
IS
Y
rLM
r1
Y1
The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
The Zero Lower Bound on Nominal Interest Rates
bull r = i minus Eπbull iminimum = 0
bull Therefore rminimum = iminimum minus Eπ = 0 minus Eπ
bull Therefore rminimum = minus Eπ
bull For example if Eπ = minus3 then rminimum = minus Eπ = 3
IS
Y
rLM
r1
Y1
21
The Zero Lower Bound on Nominal Interest Rates
bull For example in the diagram the central bank will have to reduce the real interest rate to r = 21 in order to end the recession
bull But suppose expected inflation is Eπ = minus 3
bull Then the nominal interest rate would have to be brought down to i = r + Eπ = 21 ndash 30 = ndash 09
bull Which alas is impossible
IS
Y
rLM
r1
Y1
21
This example also shows how dangerous it can be if we have deflation and people begin to expect the deflation to continue
The Zero Lower Bound on Nominal Interest Rates
bull 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 bendash at the zero lower bound orndash in a liquidity trap
bull See page 350 of the textbook
The Zero Lower Bound on Nominal Interest Rates Solutions
bull When an economy is in a liquidity trap monetary policy cannot be used to reduce interest rates any further
bull But is there nothing else that can be done to bring the economy back to life
bull Yes there isbull Expansionary fiscal policy can be usedbull And therersquos 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
bull In my example ndash the central bank needs to reduce
the real interest rate to r = 21 to end the recession
ndash But expected inflation is Eπ = minus 3 ndash So the nominal interest rate would
have to be brought down to i = ndash 09 which alas is impossible
bull Recall that the LM curve shifts right if either M or Eπ increases
bull If the central bank promises to be irresponsible and to create rapid inflation in the future and if people believe its promise then Eπ will increase say from minus 3 to +1
bull Then the nominal interest rate required for full-employment will be i = r + Eπ = 21 + 10 = 31 which is definitely attainable
IS
Y
rLM
r1
Y1
21
The zero-lower-bound problem can be solved if the central bank can credibly promise to be irresponsible
The Zero Lower Bound on Nominal Interest Rates Solutions
bull Although this chapter assumes a closed economy in reality foreign trade does matter
bull So the central bank can ndash print domestic currency and ndash use it to buy foreign currency ndash thereby making the domestic currency cheaper
relative to the foreign currencyndash thereby stimulating exportsndash thereby ending the recession
The Zero Lower Bound on Nominal Interest Rates Solutions
bull 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
bull This would reduce long-term interest rates directly thereby stimulating spending by the borrowers
bull This strategymdashcalled quantitative easingmdashmay also end a recession
Interaction between monetary and fiscal policy
bull IS-LM Model Monetary and fiscal policy variables (M G and T ) are exogenous
bull Real world Monetary policymakers may adjust M in response to changes in fiscal policy or vice versa
bull Such responses by the central bank may affect the effectiveness of fiscal policy
The Fedrsquos response to G gt 0
bull Suppose the government increases Gbull Possible Fed responses
1 hold M constant2 hold r constant3 hold Y constant
bull In each case the effects of G on Yare differenthellip
When G increases the IS curve shifts right
IS1
Response 1 Hold M constant
Y
rLM
r1
Y1
IS2
Y2
r2
If Fed holds M constant then LM curve does not shift
As a result interest rates rise This has a crowding-out effect Consequently GDP increases but not a lot
If Congress raises G the IS curve shifts right
IS1
Response 2 Hold r constant
Y
rLM1
r1
Y1
IS2
Y2
r2
To keep r constant Fed increases M to shift LM curve right
3 1Y Y Y
0r
LM2
Y3
Results
IS1
Response 3 Hold Y constant
Y
rLM1
r1
IS2
Y2
r2
To keep Y constant Fed reduces M to shift LM curve left
0Y
3 1r r r
LM2
Results
Y1
r3
If Congress raises G the IS curve shifts right
At this point you should be able to do problem 7 on page 353 of the textbook Please try it
Estimates of fiscal policy multipliersfrom the DRI macroeconometric model
Assumption about monetary policy
Estimated value of Y G
Fed holds nominal interest rate constant
Fed holds money supply constant
193
060
Estimated value of Y T
119
026
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 amp services
Examples ndash stock market boom or crash
change in householdsrsquo wealth C
ndash change in business or consumer confidence or expectations I andor C
Shocks in the IS -LM model
LM shocks exogenous changes in the demand for money
Examplesndash a wave of credit card fraud increases demand
for moneyndash 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 of1 a boom in the stock market that makes consumers
wealthier2 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 rb determine what happens to C I and the
unemployment rate
CASE STUDY
THE US RECESSION OF 2001
The US Recession of 2001
bull 39 on 900bull 49 on 801bull 63 on 603bull 50 on 705
The US Recession of 2001
bull Growth of GDP was negative in the 1st and 3rd quarters of 2001
bull Thatrsquos essentially before 911
Recall IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
The US Recession of 2001bull Whybull Demand shocks moved the IS
curve leftndash The ldquotech bubblerdquo ended and
stocks fell 25 between 800 and 801
ndash 911 attacks led to a 12 fall in stock prices in one week and a huge rise in uncertainty
ndash Scandals at Enron WorldCom and other corporations led to stock price declines and a decline in trust and a rise in uncertainty
ndash Lower household wealth reduced Co and higher uncertainty reduced Io
IS
Y
rLM
r1
Y1
CASE STUDY
The US recession of 2001Causes 1) Stock market decline C
300
600
900
1200
1500
1995 1996 1997 1998 1999 2000 2001 2002 2003
Ind
ex
(19
42
= 1
00
) Standard amp Poorrsquos 500
The US Recession of 2001bull Fiscal stimulus moved IS curve
rightndash Major tax cuts were enacted in
2001 and 2003ndash Government spending was
boostedbull to rebuild NYC andbull to bail out the airline industry
bull Fed printed money and moved LM curve rightndash Interest rate on 3-month
Treasury bills fellbull 64 in 1100bull 33 in 801bull 09 in 703
IS1
Y
rLM1
r1
Y1
IS2
LM2
Y3
All three toolsmdashG T and Mmdashwere used
CASE STUDY
The US recession of 2001bull Monetary policy response shifted LM curve right
Three-month T-Bill Rate
Three-month T-Bill Rate
0
1
2
3
4
5
6
7
010
120
0004
02
2000
070
320
0010
03
2000
010
320
0104
05
2001
070
620
0110
06
2001
010
620
0204
08
2002
070
920
0210
09
2002
010
920
0304
11
2003
Skip
bull I am skipping section 11-2
THE GREAT DEPRESSION
The Great Depression
Unemployment (right scale)
Real GNP(left scale)
120
140
160
180
200
220
240
1929 1931 1933 1935 1937 1939
billi
ons
of 1
958
dolla
rs
0
5
10
15
20
25
30
perc
ent o
f lab
or fo
rce
THE SPENDING HYPOTHESIS
Shocks to the IS curvebull asserts that the
Depression was largely due to an exogenous fall in the demand for goods and services ndash a leftward shift of the IS curve
bull evidence output and interest rates both fell in early 1930s which is what a leftward IS shift would cause
IS
Y
rLM
r1
Y1
THE SPENDING HYPOTHESIS
Reasons for the IS shiftbull Stock market crash exogenous C
ndash Oct-Dec 1929 SampP 500 fell 17ndash Oct 1929-Dec 1933 SampP 500 fell 71
bull Drop in investmentndash ldquocorrectionrdquo after overbuilding in the 1920sndash widespread bank failures in early 1930s made it harder
to obtain financing for investmentbull Contractionary fiscal policy
ndash Politicians raised tax rates in 1932 and cut spending to combat increasing deficits
THE MONEY HYPOTHESIS
A shock to the LM curvebull asserts that the Depression was largely due to
huge fall in the money supplybull evidence M1 fell 25 during 1929-33 bull But two problems with this hypothesis
ndash P fell even more so MP actually rose slightly during 1929-31
ndash nominal interest rates fell which is the opposite of what a leftward LM shift would cause
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull asserts that the severity of the Depression
was due to a huge deflation ndash P fell 25 during 1929-33
bull This deflation was probably caused by the fall in M so perhaps money played an important role after all
bull In what ways does a deflation affect the economy
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The stabilizing effects of deflationbull P (MP ) LM shifts right Ybull Pigou effect
P (MP )
consumersrsquo wealth
C
IS shifts right
Y
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects
of expected deflation E
bull LM curve shifts leftr and I (r ) planned expenditure income and output
bull Also the nominal interest rate decreases (idarr) ndash see IS-LM predictions grid
IS
Y
rLM
r1
Y1
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects of unexpected deflation
debt-deflation theoryP (if unexpected)
transfers purchasing power from borrowers to lenders
borrowers spend less lenders spend more if borrowersrsquo propensity to spend is larger than
lendersrsquo then aggregate spending falls the IS curve shifts left and Y falls
The evidence on output and nominal interest rates
bull Note that other than the money hypothesis all the other hypothesesmdashthe spending hypothesis the debt-deflation hypothesis and the deflationary expectations hypothesismdashpredict falling real GDP and falling nominal interest rates
bull This is exactly what happened in the early stages of the Great Depression
bull The spending hypothesis and the debt-deflation hypothesis both predict falling real interest rates whereas the deflationary expectations hypothesis predicts rising real interest rates
bull Therefore evidence on real interest rates is crucial in identifying suitable explanations for the Great Depression
Why another Depression is unlikelybull Policymakers (or their advisors) now know much more
about macroeconomicsndash The Fed knows better than to let M fall so much
especially during a contractionndash Fiscal policymakers know better than to raise
taxes or cut spending during a contractionbull Federal deposit insurance makes widespread bank
failures very unlikely
bull Automatic stabilizers make fiscal policy expansionary during an economic downturn
THE FINANCIAL CRISIS AND ECONOMIC DOWNTURN OF 2008 AND 2009
CASE STUDYThe 2008-09 Financial Crisis amp Recession
bull 2009 Real GDP fell unemployment rate approached 10
bull Important factors in the crisisndash early 2000s Federal Reserve interest rate policy ndash sub-prime mortgage crisisndash bursting of house price bubble rising foreclosure
ratesndash falling stock pricesndash failing financial institutionsndash declining consumer confidence drop in spending on
consumer durables and investment goods
A Too-Brief and Too-Simple Explanation
bull The price of housing had risen to unsustainable levels
bull When home prices inevitably crashed people suddenly felt poor and cut back their spending plans
bull This fall in planned expenditure brought about the Great Recession of 2008-09
The Housing Bubble Inflates then Deflates
bull The SampP Case-Shiller 20-City Home Price Index went from ndash 100 in Jan 2000 tondash 20654 in April 2006 tondash 14095 in May 2009 tondash 14216 in Dec 2010
bull Why did the housing bubble inflate
The Housing Bubble Reasons
bull The Fed kept the interest rates too low for too long
bull Securitization technology got a lot fancier in the mortgage bond market
bull The government regulators were sleepingbull Pretty much everybody believed that home
prices could never fall
The Housing Bubble Low FFR
bull The Fed had reduced the Federal Funds Rate to fight the Recession of 2001
bull After that recession ended the Fed continued to keep interest rates low until 2004ndash The Fed was watching inflation which remained
tame Consequently the Fed saw little reason to raise interest rates
ndash The Fed did not believe that housing prices had formed a bubble hellip until it was blindingly obvious
The Housing Bubble Securitization
bull In the past people with money did not like to lend money to home buyers because such loans were risky and had unreliable returns
bull 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
bull The financial sector was regulated by people who were ideologically opposed to regulation
bull They turned a blind eye to even the worst lending practices
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
Shifts of the IS curve
bull Recall from Chapter 11 that ndash the consumption function is
C(Y ndash T) = Co + Cy ( Y ndash T) and
ndash The investment function is I(r) = Io ndash Ir r
bull Recall also that the IS curve shifts right if there isndash an increase in Co + Io + G orndash a decrease in T
bull As a result both Y and r increase
IS
Y
rLM
r1
Y1
Shifts of the IS curve
bull Similarly the IS curve shifts left if there isndash a decrease in Co + Io + G
orndash an increase in T
bull As a result both Y and r decrease
IS
Y
rLM
r1
Y1
Shifts of the IS curve
bull In other words we can make the following predictions
IS
Y
rLM
r1
Y1
IS-LM Predictions
Y r
Co + Io + G + +
T minus minus
Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
rC
IT
C
CGIC
CY
y
r
y
yoo
y
11
)(1
1
TC
CGIC
CY
y
yoo
y
1
)(1
1Keynesian Cross
IS Curve
In the Keynesian Cross model expansionary fiscal policy boosts GDP by an amount dictated by the multipliers
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)
KC Spending Multiplier KC Tax-Cut Multiplier
Fiscal Policy is Weakened by the Crowding-Out Effect
bull We have just seen that in the IS-LM model expansionary fiscal policy (Guarr or Tdarr) ndash leads to higher interest rates whichndash exerts downward pressure on investment spending whichndash exerts downward pressure on GDP and jobs
bull This negative aspect of expansionary fiscal policy is called the crowding-out effect
bull This effect was absent in the Keynesian Cross modelbull Thus fiscal policy is less effective in the IS-LM model
than in the Keynesian Cross model
causing GDP to rise
IS1
An increase in government purchases graph
1 IS curve shifts right
Y
rLM
r1
Y1
1by
1 MPCG
IS2
Y2
r2
12 This raises money
demand causing the interest rate to risehellip
2
3 hellipwhich reduces investment so the final increase in Y
1is smaller than
1 MPCG
3
IS1
1
A tax cut
Y
rLM
r1
Y1
IS2
Y2
r2
Consumers save (1MPC) of the tax cut so the initial boost in spending is smaller for T than for an equal Ghellip
and the IS curve shifts by
MPC
1 MPCT
1
2
2hellipso the effects on r and Y are smaller for T than for an equal G
2
Shifts of the LM curve
IS
Y
rLM
r1
Y1
Shifts of the LM curve
bull Similarly the LM curve shifts left if there isndash a decrease in MP or Eπ
orndash an increase in Lo
bull As a result Y decreases and r increases
IS
Y
rLM
r1
Y1
Shifts of the LM curve
Shifts of the LM curve
bull Recall from Ch 11 that if expected inflation (Eπ) increases (decreases) the LM curve shifts down (up) by the exact same amount
bull Therefore if Eπ decreases r will increase but by a smaller amount
bull Therefore i = r + Eπ will decrease
IS
Y
rLM
r1
Y1
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
At this point you should be able to do problems 1 2 3 (a) ndash (f) 4 and 5 on pages 352 ndash 353 of the textbook Please try them
Monetary Policy
bull The practice of changing the quantity of money (M) in order to affect the macroeconomic outcome is called monetary policyndash an increase in the quantity of money (Muarr) is
called expansionary monetary policy andndash A decrease in the quantity of money (Mdarr) is
called contractionary monetary policy
Shifts of the LM curvebull When the central bank of a
country makes changes to the quantity of money (M)ndash only the LM curve changes
and ndash the real interest rate (r)
changes in the opposite direction
ndash As expected inflation (Eπ) is assumed exogenous in the IS-LM model when the real interest rate (r) changes the nominal interest rate (i = r + Eπ) changes in the same direction
IS
Y
rLM
r1
Y1
Shifts of the LM curve
bull One can think of the central bank as ndash targeting M and
affecting r and i in the process or as
ndash targeting r andor i and adjusting M to achieve the target
IS
Y
rLM
r1
Y1
Monetary Policy Re-defined
bull Therefore one can re-define expansionary and contractionary monetary policy as followsndash Monetary policy is expansionary when the central
bank attempts to reduce interest rates (real and nominal) and
ndash Monetary policy is contractionary when the central bank attempts to increase the interest rates (real and nominal)
The Federal Funds Rate
bull 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
bull 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
bull The Federal Funds Rate is the interest rate that banks charge each other for overnight loans
bull If the Fed wishes the FFR to be 18 all it has to do is to announce that ndash it will lend money to any bank at 18 interest
andndash will pay 18 interest on deposits received from
any bank
The Federal Funds Ratebull 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 followsndash Monetary policy is expansionary when the Fed seeks
to reduce the federal funds rate andndash Monetary policy is contractionary when the Fed
seeks to increase the federal funds ratebull 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
bull We have seen that when faced with a recession the central bank can ndash Increase the money supply
(Muarr)ndash Thereby shifting the LM
curve rightndash Thereby reducing the real
interest rate (r = i minus Eπ darr) and the nominal interest rate (i = r + Eπdarr) and increasing GDP (Yuarr) to drag the economy out of the recession
IS
Y
rLM
r1
Y1
The Zero Lower Bound on Nominal Interest Rates
bull The problem is that there is a limit to how low the nominal interest rate can be
bull Nominal interest rates (such as the federal funds rate) cannot be negative
bull To deal with the 2008 economic crisis the Fed reduced the FFR to zero
bull But the recession persistedbull Unfortunately the Fed could
not reduce interest rates below zero monetary policy had reached its limit
IS
Y
rLM
r1
Y1
The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
The Zero Lower Bound on Nominal Interest Rates
bull r = i minus Eπbull iminimum = 0
bull Therefore rminimum = iminimum minus Eπ = 0 minus Eπ
bull Therefore rminimum = minus Eπ
bull For example if Eπ = minus3 then rminimum = minus Eπ = 3
IS
Y
rLM
r1
Y1
21
The Zero Lower Bound on Nominal Interest Rates
bull For example in the diagram the central bank will have to reduce the real interest rate to r = 21 in order to end the recession
bull But suppose expected inflation is Eπ = minus 3
bull Then the nominal interest rate would have to be brought down to i = r + Eπ = 21 ndash 30 = ndash 09
bull Which alas is impossible
IS
Y
rLM
r1
Y1
21
This example also shows how dangerous it can be if we have deflation and people begin to expect the deflation to continue
The Zero Lower Bound on Nominal Interest Rates
bull 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 bendash at the zero lower bound orndash in a liquidity trap
bull See page 350 of the textbook
The Zero Lower Bound on Nominal Interest Rates Solutions
bull When an economy is in a liquidity trap monetary policy cannot be used to reduce interest rates any further
bull But is there nothing else that can be done to bring the economy back to life
bull Yes there isbull Expansionary fiscal policy can be usedbull And therersquos 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
bull In my example ndash the central bank needs to reduce
the real interest rate to r = 21 to end the recession
ndash But expected inflation is Eπ = minus 3 ndash So the nominal interest rate would
have to be brought down to i = ndash 09 which alas is impossible
bull Recall that the LM curve shifts right if either M or Eπ increases
bull If the central bank promises to be irresponsible and to create rapid inflation in the future and if people believe its promise then Eπ will increase say from minus 3 to +1
bull Then the nominal interest rate required for full-employment will be i = r + Eπ = 21 + 10 = 31 which is definitely attainable
IS
Y
rLM
r1
Y1
21
The zero-lower-bound problem can be solved if the central bank can credibly promise to be irresponsible
The Zero Lower Bound on Nominal Interest Rates Solutions
bull Although this chapter assumes a closed economy in reality foreign trade does matter
bull So the central bank can ndash print domestic currency and ndash use it to buy foreign currency ndash thereby making the domestic currency cheaper
relative to the foreign currencyndash thereby stimulating exportsndash thereby ending the recession
The Zero Lower Bound on Nominal Interest Rates Solutions
bull 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
bull This would reduce long-term interest rates directly thereby stimulating spending by the borrowers
bull This strategymdashcalled quantitative easingmdashmay also end a recession
Interaction between monetary and fiscal policy
bull IS-LM Model Monetary and fiscal policy variables (M G and T ) are exogenous
bull Real world Monetary policymakers may adjust M in response to changes in fiscal policy or vice versa
bull Such responses by the central bank may affect the effectiveness of fiscal policy
The Fedrsquos response to G gt 0
bull Suppose the government increases Gbull Possible Fed responses
1 hold M constant2 hold r constant3 hold Y constant
bull In each case the effects of G on Yare differenthellip
When G increases the IS curve shifts right
IS1
Response 1 Hold M constant
Y
rLM
r1
Y1
IS2
Y2
r2
If Fed holds M constant then LM curve does not shift
As a result interest rates rise This has a crowding-out effect Consequently GDP increases but not a lot
If Congress raises G the IS curve shifts right
IS1
Response 2 Hold r constant
Y
rLM1
r1
Y1
IS2
Y2
r2
To keep r constant Fed increases M to shift LM curve right
3 1Y Y Y
0r
LM2
Y3
Results
IS1
Response 3 Hold Y constant
Y
rLM1
r1
IS2
Y2
r2
To keep Y constant Fed reduces M to shift LM curve left
0Y
3 1r r r
LM2
Results
Y1
r3
If Congress raises G the IS curve shifts right
At this point you should be able to do problem 7 on page 353 of the textbook Please try it
Estimates of fiscal policy multipliersfrom the DRI macroeconometric model
Assumption about monetary policy
Estimated value of Y G
Fed holds nominal interest rate constant
Fed holds money supply constant
193
060
Estimated value of Y T
119
026
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 amp services
Examples ndash stock market boom or crash
change in householdsrsquo wealth C
ndash change in business or consumer confidence or expectations I andor C
Shocks in the IS -LM model
LM shocks exogenous changes in the demand for money
Examplesndash a wave of credit card fraud increases demand
for moneyndash 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 of1 a boom in the stock market that makes consumers
wealthier2 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 rb determine what happens to C I and the
unemployment rate
CASE STUDY
THE US RECESSION OF 2001
The US Recession of 2001
bull 39 on 900bull 49 on 801bull 63 on 603bull 50 on 705
The US Recession of 2001
bull Growth of GDP was negative in the 1st and 3rd quarters of 2001
bull Thatrsquos essentially before 911
Recall IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
The US Recession of 2001bull Whybull Demand shocks moved the IS
curve leftndash The ldquotech bubblerdquo ended and
stocks fell 25 between 800 and 801
ndash 911 attacks led to a 12 fall in stock prices in one week and a huge rise in uncertainty
ndash Scandals at Enron WorldCom and other corporations led to stock price declines and a decline in trust and a rise in uncertainty
ndash Lower household wealth reduced Co and higher uncertainty reduced Io
IS
Y
rLM
r1
Y1
CASE STUDY
The US recession of 2001Causes 1) Stock market decline C
300
600
900
1200
1500
1995 1996 1997 1998 1999 2000 2001 2002 2003
Ind
ex
(19
42
= 1
00
) Standard amp Poorrsquos 500
The US Recession of 2001bull Fiscal stimulus moved IS curve
rightndash Major tax cuts were enacted in
2001 and 2003ndash Government spending was
boostedbull to rebuild NYC andbull to bail out the airline industry
bull Fed printed money and moved LM curve rightndash Interest rate on 3-month
Treasury bills fellbull 64 in 1100bull 33 in 801bull 09 in 703
IS1
Y
rLM1
r1
Y1
IS2
LM2
Y3
All three toolsmdashG T and Mmdashwere used
CASE STUDY
The US recession of 2001bull Monetary policy response shifted LM curve right
Three-month T-Bill Rate
Three-month T-Bill Rate
0
1
2
3
4
5
6
7
010
120
0004
02
2000
070
320
0010
03
2000
010
320
0104
05
2001
070
620
0110
06
2001
010
620
0204
08
2002
070
920
0210
09
2002
010
920
0304
11
2003
Skip
bull I am skipping section 11-2
THE GREAT DEPRESSION
The Great Depression
Unemployment (right scale)
Real GNP(left scale)
120
140
160
180
200
220
240
1929 1931 1933 1935 1937 1939
billi
ons
of 1
958
dolla
rs
0
5
10
15
20
25
30
perc
ent o
f lab
or fo
rce
THE SPENDING HYPOTHESIS
Shocks to the IS curvebull asserts that the
Depression was largely due to an exogenous fall in the demand for goods and services ndash a leftward shift of the IS curve
bull evidence output and interest rates both fell in early 1930s which is what a leftward IS shift would cause
IS
Y
rLM
r1
Y1
THE SPENDING HYPOTHESIS
Reasons for the IS shiftbull Stock market crash exogenous C
ndash Oct-Dec 1929 SampP 500 fell 17ndash Oct 1929-Dec 1933 SampP 500 fell 71
bull Drop in investmentndash ldquocorrectionrdquo after overbuilding in the 1920sndash widespread bank failures in early 1930s made it harder
to obtain financing for investmentbull Contractionary fiscal policy
ndash Politicians raised tax rates in 1932 and cut spending to combat increasing deficits
THE MONEY HYPOTHESIS
A shock to the LM curvebull asserts that the Depression was largely due to
huge fall in the money supplybull evidence M1 fell 25 during 1929-33 bull But two problems with this hypothesis
ndash P fell even more so MP actually rose slightly during 1929-31
ndash nominal interest rates fell which is the opposite of what a leftward LM shift would cause
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull asserts that the severity of the Depression
was due to a huge deflation ndash P fell 25 during 1929-33
bull This deflation was probably caused by the fall in M so perhaps money played an important role after all
bull In what ways does a deflation affect the economy
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The stabilizing effects of deflationbull P (MP ) LM shifts right Ybull Pigou effect
P (MP )
consumersrsquo wealth
C
IS shifts right
Y
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects
of expected deflation E
bull LM curve shifts leftr and I (r ) planned expenditure income and output
bull Also the nominal interest rate decreases (idarr) ndash see IS-LM predictions grid
IS
Y
rLM
r1
Y1
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects of unexpected deflation
debt-deflation theoryP (if unexpected)
transfers purchasing power from borrowers to lenders
borrowers spend less lenders spend more if borrowersrsquo propensity to spend is larger than
lendersrsquo then aggregate spending falls the IS curve shifts left and Y falls
The evidence on output and nominal interest rates
bull Note that other than the money hypothesis all the other hypothesesmdashthe spending hypothesis the debt-deflation hypothesis and the deflationary expectations hypothesismdashpredict falling real GDP and falling nominal interest rates
bull This is exactly what happened in the early stages of the Great Depression
bull The spending hypothesis and the debt-deflation hypothesis both predict falling real interest rates whereas the deflationary expectations hypothesis predicts rising real interest rates
bull Therefore evidence on real interest rates is crucial in identifying suitable explanations for the Great Depression
Why another Depression is unlikelybull Policymakers (or their advisors) now know much more
about macroeconomicsndash The Fed knows better than to let M fall so much
especially during a contractionndash Fiscal policymakers know better than to raise
taxes or cut spending during a contractionbull Federal deposit insurance makes widespread bank
failures very unlikely
bull Automatic stabilizers make fiscal policy expansionary during an economic downturn
THE FINANCIAL CRISIS AND ECONOMIC DOWNTURN OF 2008 AND 2009
CASE STUDYThe 2008-09 Financial Crisis amp Recession
bull 2009 Real GDP fell unemployment rate approached 10
bull Important factors in the crisisndash early 2000s Federal Reserve interest rate policy ndash sub-prime mortgage crisisndash bursting of house price bubble rising foreclosure
ratesndash falling stock pricesndash failing financial institutionsndash declining consumer confidence drop in spending on
consumer durables and investment goods
A Too-Brief and Too-Simple Explanation
bull The price of housing had risen to unsustainable levels
bull When home prices inevitably crashed people suddenly felt poor and cut back their spending plans
bull This fall in planned expenditure brought about the Great Recession of 2008-09
The Housing Bubble Inflates then Deflates
bull The SampP Case-Shiller 20-City Home Price Index went from ndash 100 in Jan 2000 tondash 20654 in April 2006 tondash 14095 in May 2009 tondash 14216 in Dec 2010
bull Why did the housing bubble inflate
The Housing Bubble Reasons
bull The Fed kept the interest rates too low for too long
bull Securitization technology got a lot fancier in the mortgage bond market
bull The government regulators were sleepingbull Pretty much everybody believed that home
prices could never fall
The Housing Bubble Low FFR
bull The Fed had reduced the Federal Funds Rate to fight the Recession of 2001
bull After that recession ended the Fed continued to keep interest rates low until 2004ndash The Fed was watching inflation which remained
tame Consequently the Fed saw little reason to raise interest rates
ndash The Fed did not believe that housing prices had formed a bubble hellip until it was blindingly obvious
The Housing Bubble Securitization
bull In the past people with money did not like to lend money to home buyers because such loans were risky and had unreliable returns
bull 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
bull The financial sector was regulated by people who were ideologically opposed to regulation
bull They turned a blind eye to even the worst lending practices
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
Shifts of the IS curve
bull Similarly the IS curve shifts left if there isndash a decrease in Co + Io + G
orndash an increase in T
bull As a result both Y and r decrease
IS
Y
rLM
r1
Y1
Shifts of the IS curve
bull In other words we can make the following predictions
IS
Y
rLM
r1
Y1
IS-LM Predictions
Y r
Co + Io + G + +
T minus minus
Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
rC
IT
C
CGIC
CY
y
r
y
yoo
y
11
)(1
1
TC
CGIC
CY
y
yoo
y
1
)(1
1Keynesian Cross
IS Curve
In the Keynesian Cross model expansionary fiscal policy boosts GDP by an amount dictated by the multipliers
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)
KC Spending Multiplier KC Tax-Cut Multiplier
Fiscal Policy is Weakened by the Crowding-Out Effect
bull We have just seen that in the IS-LM model expansionary fiscal policy (Guarr or Tdarr) ndash leads to higher interest rates whichndash exerts downward pressure on investment spending whichndash exerts downward pressure on GDP and jobs
bull This negative aspect of expansionary fiscal policy is called the crowding-out effect
bull This effect was absent in the Keynesian Cross modelbull Thus fiscal policy is less effective in the IS-LM model
than in the Keynesian Cross model
causing GDP to rise
IS1
An increase in government purchases graph
1 IS curve shifts right
Y
rLM
r1
Y1
1by
1 MPCG
IS2
Y2
r2
12 This raises money
demand causing the interest rate to risehellip
2
3 hellipwhich reduces investment so the final increase in Y
1is smaller than
1 MPCG
3
IS1
1
A tax cut
Y
rLM
r1
Y1
IS2
Y2
r2
Consumers save (1MPC) of the tax cut so the initial boost in spending is smaller for T than for an equal Ghellip
and the IS curve shifts by
MPC
1 MPCT
1
2
2hellipso the effects on r and Y are smaller for T than for an equal G
2
Shifts of the LM curve
IS
Y
rLM
r1
Y1
Shifts of the LM curve
bull Similarly the LM curve shifts left if there isndash a decrease in MP or Eπ
orndash an increase in Lo
bull As a result Y decreases and r increases
IS
Y
rLM
r1
Y1
Shifts of the LM curve
Shifts of the LM curve
bull Recall from Ch 11 that if expected inflation (Eπ) increases (decreases) the LM curve shifts down (up) by the exact same amount
bull Therefore if Eπ decreases r will increase but by a smaller amount
bull Therefore i = r + Eπ will decrease
IS
Y
rLM
r1
Y1
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
At this point you should be able to do problems 1 2 3 (a) ndash (f) 4 and 5 on pages 352 ndash 353 of the textbook Please try them
Monetary Policy
bull The practice of changing the quantity of money (M) in order to affect the macroeconomic outcome is called monetary policyndash an increase in the quantity of money (Muarr) is
called expansionary monetary policy andndash A decrease in the quantity of money (Mdarr) is
called contractionary monetary policy
Shifts of the LM curvebull When the central bank of a
country makes changes to the quantity of money (M)ndash only the LM curve changes
and ndash the real interest rate (r)
changes in the opposite direction
ndash As expected inflation (Eπ) is assumed exogenous in the IS-LM model when the real interest rate (r) changes the nominal interest rate (i = r + Eπ) changes in the same direction
IS
Y
rLM
r1
Y1
Shifts of the LM curve
bull One can think of the central bank as ndash targeting M and
affecting r and i in the process or as
ndash targeting r andor i and adjusting M to achieve the target
IS
Y
rLM
r1
Y1
Monetary Policy Re-defined
bull Therefore one can re-define expansionary and contractionary monetary policy as followsndash Monetary policy is expansionary when the central
bank attempts to reduce interest rates (real and nominal) and
ndash Monetary policy is contractionary when the central bank attempts to increase the interest rates (real and nominal)
The Federal Funds Rate
bull 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
bull 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
bull The Federal Funds Rate is the interest rate that banks charge each other for overnight loans
bull If the Fed wishes the FFR to be 18 all it has to do is to announce that ndash it will lend money to any bank at 18 interest
andndash will pay 18 interest on deposits received from
any bank
The Federal Funds Ratebull 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 followsndash Monetary policy is expansionary when the Fed seeks
to reduce the federal funds rate andndash Monetary policy is contractionary when the Fed
seeks to increase the federal funds ratebull 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
bull We have seen that when faced with a recession the central bank can ndash Increase the money supply
(Muarr)ndash Thereby shifting the LM
curve rightndash Thereby reducing the real
interest rate (r = i minus Eπ darr) and the nominal interest rate (i = r + Eπdarr) and increasing GDP (Yuarr) to drag the economy out of the recession
IS
Y
rLM
r1
Y1
The Zero Lower Bound on Nominal Interest Rates
bull The problem is that there is a limit to how low the nominal interest rate can be
bull Nominal interest rates (such as the federal funds rate) cannot be negative
bull To deal with the 2008 economic crisis the Fed reduced the FFR to zero
bull But the recession persistedbull Unfortunately the Fed could
not reduce interest rates below zero monetary policy had reached its limit
IS
Y
rLM
r1
Y1
The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
The Zero Lower Bound on Nominal Interest Rates
bull r = i minus Eπbull iminimum = 0
bull Therefore rminimum = iminimum minus Eπ = 0 minus Eπ
bull Therefore rminimum = minus Eπ
bull For example if Eπ = minus3 then rminimum = minus Eπ = 3
IS
Y
rLM
r1
Y1
21
The Zero Lower Bound on Nominal Interest Rates
bull For example in the diagram the central bank will have to reduce the real interest rate to r = 21 in order to end the recession
bull But suppose expected inflation is Eπ = minus 3
bull Then the nominal interest rate would have to be brought down to i = r + Eπ = 21 ndash 30 = ndash 09
bull Which alas is impossible
IS
Y
rLM
r1
Y1
21
This example also shows how dangerous it can be if we have deflation and people begin to expect the deflation to continue
The Zero Lower Bound on Nominal Interest Rates
bull 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 bendash at the zero lower bound orndash in a liquidity trap
bull See page 350 of the textbook
The Zero Lower Bound on Nominal Interest Rates Solutions
bull When an economy is in a liquidity trap monetary policy cannot be used to reduce interest rates any further
bull But is there nothing else that can be done to bring the economy back to life
bull Yes there isbull Expansionary fiscal policy can be usedbull And therersquos 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
bull In my example ndash the central bank needs to reduce
the real interest rate to r = 21 to end the recession
ndash But expected inflation is Eπ = minus 3 ndash So the nominal interest rate would
have to be brought down to i = ndash 09 which alas is impossible
bull Recall that the LM curve shifts right if either M or Eπ increases
bull If the central bank promises to be irresponsible and to create rapid inflation in the future and if people believe its promise then Eπ will increase say from minus 3 to +1
bull Then the nominal interest rate required for full-employment will be i = r + Eπ = 21 + 10 = 31 which is definitely attainable
IS
Y
rLM
r1
Y1
21
The zero-lower-bound problem can be solved if the central bank can credibly promise to be irresponsible
The Zero Lower Bound on Nominal Interest Rates Solutions
bull Although this chapter assumes a closed economy in reality foreign trade does matter
bull So the central bank can ndash print domestic currency and ndash use it to buy foreign currency ndash thereby making the domestic currency cheaper
relative to the foreign currencyndash thereby stimulating exportsndash thereby ending the recession
The Zero Lower Bound on Nominal Interest Rates Solutions
bull 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
bull This would reduce long-term interest rates directly thereby stimulating spending by the borrowers
bull This strategymdashcalled quantitative easingmdashmay also end a recession
Interaction between monetary and fiscal policy
bull IS-LM Model Monetary and fiscal policy variables (M G and T ) are exogenous
bull Real world Monetary policymakers may adjust M in response to changes in fiscal policy or vice versa
bull Such responses by the central bank may affect the effectiveness of fiscal policy
The Fedrsquos response to G gt 0
bull Suppose the government increases Gbull Possible Fed responses
1 hold M constant2 hold r constant3 hold Y constant
bull In each case the effects of G on Yare differenthellip
When G increases the IS curve shifts right
IS1
Response 1 Hold M constant
Y
rLM
r1
Y1
IS2
Y2
r2
If Fed holds M constant then LM curve does not shift
As a result interest rates rise This has a crowding-out effect Consequently GDP increases but not a lot
If Congress raises G the IS curve shifts right
IS1
Response 2 Hold r constant
Y
rLM1
r1
Y1
IS2
Y2
r2
To keep r constant Fed increases M to shift LM curve right
3 1Y Y Y
0r
LM2
Y3
Results
IS1
Response 3 Hold Y constant
Y
rLM1
r1
IS2
Y2
r2
To keep Y constant Fed reduces M to shift LM curve left
0Y
3 1r r r
LM2
Results
Y1
r3
If Congress raises G the IS curve shifts right
At this point you should be able to do problem 7 on page 353 of the textbook Please try it
Estimates of fiscal policy multipliersfrom the DRI macroeconometric model
Assumption about monetary policy
Estimated value of Y G
Fed holds nominal interest rate constant
Fed holds money supply constant
193
060
Estimated value of Y T
119
026
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 amp services
Examples ndash stock market boom or crash
change in householdsrsquo wealth C
ndash change in business or consumer confidence or expectations I andor C
Shocks in the IS -LM model
LM shocks exogenous changes in the demand for money
Examplesndash a wave of credit card fraud increases demand
for moneyndash 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 of1 a boom in the stock market that makes consumers
wealthier2 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 rb determine what happens to C I and the
unemployment rate
CASE STUDY
THE US RECESSION OF 2001
The US Recession of 2001
bull 39 on 900bull 49 on 801bull 63 on 603bull 50 on 705
The US Recession of 2001
bull Growth of GDP was negative in the 1st and 3rd quarters of 2001
bull Thatrsquos essentially before 911
Recall IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
The US Recession of 2001bull Whybull Demand shocks moved the IS
curve leftndash The ldquotech bubblerdquo ended and
stocks fell 25 between 800 and 801
ndash 911 attacks led to a 12 fall in stock prices in one week and a huge rise in uncertainty
ndash Scandals at Enron WorldCom and other corporations led to stock price declines and a decline in trust and a rise in uncertainty
ndash Lower household wealth reduced Co and higher uncertainty reduced Io
IS
Y
rLM
r1
Y1
CASE STUDY
The US recession of 2001Causes 1) Stock market decline C
300
600
900
1200
1500
1995 1996 1997 1998 1999 2000 2001 2002 2003
Ind
ex
(19
42
= 1
00
) Standard amp Poorrsquos 500
The US Recession of 2001bull Fiscal stimulus moved IS curve
rightndash Major tax cuts were enacted in
2001 and 2003ndash Government spending was
boostedbull to rebuild NYC andbull to bail out the airline industry
bull Fed printed money and moved LM curve rightndash Interest rate on 3-month
Treasury bills fellbull 64 in 1100bull 33 in 801bull 09 in 703
IS1
Y
rLM1
r1
Y1
IS2
LM2
Y3
All three toolsmdashG T and Mmdashwere used
CASE STUDY
The US recession of 2001bull Monetary policy response shifted LM curve right
Three-month T-Bill Rate
Three-month T-Bill Rate
0
1
2
3
4
5
6
7
010
120
0004
02
2000
070
320
0010
03
2000
010
320
0104
05
2001
070
620
0110
06
2001
010
620
0204
08
2002
070
920
0210
09
2002
010
920
0304
11
2003
Skip
bull I am skipping section 11-2
THE GREAT DEPRESSION
The Great Depression
Unemployment (right scale)
Real GNP(left scale)
120
140
160
180
200
220
240
1929 1931 1933 1935 1937 1939
billi
ons
of 1
958
dolla
rs
0
5
10
15
20
25
30
perc
ent o
f lab
or fo
rce
THE SPENDING HYPOTHESIS
Shocks to the IS curvebull asserts that the
Depression was largely due to an exogenous fall in the demand for goods and services ndash a leftward shift of the IS curve
bull evidence output and interest rates both fell in early 1930s which is what a leftward IS shift would cause
IS
Y
rLM
r1
Y1
THE SPENDING HYPOTHESIS
Reasons for the IS shiftbull Stock market crash exogenous C
ndash Oct-Dec 1929 SampP 500 fell 17ndash Oct 1929-Dec 1933 SampP 500 fell 71
bull Drop in investmentndash ldquocorrectionrdquo after overbuilding in the 1920sndash widespread bank failures in early 1930s made it harder
to obtain financing for investmentbull Contractionary fiscal policy
ndash Politicians raised tax rates in 1932 and cut spending to combat increasing deficits
THE MONEY HYPOTHESIS
A shock to the LM curvebull asserts that the Depression was largely due to
huge fall in the money supplybull evidence M1 fell 25 during 1929-33 bull But two problems with this hypothesis
ndash P fell even more so MP actually rose slightly during 1929-31
ndash nominal interest rates fell which is the opposite of what a leftward LM shift would cause
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull asserts that the severity of the Depression
was due to a huge deflation ndash P fell 25 during 1929-33
bull This deflation was probably caused by the fall in M so perhaps money played an important role after all
bull In what ways does a deflation affect the economy
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The stabilizing effects of deflationbull P (MP ) LM shifts right Ybull Pigou effect
P (MP )
consumersrsquo wealth
C
IS shifts right
Y
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects
of expected deflation E
bull LM curve shifts leftr and I (r ) planned expenditure income and output
bull Also the nominal interest rate decreases (idarr) ndash see IS-LM predictions grid
IS
Y
rLM
r1
Y1
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects of unexpected deflation
debt-deflation theoryP (if unexpected)
transfers purchasing power from borrowers to lenders
borrowers spend less lenders spend more if borrowersrsquo propensity to spend is larger than
lendersrsquo then aggregate spending falls the IS curve shifts left and Y falls
The evidence on output and nominal interest rates
bull Note that other than the money hypothesis all the other hypothesesmdashthe spending hypothesis the debt-deflation hypothesis and the deflationary expectations hypothesismdashpredict falling real GDP and falling nominal interest rates
bull This is exactly what happened in the early stages of the Great Depression
bull The spending hypothesis and the debt-deflation hypothesis both predict falling real interest rates whereas the deflationary expectations hypothesis predicts rising real interest rates
bull Therefore evidence on real interest rates is crucial in identifying suitable explanations for the Great Depression
Why another Depression is unlikelybull Policymakers (or their advisors) now know much more
about macroeconomicsndash The Fed knows better than to let M fall so much
especially during a contractionndash Fiscal policymakers know better than to raise
taxes or cut spending during a contractionbull Federal deposit insurance makes widespread bank
failures very unlikely
bull Automatic stabilizers make fiscal policy expansionary during an economic downturn
THE FINANCIAL CRISIS AND ECONOMIC DOWNTURN OF 2008 AND 2009
CASE STUDYThe 2008-09 Financial Crisis amp Recession
bull 2009 Real GDP fell unemployment rate approached 10
bull Important factors in the crisisndash early 2000s Federal Reserve interest rate policy ndash sub-prime mortgage crisisndash bursting of house price bubble rising foreclosure
ratesndash falling stock pricesndash failing financial institutionsndash declining consumer confidence drop in spending on
consumer durables and investment goods
A Too-Brief and Too-Simple Explanation
bull The price of housing had risen to unsustainable levels
bull When home prices inevitably crashed people suddenly felt poor and cut back their spending plans
bull This fall in planned expenditure brought about the Great Recession of 2008-09
The Housing Bubble Inflates then Deflates
bull The SampP Case-Shiller 20-City Home Price Index went from ndash 100 in Jan 2000 tondash 20654 in April 2006 tondash 14095 in May 2009 tondash 14216 in Dec 2010
bull Why did the housing bubble inflate
The Housing Bubble Reasons
bull The Fed kept the interest rates too low for too long
bull Securitization technology got a lot fancier in the mortgage bond market
bull The government regulators were sleepingbull Pretty much everybody believed that home
prices could never fall
The Housing Bubble Low FFR
bull The Fed had reduced the Federal Funds Rate to fight the Recession of 2001
bull After that recession ended the Fed continued to keep interest rates low until 2004ndash The Fed was watching inflation which remained
tame Consequently the Fed saw little reason to raise interest rates
ndash The Fed did not believe that housing prices had formed a bubble hellip until it was blindingly obvious
The Housing Bubble Securitization
bull In the past people with money did not like to lend money to home buyers because such loans were risky and had unreliable returns
bull 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
bull The financial sector was regulated by people who were ideologically opposed to regulation
bull They turned a blind eye to even the worst lending practices
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
Shifts of the IS curve
bull In other words we can make the following predictions
IS
Y
rLM
r1
Y1
IS-LM Predictions
Y r
Co + Io + G + +
T minus minus
Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
rC
IT
C
CGIC
CY
y
r
y
yoo
y
11
)(1
1
TC
CGIC
CY
y
yoo
y
1
)(1
1Keynesian Cross
IS Curve
In the Keynesian Cross model expansionary fiscal policy boosts GDP by an amount dictated by the multipliers
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)
KC Spending Multiplier KC Tax-Cut Multiplier
Fiscal Policy is Weakened by the Crowding-Out Effect
bull We have just seen that in the IS-LM model expansionary fiscal policy (Guarr or Tdarr) ndash leads to higher interest rates whichndash exerts downward pressure on investment spending whichndash exerts downward pressure on GDP and jobs
bull This negative aspect of expansionary fiscal policy is called the crowding-out effect
bull This effect was absent in the Keynesian Cross modelbull Thus fiscal policy is less effective in the IS-LM model
than in the Keynesian Cross model
causing GDP to rise
IS1
An increase in government purchases graph
1 IS curve shifts right
Y
rLM
r1
Y1
1by
1 MPCG
IS2
Y2
r2
12 This raises money
demand causing the interest rate to risehellip
2
3 hellipwhich reduces investment so the final increase in Y
1is smaller than
1 MPCG
3
IS1
1
A tax cut
Y
rLM
r1
Y1
IS2
Y2
r2
Consumers save (1MPC) of the tax cut so the initial boost in spending is smaller for T than for an equal Ghellip
and the IS curve shifts by
MPC
1 MPCT
1
2
2hellipso the effects on r and Y are smaller for T than for an equal G
2
Shifts of the LM curve
IS
Y
rLM
r1
Y1
Shifts of the LM curve
bull Similarly the LM curve shifts left if there isndash a decrease in MP or Eπ
orndash an increase in Lo
bull As a result Y decreases and r increases
IS
Y
rLM
r1
Y1
Shifts of the LM curve
Shifts of the LM curve
bull Recall from Ch 11 that if expected inflation (Eπ) increases (decreases) the LM curve shifts down (up) by the exact same amount
bull Therefore if Eπ decreases r will increase but by a smaller amount
bull Therefore i = r + Eπ will decrease
IS
Y
rLM
r1
Y1
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
At this point you should be able to do problems 1 2 3 (a) ndash (f) 4 and 5 on pages 352 ndash 353 of the textbook Please try them
Monetary Policy
bull The practice of changing the quantity of money (M) in order to affect the macroeconomic outcome is called monetary policyndash an increase in the quantity of money (Muarr) is
called expansionary monetary policy andndash A decrease in the quantity of money (Mdarr) is
called contractionary monetary policy
Shifts of the LM curvebull When the central bank of a
country makes changes to the quantity of money (M)ndash only the LM curve changes
and ndash the real interest rate (r)
changes in the opposite direction
ndash As expected inflation (Eπ) is assumed exogenous in the IS-LM model when the real interest rate (r) changes the nominal interest rate (i = r + Eπ) changes in the same direction
IS
Y
rLM
r1
Y1
Shifts of the LM curve
bull One can think of the central bank as ndash targeting M and
affecting r and i in the process or as
ndash targeting r andor i and adjusting M to achieve the target
IS
Y
rLM
r1
Y1
Monetary Policy Re-defined
bull Therefore one can re-define expansionary and contractionary monetary policy as followsndash Monetary policy is expansionary when the central
bank attempts to reduce interest rates (real and nominal) and
ndash Monetary policy is contractionary when the central bank attempts to increase the interest rates (real and nominal)
The Federal Funds Rate
bull 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
bull 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
bull The Federal Funds Rate is the interest rate that banks charge each other for overnight loans
bull If the Fed wishes the FFR to be 18 all it has to do is to announce that ndash it will lend money to any bank at 18 interest
andndash will pay 18 interest on deposits received from
any bank
The Federal Funds Ratebull 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 followsndash Monetary policy is expansionary when the Fed seeks
to reduce the federal funds rate andndash Monetary policy is contractionary when the Fed
seeks to increase the federal funds ratebull 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
bull We have seen that when faced with a recession the central bank can ndash Increase the money supply
(Muarr)ndash Thereby shifting the LM
curve rightndash Thereby reducing the real
interest rate (r = i minus Eπ darr) and the nominal interest rate (i = r + Eπdarr) and increasing GDP (Yuarr) to drag the economy out of the recession
IS
Y
rLM
r1
Y1
The Zero Lower Bound on Nominal Interest Rates
bull The problem is that there is a limit to how low the nominal interest rate can be
bull Nominal interest rates (such as the federal funds rate) cannot be negative
bull To deal with the 2008 economic crisis the Fed reduced the FFR to zero
bull But the recession persistedbull Unfortunately the Fed could
not reduce interest rates below zero monetary policy had reached its limit
IS
Y
rLM
r1
Y1
The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
The Zero Lower Bound on Nominal Interest Rates
bull r = i minus Eπbull iminimum = 0
bull Therefore rminimum = iminimum minus Eπ = 0 minus Eπ
bull Therefore rminimum = minus Eπ
bull For example if Eπ = minus3 then rminimum = minus Eπ = 3
IS
Y
rLM
r1
Y1
21
The Zero Lower Bound on Nominal Interest Rates
bull For example in the diagram the central bank will have to reduce the real interest rate to r = 21 in order to end the recession
bull But suppose expected inflation is Eπ = minus 3
bull Then the nominal interest rate would have to be brought down to i = r + Eπ = 21 ndash 30 = ndash 09
bull Which alas is impossible
IS
Y
rLM
r1
Y1
21
This example also shows how dangerous it can be if we have deflation and people begin to expect the deflation to continue
The Zero Lower Bound on Nominal Interest Rates
bull 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 bendash at the zero lower bound orndash in a liquidity trap
bull See page 350 of the textbook
The Zero Lower Bound on Nominal Interest Rates Solutions
bull When an economy is in a liquidity trap monetary policy cannot be used to reduce interest rates any further
bull But is there nothing else that can be done to bring the economy back to life
bull Yes there isbull Expansionary fiscal policy can be usedbull And therersquos 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
bull In my example ndash the central bank needs to reduce
the real interest rate to r = 21 to end the recession
ndash But expected inflation is Eπ = minus 3 ndash So the nominal interest rate would
have to be brought down to i = ndash 09 which alas is impossible
bull Recall that the LM curve shifts right if either M or Eπ increases
bull If the central bank promises to be irresponsible and to create rapid inflation in the future and if people believe its promise then Eπ will increase say from minus 3 to +1
bull Then the nominal interest rate required for full-employment will be i = r + Eπ = 21 + 10 = 31 which is definitely attainable
IS
Y
rLM
r1
Y1
21
The zero-lower-bound problem can be solved if the central bank can credibly promise to be irresponsible
The Zero Lower Bound on Nominal Interest Rates Solutions
bull Although this chapter assumes a closed economy in reality foreign trade does matter
bull So the central bank can ndash print domestic currency and ndash use it to buy foreign currency ndash thereby making the domestic currency cheaper
relative to the foreign currencyndash thereby stimulating exportsndash thereby ending the recession
The Zero Lower Bound on Nominal Interest Rates Solutions
bull 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
bull This would reduce long-term interest rates directly thereby stimulating spending by the borrowers
bull This strategymdashcalled quantitative easingmdashmay also end a recession
Interaction between monetary and fiscal policy
bull IS-LM Model Monetary and fiscal policy variables (M G and T ) are exogenous
bull Real world Monetary policymakers may adjust M in response to changes in fiscal policy or vice versa
bull Such responses by the central bank may affect the effectiveness of fiscal policy
The Fedrsquos response to G gt 0
bull Suppose the government increases Gbull Possible Fed responses
1 hold M constant2 hold r constant3 hold Y constant
bull In each case the effects of G on Yare differenthellip
When G increases the IS curve shifts right
IS1
Response 1 Hold M constant
Y
rLM
r1
Y1
IS2
Y2
r2
If Fed holds M constant then LM curve does not shift
As a result interest rates rise This has a crowding-out effect Consequently GDP increases but not a lot
If Congress raises G the IS curve shifts right
IS1
Response 2 Hold r constant
Y
rLM1
r1
Y1
IS2
Y2
r2
To keep r constant Fed increases M to shift LM curve right
3 1Y Y Y
0r
LM2
Y3
Results
IS1
Response 3 Hold Y constant
Y
rLM1
r1
IS2
Y2
r2
To keep Y constant Fed reduces M to shift LM curve left
0Y
3 1r r r
LM2
Results
Y1
r3
If Congress raises G the IS curve shifts right
At this point you should be able to do problem 7 on page 353 of the textbook Please try it
Estimates of fiscal policy multipliersfrom the DRI macroeconometric model
Assumption about monetary policy
Estimated value of Y G
Fed holds nominal interest rate constant
Fed holds money supply constant
193
060
Estimated value of Y T
119
026
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 amp services
Examples ndash stock market boom or crash
change in householdsrsquo wealth C
ndash change in business or consumer confidence or expectations I andor C
Shocks in the IS -LM model
LM shocks exogenous changes in the demand for money
Examplesndash a wave of credit card fraud increases demand
for moneyndash 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 of1 a boom in the stock market that makes consumers
wealthier2 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 rb determine what happens to C I and the
unemployment rate
CASE STUDY
THE US RECESSION OF 2001
The US Recession of 2001
bull 39 on 900bull 49 on 801bull 63 on 603bull 50 on 705
The US Recession of 2001
bull Growth of GDP was negative in the 1st and 3rd quarters of 2001
bull Thatrsquos essentially before 911
Recall IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
The US Recession of 2001bull Whybull Demand shocks moved the IS
curve leftndash The ldquotech bubblerdquo ended and
stocks fell 25 between 800 and 801
ndash 911 attacks led to a 12 fall in stock prices in one week and a huge rise in uncertainty
ndash Scandals at Enron WorldCom and other corporations led to stock price declines and a decline in trust and a rise in uncertainty
ndash Lower household wealth reduced Co and higher uncertainty reduced Io
IS
Y
rLM
r1
Y1
CASE STUDY
The US recession of 2001Causes 1) Stock market decline C
300
600
900
1200
1500
1995 1996 1997 1998 1999 2000 2001 2002 2003
Ind
ex
(19
42
= 1
00
) Standard amp Poorrsquos 500
The US Recession of 2001bull Fiscal stimulus moved IS curve
rightndash Major tax cuts were enacted in
2001 and 2003ndash Government spending was
boostedbull to rebuild NYC andbull to bail out the airline industry
bull Fed printed money and moved LM curve rightndash Interest rate on 3-month
Treasury bills fellbull 64 in 1100bull 33 in 801bull 09 in 703
IS1
Y
rLM1
r1
Y1
IS2
LM2
Y3
All three toolsmdashG T and Mmdashwere used
CASE STUDY
The US recession of 2001bull Monetary policy response shifted LM curve right
Three-month T-Bill Rate
Three-month T-Bill Rate
0
1
2
3
4
5
6
7
010
120
0004
02
2000
070
320
0010
03
2000
010
320
0104
05
2001
070
620
0110
06
2001
010
620
0204
08
2002
070
920
0210
09
2002
010
920
0304
11
2003
Skip
bull I am skipping section 11-2
THE GREAT DEPRESSION
The Great Depression
Unemployment (right scale)
Real GNP(left scale)
120
140
160
180
200
220
240
1929 1931 1933 1935 1937 1939
billi
ons
of 1
958
dolla
rs
0
5
10
15
20
25
30
perc
ent o
f lab
or fo
rce
THE SPENDING HYPOTHESIS
Shocks to the IS curvebull asserts that the
Depression was largely due to an exogenous fall in the demand for goods and services ndash a leftward shift of the IS curve
bull evidence output and interest rates both fell in early 1930s which is what a leftward IS shift would cause
IS
Y
rLM
r1
Y1
THE SPENDING HYPOTHESIS
Reasons for the IS shiftbull Stock market crash exogenous C
ndash Oct-Dec 1929 SampP 500 fell 17ndash Oct 1929-Dec 1933 SampP 500 fell 71
bull Drop in investmentndash ldquocorrectionrdquo after overbuilding in the 1920sndash widespread bank failures in early 1930s made it harder
to obtain financing for investmentbull Contractionary fiscal policy
ndash Politicians raised tax rates in 1932 and cut spending to combat increasing deficits
THE MONEY HYPOTHESIS
A shock to the LM curvebull asserts that the Depression was largely due to
huge fall in the money supplybull evidence M1 fell 25 during 1929-33 bull But two problems with this hypothesis
ndash P fell even more so MP actually rose slightly during 1929-31
ndash nominal interest rates fell which is the opposite of what a leftward LM shift would cause
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull asserts that the severity of the Depression
was due to a huge deflation ndash P fell 25 during 1929-33
bull This deflation was probably caused by the fall in M so perhaps money played an important role after all
bull In what ways does a deflation affect the economy
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The stabilizing effects of deflationbull P (MP ) LM shifts right Ybull Pigou effect
P (MP )
consumersrsquo wealth
C
IS shifts right
Y
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects
of expected deflation E
bull LM curve shifts leftr and I (r ) planned expenditure income and output
bull Also the nominal interest rate decreases (idarr) ndash see IS-LM predictions grid
IS
Y
rLM
r1
Y1
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects of unexpected deflation
debt-deflation theoryP (if unexpected)
transfers purchasing power from borrowers to lenders
borrowers spend less lenders spend more if borrowersrsquo propensity to spend is larger than
lendersrsquo then aggregate spending falls the IS curve shifts left and Y falls
The evidence on output and nominal interest rates
bull Note that other than the money hypothesis all the other hypothesesmdashthe spending hypothesis the debt-deflation hypothesis and the deflationary expectations hypothesismdashpredict falling real GDP and falling nominal interest rates
bull This is exactly what happened in the early stages of the Great Depression
bull The spending hypothesis and the debt-deflation hypothesis both predict falling real interest rates whereas the deflationary expectations hypothesis predicts rising real interest rates
bull Therefore evidence on real interest rates is crucial in identifying suitable explanations for the Great Depression
Why another Depression is unlikelybull Policymakers (or their advisors) now know much more
about macroeconomicsndash The Fed knows better than to let M fall so much
especially during a contractionndash Fiscal policymakers know better than to raise
taxes or cut spending during a contractionbull Federal deposit insurance makes widespread bank
failures very unlikely
bull Automatic stabilizers make fiscal policy expansionary during an economic downturn
THE FINANCIAL CRISIS AND ECONOMIC DOWNTURN OF 2008 AND 2009
CASE STUDYThe 2008-09 Financial Crisis amp Recession
bull 2009 Real GDP fell unemployment rate approached 10
bull Important factors in the crisisndash early 2000s Federal Reserve interest rate policy ndash sub-prime mortgage crisisndash bursting of house price bubble rising foreclosure
ratesndash falling stock pricesndash failing financial institutionsndash declining consumer confidence drop in spending on
consumer durables and investment goods
A Too-Brief and Too-Simple Explanation
bull The price of housing had risen to unsustainable levels
bull When home prices inevitably crashed people suddenly felt poor and cut back their spending plans
bull This fall in planned expenditure brought about the Great Recession of 2008-09
The Housing Bubble Inflates then Deflates
bull The SampP Case-Shiller 20-City Home Price Index went from ndash 100 in Jan 2000 tondash 20654 in April 2006 tondash 14095 in May 2009 tondash 14216 in Dec 2010
bull Why did the housing bubble inflate
The Housing Bubble Reasons
bull The Fed kept the interest rates too low for too long
bull Securitization technology got a lot fancier in the mortgage bond market
bull The government regulators were sleepingbull Pretty much everybody believed that home
prices could never fall
The Housing Bubble Low FFR
bull The Fed had reduced the Federal Funds Rate to fight the Recession of 2001
bull After that recession ended the Fed continued to keep interest rates low until 2004ndash The Fed was watching inflation which remained
tame Consequently the Fed saw little reason to raise interest rates
ndash The Fed did not believe that housing prices had formed a bubble hellip until it was blindingly obvious
The Housing Bubble Securitization
bull In the past people with money did not like to lend money to home buyers because such loans were risky and had unreliable returns
bull 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
bull The financial sector was regulated by people who were ideologically opposed to regulation
bull They turned a blind eye to even the worst lending practices
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
rC
IT
C
CGIC
CY
y
r
y
yoo
y
11
)(1
1
TC
CGIC
CY
y
yoo
y
1
)(1
1Keynesian Cross
IS Curve
In the Keynesian Cross model expansionary fiscal policy boosts GDP by an amount dictated by the multipliers
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)
KC Spending Multiplier KC Tax-Cut Multiplier
Fiscal Policy is Weakened by the Crowding-Out Effect
bull We have just seen that in the IS-LM model expansionary fiscal policy (Guarr or Tdarr) ndash leads to higher interest rates whichndash exerts downward pressure on investment spending whichndash exerts downward pressure on GDP and jobs
bull This negative aspect of expansionary fiscal policy is called the crowding-out effect
bull This effect was absent in the Keynesian Cross modelbull Thus fiscal policy is less effective in the IS-LM model
than in the Keynesian Cross model
causing GDP to rise
IS1
An increase in government purchases graph
1 IS curve shifts right
Y
rLM
r1
Y1
1by
1 MPCG
IS2
Y2
r2
12 This raises money
demand causing the interest rate to risehellip
2
3 hellipwhich reduces investment so the final increase in Y
1is smaller than
1 MPCG
3
IS1
1
A tax cut
Y
rLM
r1
Y1
IS2
Y2
r2
Consumers save (1MPC) of the tax cut so the initial boost in spending is smaller for T than for an equal Ghellip
and the IS curve shifts by
MPC
1 MPCT
1
2
2hellipso the effects on r and Y are smaller for T than for an equal G
2
Shifts of the LM curve
IS
Y
rLM
r1
Y1
Shifts of the LM curve
bull Similarly the LM curve shifts left if there isndash a decrease in MP or Eπ
orndash an increase in Lo
bull As a result Y decreases and r increases
IS
Y
rLM
r1
Y1
Shifts of the LM curve
Shifts of the LM curve
bull Recall from Ch 11 that if expected inflation (Eπ) increases (decreases) the LM curve shifts down (up) by the exact same amount
bull Therefore if Eπ decreases r will increase but by a smaller amount
bull Therefore i = r + Eπ will decrease
IS
Y
rLM
r1
Y1
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
At this point you should be able to do problems 1 2 3 (a) ndash (f) 4 and 5 on pages 352 ndash 353 of the textbook Please try them
Monetary Policy
bull The practice of changing the quantity of money (M) in order to affect the macroeconomic outcome is called monetary policyndash an increase in the quantity of money (Muarr) is
called expansionary monetary policy andndash A decrease in the quantity of money (Mdarr) is
called contractionary monetary policy
Shifts of the LM curvebull When the central bank of a
country makes changes to the quantity of money (M)ndash only the LM curve changes
and ndash the real interest rate (r)
changes in the opposite direction
ndash As expected inflation (Eπ) is assumed exogenous in the IS-LM model when the real interest rate (r) changes the nominal interest rate (i = r + Eπ) changes in the same direction
IS
Y
rLM
r1
Y1
Shifts of the LM curve
bull One can think of the central bank as ndash targeting M and
affecting r and i in the process or as
ndash targeting r andor i and adjusting M to achieve the target
IS
Y
rLM
r1
Y1
Monetary Policy Re-defined
bull Therefore one can re-define expansionary and contractionary monetary policy as followsndash Monetary policy is expansionary when the central
bank attempts to reduce interest rates (real and nominal) and
ndash Monetary policy is contractionary when the central bank attempts to increase the interest rates (real and nominal)
The Federal Funds Rate
bull 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
bull 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
bull The Federal Funds Rate is the interest rate that banks charge each other for overnight loans
bull If the Fed wishes the FFR to be 18 all it has to do is to announce that ndash it will lend money to any bank at 18 interest
andndash will pay 18 interest on deposits received from
any bank
The Federal Funds Ratebull 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 followsndash Monetary policy is expansionary when the Fed seeks
to reduce the federal funds rate andndash Monetary policy is contractionary when the Fed
seeks to increase the federal funds ratebull 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
bull We have seen that when faced with a recession the central bank can ndash Increase the money supply
(Muarr)ndash Thereby shifting the LM
curve rightndash Thereby reducing the real
interest rate (r = i minus Eπ darr) and the nominal interest rate (i = r + Eπdarr) and increasing GDP (Yuarr) to drag the economy out of the recession
IS
Y
rLM
r1
Y1
The Zero Lower Bound on Nominal Interest Rates
bull The problem is that there is a limit to how low the nominal interest rate can be
bull Nominal interest rates (such as the federal funds rate) cannot be negative
bull To deal with the 2008 economic crisis the Fed reduced the FFR to zero
bull But the recession persistedbull Unfortunately the Fed could
not reduce interest rates below zero monetary policy had reached its limit
IS
Y
rLM
r1
Y1
The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
The Zero Lower Bound on Nominal Interest Rates
bull r = i minus Eπbull iminimum = 0
bull Therefore rminimum = iminimum minus Eπ = 0 minus Eπ
bull Therefore rminimum = minus Eπ
bull For example if Eπ = minus3 then rminimum = minus Eπ = 3
IS
Y
rLM
r1
Y1
21
The Zero Lower Bound on Nominal Interest Rates
bull For example in the diagram the central bank will have to reduce the real interest rate to r = 21 in order to end the recession
bull But suppose expected inflation is Eπ = minus 3
bull Then the nominal interest rate would have to be brought down to i = r + Eπ = 21 ndash 30 = ndash 09
bull Which alas is impossible
IS
Y
rLM
r1
Y1
21
This example also shows how dangerous it can be if we have deflation and people begin to expect the deflation to continue
The Zero Lower Bound on Nominal Interest Rates
bull 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 bendash at the zero lower bound orndash in a liquidity trap
bull See page 350 of the textbook
The Zero Lower Bound on Nominal Interest Rates Solutions
bull When an economy is in a liquidity trap monetary policy cannot be used to reduce interest rates any further
bull But is there nothing else that can be done to bring the economy back to life
bull Yes there isbull Expansionary fiscal policy can be usedbull And therersquos 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
bull In my example ndash the central bank needs to reduce
the real interest rate to r = 21 to end the recession
ndash But expected inflation is Eπ = minus 3 ndash So the nominal interest rate would
have to be brought down to i = ndash 09 which alas is impossible
bull Recall that the LM curve shifts right if either M or Eπ increases
bull If the central bank promises to be irresponsible and to create rapid inflation in the future and if people believe its promise then Eπ will increase say from minus 3 to +1
bull Then the nominal interest rate required for full-employment will be i = r + Eπ = 21 + 10 = 31 which is definitely attainable
IS
Y
rLM
r1
Y1
21
The zero-lower-bound problem can be solved if the central bank can credibly promise to be irresponsible
The Zero Lower Bound on Nominal Interest Rates Solutions
bull Although this chapter assumes a closed economy in reality foreign trade does matter
bull So the central bank can ndash print domestic currency and ndash use it to buy foreign currency ndash thereby making the domestic currency cheaper
relative to the foreign currencyndash thereby stimulating exportsndash thereby ending the recession
The Zero Lower Bound on Nominal Interest Rates Solutions
bull 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
bull This would reduce long-term interest rates directly thereby stimulating spending by the borrowers
bull This strategymdashcalled quantitative easingmdashmay also end a recession
Interaction between monetary and fiscal policy
bull IS-LM Model Monetary and fiscal policy variables (M G and T ) are exogenous
bull Real world Monetary policymakers may adjust M in response to changes in fiscal policy or vice versa
bull Such responses by the central bank may affect the effectiveness of fiscal policy
The Fedrsquos response to G gt 0
bull Suppose the government increases Gbull Possible Fed responses
1 hold M constant2 hold r constant3 hold Y constant
bull In each case the effects of G on Yare differenthellip
When G increases the IS curve shifts right
IS1
Response 1 Hold M constant
Y
rLM
r1
Y1
IS2
Y2
r2
If Fed holds M constant then LM curve does not shift
As a result interest rates rise This has a crowding-out effect Consequently GDP increases but not a lot
If Congress raises G the IS curve shifts right
IS1
Response 2 Hold r constant
Y
rLM1
r1
Y1
IS2
Y2
r2
To keep r constant Fed increases M to shift LM curve right
3 1Y Y Y
0r
LM2
Y3
Results
IS1
Response 3 Hold Y constant
Y
rLM1
r1
IS2
Y2
r2
To keep Y constant Fed reduces M to shift LM curve left
0Y
3 1r r r
LM2
Results
Y1
r3
If Congress raises G the IS curve shifts right
At this point you should be able to do problem 7 on page 353 of the textbook Please try it
Estimates of fiscal policy multipliersfrom the DRI macroeconometric model
Assumption about monetary policy
Estimated value of Y G
Fed holds nominal interest rate constant
Fed holds money supply constant
193
060
Estimated value of Y T
119
026
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 amp services
Examples ndash stock market boom or crash
change in householdsrsquo wealth C
ndash change in business or consumer confidence or expectations I andor C
Shocks in the IS -LM model
LM shocks exogenous changes in the demand for money
Examplesndash a wave of credit card fraud increases demand
for moneyndash 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 of1 a boom in the stock market that makes consumers
wealthier2 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 rb determine what happens to C I and the
unemployment rate
CASE STUDY
THE US RECESSION OF 2001
The US Recession of 2001
bull 39 on 900bull 49 on 801bull 63 on 603bull 50 on 705
The US Recession of 2001
bull Growth of GDP was negative in the 1st and 3rd quarters of 2001
bull Thatrsquos essentially before 911
Recall IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
The US Recession of 2001bull Whybull Demand shocks moved the IS
curve leftndash The ldquotech bubblerdquo ended and
stocks fell 25 between 800 and 801
ndash 911 attacks led to a 12 fall in stock prices in one week and a huge rise in uncertainty
ndash Scandals at Enron WorldCom and other corporations led to stock price declines and a decline in trust and a rise in uncertainty
ndash Lower household wealth reduced Co and higher uncertainty reduced Io
IS
Y
rLM
r1
Y1
CASE STUDY
The US recession of 2001Causes 1) Stock market decline C
300
600
900
1200
1500
1995 1996 1997 1998 1999 2000 2001 2002 2003
Ind
ex
(19
42
= 1
00
) Standard amp Poorrsquos 500
The US Recession of 2001bull Fiscal stimulus moved IS curve
rightndash Major tax cuts were enacted in
2001 and 2003ndash Government spending was
boostedbull to rebuild NYC andbull to bail out the airline industry
bull Fed printed money and moved LM curve rightndash Interest rate on 3-month
Treasury bills fellbull 64 in 1100bull 33 in 801bull 09 in 703
IS1
Y
rLM1
r1
Y1
IS2
LM2
Y3
All three toolsmdashG T and Mmdashwere used
CASE STUDY
The US recession of 2001bull Monetary policy response shifted LM curve right
Three-month T-Bill Rate
Three-month T-Bill Rate
0
1
2
3
4
5
6
7
010
120
0004
02
2000
070
320
0010
03
2000
010
320
0104
05
2001
070
620
0110
06
2001
010
620
0204
08
2002
070
920
0210
09
2002
010
920
0304
11
2003
Skip
bull I am skipping section 11-2
THE GREAT DEPRESSION
The Great Depression
Unemployment (right scale)
Real GNP(left scale)
120
140
160
180
200
220
240
1929 1931 1933 1935 1937 1939
billi
ons
of 1
958
dolla
rs
0
5
10
15
20
25
30
perc
ent o
f lab
or fo
rce
THE SPENDING HYPOTHESIS
Shocks to the IS curvebull asserts that the
Depression was largely due to an exogenous fall in the demand for goods and services ndash a leftward shift of the IS curve
bull evidence output and interest rates both fell in early 1930s which is what a leftward IS shift would cause
IS
Y
rLM
r1
Y1
THE SPENDING HYPOTHESIS
Reasons for the IS shiftbull Stock market crash exogenous C
ndash Oct-Dec 1929 SampP 500 fell 17ndash Oct 1929-Dec 1933 SampP 500 fell 71
bull Drop in investmentndash ldquocorrectionrdquo after overbuilding in the 1920sndash widespread bank failures in early 1930s made it harder
to obtain financing for investmentbull Contractionary fiscal policy
ndash Politicians raised tax rates in 1932 and cut spending to combat increasing deficits
THE MONEY HYPOTHESIS
A shock to the LM curvebull asserts that the Depression was largely due to
huge fall in the money supplybull evidence M1 fell 25 during 1929-33 bull But two problems with this hypothesis
ndash P fell even more so MP actually rose slightly during 1929-31
ndash nominal interest rates fell which is the opposite of what a leftward LM shift would cause
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull asserts that the severity of the Depression
was due to a huge deflation ndash P fell 25 during 1929-33
bull This deflation was probably caused by the fall in M so perhaps money played an important role after all
bull In what ways does a deflation affect the economy
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The stabilizing effects of deflationbull P (MP ) LM shifts right Ybull Pigou effect
P (MP )
consumersrsquo wealth
C
IS shifts right
Y
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects
of expected deflation E
bull LM curve shifts leftr and I (r ) planned expenditure income and output
bull Also the nominal interest rate decreases (idarr) ndash see IS-LM predictions grid
IS
Y
rLM
r1
Y1
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects of unexpected deflation
debt-deflation theoryP (if unexpected)
transfers purchasing power from borrowers to lenders
borrowers spend less lenders spend more if borrowersrsquo propensity to spend is larger than
lendersrsquo then aggregate spending falls the IS curve shifts left and Y falls
The evidence on output and nominal interest rates
bull Note that other than the money hypothesis all the other hypothesesmdashthe spending hypothesis the debt-deflation hypothesis and the deflationary expectations hypothesismdashpredict falling real GDP and falling nominal interest rates
bull This is exactly what happened in the early stages of the Great Depression
bull The spending hypothesis and the debt-deflation hypothesis both predict falling real interest rates whereas the deflationary expectations hypothesis predicts rising real interest rates
bull Therefore evidence on real interest rates is crucial in identifying suitable explanations for the Great Depression
Why another Depression is unlikelybull Policymakers (or their advisors) now know much more
about macroeconomicsndash The Fed knows better than to let M fall so much
especially during a contractionndash Fiscal policymakers know better than to raise
taxes or cut spending during a contractionbull Federal deposit insurance makes widespread bank
failures very unlikely
bull Automatic stabilizers make fiscal policy expansionary during an economic downturn
THE FINANCIAL CRISIS AND ECONOMIC DOWNTURN OF 2008 AND 2009
CASE STUDYThe 2008-09 Financial Crisis amp Recession
bull 2009 Real GDP fell unemployment rate approached 10
bull Important factors in the crisisndash early 2000s Federal Reserve interest rate policy ndash sub-prime mortgage crisisndash bursting of house price bubble rising foreclosure
ratesndash falling stock pricesndash failing financial institutionsndash declining consumer confidence drop in spending on
consumer durables and investment goods
A Too-Brief and Too-Simple Explanation
bull The price of housing had risen to unsustainable levels
bull When home prices inevitably crashed people suddenly felt poor and cut back their spending plans
bull This fall in planned expenditure brought about the Great Recession of 2008-09
The Housing Bubble Inflates then Deflates
bull The SampP Case-Shiller 20-City Home Price Index went from ndash 100 in Jan 2000 tondash 20654 in April 2006 tondash 14095 in May 2009 tondash 14216 in Dec 2010
bull Why did the housing bubble inflate
The Housing Bubble Reasons
bull The Fed kept the interest rates too low for too long
bull Securitization technology got a lot fancier in the mortgage bond market
bull The government regulators were sleepingbull Pretty much everybody believed that home
prices could never fall
The Housing Bubble Low FFR
bull The Fed had reduced the Federal Funds Rate to fight the Recession of 2001
bull After that recession ended the Fed continued to keep interest rates low until 2004ndash The Fed was watching inflation which remained
tame Consequently the Fed saw little reason to raise interest rates
ndash The Fed did not believe that housing prices had formed a bubble hellip until it was blindingly obvious
The Housing Bubble Securitization
bull In the past people with money did not like to lend money to home buyers because such loans were risky and had unreliable returns
bull 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
bull The financial sector was regulated by people who were ideologically opposed to regulation
bull They turned a blind eye to even the worst lending practices
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
Fiscal Policy is Weakened by the Crowding-Out Effect
bull We have just seen that in the IS-LM model expansionary fiscal policy (Guarr or Tdarr) ndash leads to higher interest rates whichndash exerts downward pressure on investment spending whichndash exerts downward pressure on GDP and jobs
bull This negative aspect of expansionary fiscal policy is called the crowding-out effect
bull This effect was absent in the Keynesian Cross modelbull Thus fiscal policy is less effective in the IS-LM model
than in the Keynesian Cross model
causing GDP to rise
IS1
An increase in government purchases graph
1 IS curve shifts right
Y
rLM
r1
Y1
1by
1 MPCG
IS2
Y2
r2
12 This raises money
demand causing the interest rate to risehellip
2
3 hellipwhich reduces investment so the final increase in Y
1is smaller than
1 MPCG
3
IS1
1
A tax cut
Y
rLM
r1
Y1
IS2
Y2
r2
Consumers save (1MPC) of the tax cut so the initial boost in spending is smaller for T than for an equal Ghellip
and the IS curve shifts by
MPC
1 MPCT
1
2
2hellipso the effects on r and Y are smaller for T than for an equal G
2
Shifts of the LM curve
IS
Y
rLM
r1
Y1
Shifts of the LM curve
bull Similarly the LM curve shifts left if there isndash a decrease in MP or Eπ
orndash an increase in Lo
bull As a result Y decreases and r increases
IS
Y
rLM
r1
Y1
Shifts of the LM curve
Shifts of the LM curve
bull Recall from Ch 11 that if expected inflation (Eπ) increases (decreases) the LM curve shifts down (up) by the exact same amount
bull Therefore if Eπ decreases r will increase but by a smaller amount
bull Therefore i = r + Eπ will decrease
IS
Y
rLM
r1
Y1
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
At this point you should be able to do problems 1 2 3 (a) ndash (f) 4 and 5 on pages 352 ndash 353 of the textbook Please try them
Monetary Policy
bull The practice of changing the quantity of money (M) in order to affect the macroeconomic outcome is called monetary policyndash an increase in the quantity of money (Muarr) is
called expansionary monetary policy andndash A decrease in the quantity of money (Mdarr) is
called contractionary monetary policy
Shifts of the LM curvebull When the central bank of a
country makes changes to the quantity of money (M)ndash only the LM curve changes
and ndash the real interest rate (r)
changes in the opposite direction
ndash As expected inflation (Eπ) is assumed exogenous in the IS-LM model when the real interest rate (r) changes the nominal interest rate (i = r + Eπ) changes in the same direction
IS
Y
rLM
r1
Y1
Shifts of the LM curve
bull One can think of the central bank as ndash targeting M and
affecting r and i in the process or as
ndash targeting r andor i and adjusting M to achieve the target
IS
Y
rLM
r1
Y1
Monetary Policy Re-defined
bull Therefore one can re-define expansionary and contractionary monetary policy as followsndash Monetary policy is expansionary when the central
bank attempts to reduce interest rates (real and nominal) and
ndash Monetary policy is contractionary when the central bank attempts to increase the interest rates (real and nominal)
The Federal Funds Rate
bull 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
bull 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
bull The Federal Funds Rate is the interest rate that banks charge each other for overnight loans
bull If the Fed wishes the FFR to be 18 all it has to do is to announce that ndash it will lend money to any bank at 18 interest
andndash will pay 18 interest on deposits received from
any bank
The Federal Funds Ratebull 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 followsndash Monetary policy is expansionary when the Fed seeks
to reduce the federal funds rate andndash Monetary policy is contractionary when the Fed
seeks to increase the federal funds ratebull 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
bull We have seen that when faced with a recession the central bank can ndash Increase the money supply
(Muarr)ndash Thereby shifting the LM
curve rightndash Thereby reducing the real
interest rate (r = i minus Eπ darr) and the nominal interest rate (i = r + Eπdarr) and increasing GDP (Yuarr) to drag the economy out of the recession
IS
Y
rLM
r1
Y1
The Zero Lower Bound on Nominal Interest Rates
bull The problem is that there is a limit to how low the nominal interest rate can be
bull Nominal interest rates (such as the federal funds rate) cannot be negative
bull To deal with the 2008 economic crisis the Fed reduced the FFR to zero
bull But the recession persistedbull Unfortunately the Fed could
not reduce interest rates below zero monetary policy had reached its limit
IS
Y
rLM
r1
Y1
The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
The Zero Lower Bound on Nominal Interest Rates
bull r = i minus Eπbull iminimum = 0
bull Therefore rminimum = iminimum minus Eπ = 0 minus Eπ
bull Therefore rminimum = minus Eπ
bull For example if Eπ = minus3 then rminimum = minus Eπ = 3
IS
Y
rLM
r1
Y1
21
The Zero Lower Bound on Nominal Interest Rates
bull For example in the diagram the central bank will have to reduce the real interest rate to r = 21 in order to end the recession
bull But suppose expected inflation is Eπ = minus 3
bull Then the nominal interest rate would have to be brought down to i = r + Eπ = 21 ndash 30 = ndash 09
bull Which alas is impossible
IS
Y
rLM
r1
Y1
21
This example also shows how dangerous it can be if we have deflation and people begin to expect the deflation to continue
The Zero Lower Bound on Nominal Interest Rates
bull 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 bendash at the zero lower bound orndash in a liquidity trap
bull See page 350 of the textbook
The Zero Lower Bound on Nominal Interest Rates Solutions
bull When an economy is in a liquidity trap monetary policy cannot be used to reduce interest rates any further
bull But is there nothing else that can be done to bring the economy back to life
bull Yes there isbull Expansionary fiscal policy can be usedbull And therersquos 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
bull In my example ndash the central bank needs to reduce
the real interest rate to r = 21 to end the recession
ndash But expected inflation is Eπ = minus 3 ndash So the nominal interest rate would
have to be brought down to i = ndash 09 which alas is impossible
bull Recall that the LM curve shifts right if either M or Eπ increases
bull If the central bank promises to be irresponsible and to create rapid inflation in the future and if people believe its promise then Eπ will increase say from minus 3 to +1
bull Then the nominal interest rate required for full-employment will be i = r + Eπ = 21 + 10 = 31 which is definitely attainable
IS
Y
rLM
r1
Y1
21
The zero-lower-bound problem can be solved if the central bank can credibly promise to be irresponsible
The Zero Lower Bound on Nominal Interest Rates Solutions
bull Although this chapter assumes a closed economy in reality foreign trade does matter
bull So the central bank can ndash print domestic currency and ndash use it to buy foreign currency ndash thereby making the domestic currency cheaper
relative to the foreign currencyndash thereby stimulating exportsndash thereby ending the recession
The Zero Lower Bound on Nominal Interest Rates Solutions
bull 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
bull This would reduce long-term interest rates directly thereby stimulating spending by the borrowers
bull This strategymdashcalled quantitative easingmdashmay also end a recession
Interaction between monetary and fiscal policy
bull IS-LM Model Monetary and fiscal policy variables (M G and T ) are exogenous
bull Real world Monetary policymakers may adjust M in response to changes in fiscal policy or vice versa
bull Such responses by the central bank may affect the effectiveness of fiscal policy
The Fedrsquos response to G gt 0
bull Suppose the government increases Gbull Possible Fed responses
1 hold M constant2 hold r constant3 hold Y constant
bull In each case the effects of G on Yare differenthellip
When G increases the IS curve shifts right
IS1
Response 1 Hold M constant
Y
rLM
r1
Y1
IS2
Y2
r2
If Fed holds M constant then LM curve does not shift
As a result interest rates rise This has a crowding-out effect Consequently GDP increases but not a lot
If Congress raises G the IS curve shifts right
IS1
Response 2 Hold r constant
Y
rLM1
r1
Y1
IS2
Y2
r2
To keep r constant Fed increases M to shift LM curve right
3 1Y Y Y
0r
LM2
Y3
Results
IS1
Response 3 Hold Y constant
Y
rLM1
r1
IS2
Y2
r2
To keep Y constant Fed reduces M to shift LM curve left
0Y
3 1r r r
LM2
Results
Y1
r3
If Congress raises G the IS curve shifts right
At this point you should be able to do problem 7 on page 353 of the textbook Please try it
Estimates of fiscal policy multipliersfrom the DRI macroeconometric model
Assumption about monetary policy
Estimated value of Y G
Fed holds nominal interest rate constant
Fed holds money supply constant
193
060
Estimated value of Y T
119
026
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 amp services
Examples ndash stock market boom or crash
change in householdsrsquo wealth C
ndash change in business or consumer confidence or expectations I andor C
Shocks in the IS -LM model
LM shocks exogenous changes in the demand for money
Examplesndash a wave of credit card fraud increases demand
for moneyndash 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 of1 a boom in the stock market that makes consumers
wealthier2 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 rb determine what happens to C I and the
unemployment rate
CASE STUDY
THE US RECESSION OF 2001
The US Recession of 2001
bull 39 on 900bull 49 on 801bull 63 on 603bull 50 on 705
The US Recession of 2001
bull Growth of GDP was negative in the 1st and 3rd quarters of 2001
bull Thatrsquos essentially before 911
Recall IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
The US Recession of 2001bull Whybull Demand shocks moved the IS
curve leftndash The ldquotech bubblerdquo ended and
stocks fell 25 between 800 and 801
ndash 911 attacks led to a 12 fall in stock prices in one week and a huge rise in uncertainty
ndash Scandals at Enron WorldCom and other corporations led to stock price declines and a decline in trust and a rise in uncertainty
ndash Lower household wealth reduced Co and higher uncertainty reduced Io
IS
Y
rLM
r1
Y1
CASE STUDY
The US recession of 2001Causes 1) Stock market decline C
300
600
900
1200
1500
1995 1996 1997 1998 1999 2000 2001 2002 2003
Ind
ex
(19
42
= 1
00
) Standard amp Poorrsquos 500
The US Recession of 2001bull Fiscal stimulus moved IS curve
rightndash Major tax cuts were enacted in
2001 and 2003ndash Government spending was
boostedbull to rebuild NYC andbull to bail out the airline industry
bull Fed printed money and moved LM curve rightndash Interest rate on 3-month
Treasury bills fellbull 64 in 1100bull 33 in 801bull 09 in 703
IS1
Y
rLM1
r1
Y1
IS2
LM2
Y3
All three toolsmdashG T and Mmdashwere used
CASE STUDY
The US recession of 2001bull Monetary policy response shifted LM curve right
Three-month T-Bill Rate
Three-month T-Bill Rate
0
1
2
3
4
5
6
7
010
120
0004
02
2000
070
320
0010
03
2000
010
320
0104
05
2001
070
620
0110
06
2001
010
620
0204
08
2002
070
920
0210
09
2002
010
920
0304
11
2003
Skip
bull I am skipping section 11-2
THE GREAT DEPRESSION
The Great Depression
Unemployment (right scale)
Real GNP(left scale)
120
140
160
180
200
220
240
1929 1931 1933 1935 1937 1939
billi
ons
of 1
958
dolla
rs
0
5
10
15
20
25
30
perc
ent o
f lab
or fo
rce
THE SPENDING HYPOTHESIS
Shocks to the IS curvebull asserts that the
Depression was largely due to an exogenous fall in the demand for goods and services ndash a leftward shift of the IS curve
bull evidence output and interest rates both fell in early 1930s which is what a leftward IS shift would cause
IS
Y
rLM
r1
Y1
THE SPENDING HYPOTHESIS
Reasons for the IS shiftbull Stock market crash exogenous C
ndash Oct-Dec 1929 SampP 500 fell 17ndash Oct 1929-Dec 1933 SampP 500 fell 71
bull Drop in investmentndash ldquocorrectionrdquo after overbuilding in the 1920sndash widespread bank failures in early 1930s made it harder
to obtain financing for investmentbull Contractionary fiscal policy
ndash Politicians raised tax rates in 1932 and cut spending to combat increasing deficits
THE MONEY HYPOTHESIS
A shock to the LM curvebull asserts that the Depression was largely due to
huge fall in the money supplybull evidence M1 fell 25 during 1929-33 bull But two problems with this hypothesis
ndash P fell even more so MP actually rose slightly during 1929-31
ndash nominal interest rates fell which is the opposite of what a leftward LM shift would cause
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull asserts that the severity of the Depression
was due to a huge deflation ndash P fell 25 during 1929-33
bull This deflation was probably caused by the fall in M so perhaps money played an important role after all
bull In what ways does a deflation affect the economy
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The stabilizing effects of deflationbull P (MP ) LM shifts right Ybull Pigou effect
P (MP )
consumersrsquo wealth
C
IS shifts right
Y
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects
of expected deflation E
bull LM curve shifts leftr and I (r ) planned expenditure income and output
bull Also the nominal interest rate decreases (idarr) ndash see IS-LM predictions grid
IS
Y
rLM
r1
Y1
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects of unexpected deflation
debt-deflation theoryP (if unexpected)
transfers purchasing power from borrowers to lenders
borrowers spend less lenders spend more if borrowersrsquo propensity to spend is larger than
lendersrsquo then aggregate spending falls the IS curve shifts left and Y falls
The evidence on output and nominal interest rates
bull Note that other than the money hypothesis all the other hypothesesmdashthe spending hypothesis the debt-deflation hypothesis and the deflationary expectations hypothesismdashpredict falling real GDP and falling nominal interest rates
bull This is exactly what happened in the early stages of the Great Depression
bull The spending hypothesis and the debt-deflation hypothesis both predict falling real interest rates whereas the deflationary expectations hypothesis predicts rising real interest rates
bull Therefore evidence on real interest rates is crucial in identifying suitable explanations for the Great Depression
Why another Depression is unlikelybull Policymakers (or their advisors) now know much more
about macroeconomicsndash The Fed knows better than to let M fall so much
especially during a contractionndash Fiscal policymakers know better than to raise
taxes or cut spending during a contractionbull Federal deposit insurance makes widespread bank
failures very unlikely
bull Automatic stabilizers make fiscal policy expansionary during an economic downturn
THE FINANCIAL CRISIS AND ECONOMIC DOWNTURN OF 2008 AND 2009
CASE STUDYThe 2008-09 Financial Crisis amp Recession
bull 2009 Real GDP fell unemployment rate approached 10
bull Important factors in the crisisndash early 2000s Federal Reserve interest rate policy ndash sub-prime mortgage crisisndash bursting of house price bubble rising foreclosure
ratesndash falling stock pricesndash failing financial institutionsndash declining consumer confidence drop in spending on
consumer durables and investment goods
A Too-Brief and Too-Simple Explanation
bull The price of housing had risen to unsustainable levels
bull When home prices inevitably crashed people suddenly felt poor and cut back their spending plans
bull This fall in planned expenditure brought about the Great Recession of 2008-09
The Housing Bubble Inflates then Deflates
bull The SampP Case-Shiller 20-City Home Price Index went from ndash 100 in Jan 2000 tondash 20654 in April 2006 tondash 14095 in May 2009 tondash 14216 in Dec 2010
bull Why did the housing bubble inflate
The Housing Bubble Reasons
bull The Fed kept the interest rates too low for too long
bull Securitization technology got a lot fancier in the mortgage bond market
bull The government regulators were sleepingbull Pretty much everybody believed that home
prices could never fall
The Housing Bubble Low FFR
bull The Fed had reduced the Federal Funds Rate to fight the Recession of 2001
bull After that recession ended the Fed continued to keep interest rates low until 2004ndash The Fed was watching inflation which remained
tame Consequently the Fed saw little reason to raise interest rates
ndash The Fed did not believe that housing prices had formed a bubble hellip until it was blindingly obvious
The Housing Bubble Securitization
bull In the past people with money did not like to lend money to home buyers because such loans were risky and had unreliable returns
bull 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
bull The financial sector was regulated by people who were ideologically opposed to regulation
bull They turned a blind eye to even the worst lending practices
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
causing GDP to rise
IS1
An increase in government purchases graph
1 IS curve shifts right
Y
rLM
r1
Y1
1by
1 MPCG
IS2
Y2
r2
12 This raises money
demand causing the interest rate to risehellip
2
3 hellipwhich reduces investment so the final increase in Y
1is smaller than
1 MPCG
3
IS1
1
A tax cut
Y
rLM
r1
Y1
IS2
Y2
r2
Consumers save (1MPC) of the tax cut so the initial boost in spending is smaller for T than for an equal Ghellip
and the IS curve shifts by
MPC
1 MPCT
1
2
2hellipso the effects on r and Y are smaller for T than for an equal G
2
Shifts of the LM curve
IS
Y
rLM
r1
Y1
Shifts of the LM curve
bull Similarly the LM curve shifts left if there isndash a decrease in MP or Eπ
orndash an increase in Lo
bull As a result Y decreases and r increases
IS
Y
rLM
r1
Y1
Shifts of the LM curve
Shifts of the LM curve
bull Recall from Ch 11 that if expected inflation (Eπ) increases (decreases) the LM curve shifts down (up) by the exact same amount
bull Therefore if Eπ decreases r will increase but by a smaller amount
bull Therefore i = r + Eπ will decrease
IS
Y
rLM
r1
Y1
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
At this point you should be able to do problems 1 2 3 (a) ndash (f) 4 and 5 on pages 352 ndash 353 of the textbook Please try them
Monetary Policy
bull The practice of changing the quantity of money (M) in order to affect the macroeconomic outcome is called monetary policyndash an increase in the quantity of money (Muarr) is
called expansionary monetary policy andndash A decrease in the quantity of money (Mdarr) is
called contractionary monetary policy
Shifts of the LM curvebull When the central bank of a
country makes changes to the quantity of money (M)ndash only the LM curve changes
and ndash the real interest rate (r)
changes in the opposite direction
ndash As expected inflation (Eπ) is assumed exogenous in the IS-LM model when the real interest rate (r) changes the nominal interest rate (i = r + Eπ) changes in the same direction
IS
Y
rLM
r1
Y1
Shifts of the LM curve
bull One can think of the central bank as ndash targeting M and
affecting r and i in the process or as
ndash targeting r andor i and adjusting M to achieve the target
IS
Y
rLM
r1
Y1
Monetary Policy Re-defined
bull Therefore one can re-define expansionary and contractionary monetary policy as followsndash Monetary policy is expansionary when the central
bank attempts to reduce interest rates (real and nominal) and
ndash Monetary policy is contractionary when the central bank attempts to increase the interest rates (real and nominal)
The Federal Funds Rate
bull 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
bull 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
bull The Federal Funds Rate is the interest rate that banks charge each other for overnight loans
bull If the Fed wishes the FFR to be 18 all it has to do is to announce that ndash it will lend money to any bank at 18 interest
andndash will pay 18 interest on deposits received from
any bank
The Federal Funds Ratebull 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 followsndash Monetary policy is expansionary when the Fed seeks
to reduce the federal funds rate andndash Monetary policy is contractionary when the Fed
seeks to increase the federal funds ratebull 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
bull We have seen that when faced with a recession the central bank can ndash Increase the money supply
(Muarr)ndash Thereby shifting the LM
curve rightndash Thereby reducing the real
interest rate (r = i minus Eπ darr) and the nominal interest rate (i = r + Eπdarr) and increasing GDP (Yuarr) to drag the economy out of the recession
IS
Y
rLM
r1
Y1
The Zero Lower Bound on Nominal Interest Rates
bull The problem is that there is a limit to how low the nominal interest rate can be
bull Nominal interest rates (such as the federal funds rate) cannot be negative
bull To deal with the 2008 economic crisis the Fed reduced the FFR to zero
bull But the recession persistedbull Unfortunately the Fed could
not reduce interest rates below zero monetary policy had reached its limit
IS
Y
rLM
r1
Y1
The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
The Zero Lower Bound on Nominal Interest Rates
bull r = i minus Eπbull iminimum = 0
bull Therefore rminimum = iminimum minus Eπ = 0 minus Eπ
bull Therefore rminimum = minus Eπ
bull For example if Eπ = minus3 then rminimum = minus Eπ = 3
IS
Y
rLM
r1
Y1
21
The Zero Lower Bound on Nominal Interest Rates
bull For example in the diagram the central bank will have to reduce the real interest rate to r = 21 in order to end the recession
bull But suppose expected inflation is Eπ = minus 3
bull Then the nominal interest rate would have to be brought down to i = r + Eπ = 21 ndash 30 = ndash 09
bull Which alas is impossible
IS
Y
rLM
r1
Y1
21
This example also shows how dangerous it can be if we have deflation and people begin to expect the deflation to continue
The Zero Lower Bound on Nominal Interest Rates
bull 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 bendash at the zero lower bound orndash in a liquidity trap
bull See page 350 of the textbook
The Zero Lower Bound on Nominal Interest Rates Solutions
bull When an economy is in a liquidity trap monetary policy cannot be used to reduce interest rates any further
bull But is there nothing else that can be done to bring the economy back to life
bull Yes there isbull Expansionary fiscal policy can be usedbull And therersquos 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
bull In my example ndash the central bank needs to reduce
the real interest rate to r = 21 to end the recession
ndash But expected inflation is Eπ = minus 3 ndash So the nominal interest rate would
have to be brought down to i = ndash 09 which alas is impossible
bull Recall that the LM curve shifts right if either M or Eπ increases
bull If the central bank promises to be irresponsible and to create rapid inflation in the future and if people believe its promise then Eπ will increase say from minus 3 to +1
bull Then the nominal interest rate required for full-employment will be i = r + Eπ = 21 + 10 = 31 which is definitely attainable
IS
Y
rLM
r1
Y1
21
The zero-lower-bound problem can be solved if the central bank can credibly promise to be irresponsible
The Zero Lower Bound on Nominal Interest Rates Solutions
bull Although this chapter assumes a closed economy in reality foreign trade does matter
bull So the central bank can ndash print domestic currency and ndash use it to buy foreign currency ndash thereby making the domestic currency cheaper
relative to the foreign currencyndash thereby stimulating exportsndash thereby ending the recession
The Zero Lower Bound on Nominal Interest Rates Solutions
bull 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
bull This would reduce long-term interest rates directly thereby stimulating spending by the borrowers
bull This strategymdashcalled quantitative easingmdashmay also end a recession
Interaction between monetary and fiscal policy
bull IS-LM Model Monetary and fiscal policy variables (M G and T ) are exogenous
bull Real world Monetary policymakers may adjust M in response to changes in fiscal policy or vice versa
bull Such responses by the central bank may affect the effectiveness of fiscal policy
The Fedrsquos response to G gt 0
bull Suppose the government increases Gbull Possible Fed responses
1 hold M constant2 hold r constant3 hold Y constant
bull In each case the effects of G on Yare differenthellip
When G increases the IS curve shifts right
IS1
Response 1 Hold M constant
Y
rLM
r1
Y1
IS2
Y2
r2
If Fed holds M constant then LM curve does not shift
As a result interest rates rise This has a crowding-out effect Consequently GDP increases but not a lot
If Congress raises G the IS curve shifts right
IS1
Response 2 Hold r constant
Y
rLM1
r1
Y1
IS2
Y2
r2
To keep r constant Fed increases M to shift LM curve right
3 1Y Y Y
0r
LM2
Y3
Results
IS1
Response 3 Hold Y constant
Y
rLM1
r1
IS2
Y2
r2
To keep Y constant Fed reduces M to shift LM curve left
0Y
3 1r r r
LM2
Results
Y1
r3
If Congress raises G the IS curve shifts right
At this point you should be able to do problem 7 on page 353 of the textbook Please try it
Estimates of fiscal policy multipliersfrom the DRI macroeconometric model
Assumption about monetary policy
Estimated value of Y G
Fed holds nominal interest rate constant
Fed holds money supply constant
193
060
Estimated value of Y T
119
026
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 amp services
Examples ndash stock market boom or crash
change in householdsrsquo wealth C
ndash change in business or consumer confidence or expectations I andor C
Shocks in the IS -LM model
LM shocks exogenous changes in the demand for money
Examplesndash a wave of credit card fraud increases demand
for moneyndash 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 of1 a boom in the stock market that makes consumers
wealthier2 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 rb determine what happens to C I and the
unemployment rate
CASE STUDY
THE US RECESSION OF 2001
The US Recession of 2001
bull 39 on 900bull 49 on 801bull 63 on 603bull 50 on 705
The US Recession of 2001
bull Growth of GDP was negative in the 1st and 3rd quarters of 2001
bull Thatrsquos essentially before 911
Recall IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
The US Recession of 2001bull Whybull Demand shocks moved the IS
curve leftndash The ldquotech bubblerdquo ended and
stocks fell 25 between 800 and 801
ndash 911 attacks led to a 12 fall in stock prices in one week and a huge rise in uncertainty
ndash Scandals at Enron WorldCom and other corporations led to stock price declines and a decline in trust and a rise in uncertainty
ndash Lower household wealth reduced Co and higher uncertainty reduced Io
IS
Y
rLM
r1
Y1
CASE STUDY
The US recession of 2001Causes 1) Stock market decline C
300
600
900
1200
1500
1995 1996 1997 1998 1999 2000 2001 2002 2003
Ind
ex
(19
42
= 1
00
) Standard amp Poorrsquos 500
The US Recession of 2001bull Fiscal stimulus moved IS curve
rightndash Major tax cuts were enacted in
2001 and 2003ndash Government spending was
boostedbull to rebuild NYC andbull to bail out the airline industry
bull Fed printed money and moved LM curve rightndash Interest rate on 3-month
Treasury bills fellbull 64 in 1100bull 33 in 801bull 09 in 703
IS1
Y
rLM1
r1
Y1
IS2
LM2
Y3
All three toolsmdashG T and Mmdashwere used
CASE STUDY
The US recession of 2001bull Monetary policy response shifted LM curve right
Three-month T-Bill Rate
Three-month T-Bill Rate
0
1
2
3
4
5
6
7
010
120
0004
02
2000
070
320
0010
03
2000
010
320
0104
05
2001
070
620
0110
06
2001
010
620
0204
08
2002
070
920
0210
09
2002
010
920
0304
11
2003
Skip
bull I am skipping section 11-2
THE GREAT DEPRESSION
The Great Depression
Unemployment (right scale)
Real GNP(left scale)
120
140
160
180
200
220
240
1929 1931 1933 1935 1937 1939
billi
ons
of 1
958
dolla
rs
0
5
10
15
20
25
30
perc
ent o
f lab
or fo
rce
THE SPENDING HYPOTHESIS
Shocks to the IS curvebull asserts that the
Depression was largely due to an exogenous fall in the demand for goods and services ndash a leftward shift of the IS curve
bull evidence output and interest rates both fell in early 1930s which is what a leftward IS shift would cause
IS
Y
rLM
r1
Y1
THE SPENDING HYPOTHESIS
Reasons for the IS shiftbull Stock market crash exogenous C
ndash Oct-Dec 1929 SampP 500 fell 17ndash Oct 1929-Dec 1933 SampP 500 fell 71
bull Drop in investmentndash ldquocorrectionrdquo after overbuilding in the 1920sndash widespread bank failures in early 1930s made it harder
to obtain financing for investmentbull Contractionary fiscal policy
ndash Politicians raised tax rates in 1932 and cut spending to combat increasing deficits
THE MONEY HYPOTHESIS
A shock to the LM curvebull asserts that the Depression was largely due to
huge fall in the money supplybull evidence M1 fell 25 during 1929-33 bull But two problems with this hypothesis
ndash P fell even more so MP actually rose slightly during 1929-31
ndash nominal interest rates fell which is the opposite of what a leftward LM shift would cause
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull asserts that the severity of the Depression
was due to a huge deflation ndash P fell 25 during 1929-33
bull This deflation was probably caused by the fall in M so perhaps money played an important role after all
bull In what ways does a deflation affect the economy
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The stabilizing effects of deflationbull P (MP ) LM shifts right Ybull Pigou effect
P (MP )
consumersrsquo wealth
C
IS shifts right
Y
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects
of expected deflation E
bull LM curve shifts leftr and I (r ) planned expenditure income and output
bull Also the nominal interest rate decreases (idarr) ndash see IS-LM predictions grid
IS
Y
rLM
r1
Y1
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects of unexpected deflation
debt-deflation theoryP (if unexpected)
transfers purchasing power from borrowers to lenders
borrowers spend less lenders spend more if borrowersrsquo propensity to spend is larger than
lendersrsquo then aggregate spending falls the IS curve shifts left and Y falls
The evidence on output and nominal interest rates
bull Note that other than the money hypothesis all the other hypothesesmdashthe spending hypothesis the debt-deflation hypothesis and the deflationary expectations hypothesismdashpredict falling real GDP and falling nominal interest rates
bull This is exactly what happened in the early stages of the Great Depression
bull The spending hypothesis and the debt-deflation hypothesis both predict falling real interest rates whereas the deflationary expectations hypothesis predicts rising real interest rates
bull Therefore evidence on real interest rates is crucial in identifying suitable explanations for the Great Depression
Why another Depression is unlikelybull Policymakers (or their advisors) now know much more
about macroeconomicsndash The Fed knows better than to let M fall so much
especially during a contractionndash Fiscal policymakers know better than to raise
taxes or cut spending during a contractionbull Federal deposit insurance makes widespread bank
failures very unlikely
bull Automatic stabilizers make fiscal policy expansionary during an economic downturn
THE FINANCIAL CRISIS AND ECONOMIC DOWNTURN OF 2008 AND 2009
CASE STUDYThe 2008-09 Financial Crisis amp Recession
bull 2009 Real GDP fell unemployment rate approached 10
bull Important factors in the crisisndash early 2000s Federal Reserve interest rate policy ndash sub-prime mortgage crisisndash bursting of house price bubble rising foreclosure
ratesndash falling stock pricesndash failing financial institutionsndash declining consumer confidence drop in spending on
consumer durables and investment goods
A Too-Brief and Too-Simple Explanation
bull The price of housing had risen to unsustainable levels
bull When home prices inevitably crashed people suddenly felt poor and cut back their spending plans
bull This fall in planned expenditure brought about the Great Recession of 2008-09
The Housing Bubble Inflates then Deflates
bull The SampP Case-Shiller 20-City Home Price Index went from ndash 100 in Jan 2000 tondash 20654 in April 2006 tondash 14095 in May 2009 tondash 14216 in Dec 2010
bull Why did the housing bubble inflate
The Housing Bubble Reasons
bull The Fed kept the interest rates too low for too long
bull Securitization technology got a lot fancier in the mortgage bond market
bull The government regulators were sleepingbull Pretty much everybody believed that home
prices could never fall
The Housing Bubble Low FFR
bull The Fed had reduced the Federal Funds Rate to fight the Recession of 2001
bull After that recession ended the Fed continued to keep interest rates low until 2004ndash The Fed was watching inflation which remained
tame Consequently the Fed saw little reason to raise interest rates
ndash The Fed did not believe that housing prices had formed a bubble hellip until it was blindingly obvious
The Housing Bubble Securitization
bull In the past people with money did not like to lend money to home buyers because such loans were risky and had unreliable returns
bull 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
bull The financial sector was regulated by people who were ideologically opposed to regulation
bull They turned a blind eye to even the worst lending practices
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
IS1
1
A tax cut
Y
rLM
r1
Y1
IS2
Y2
r2
Consumers save (1MPC) of the tax cut so the initial boost in spending is smaller for T than for an equal Ghellip
and the IS curve shifts by
MPC
1 MPCT
1
2
2hellipso the effects on r and Y are smaller for T than for an equal G
2
Shifts of the LM curve
IS
Y
rLM
r1
Y1
Shifts of the LM curve
bull Similarly the LM curve shifts left if there isndash a decrease in MP or Eπ
orndash an increase in Lo
bull As a result Y decreases and r increases
IS
Y
rLM
r1
Y1
Shifts of the LM curve
Shifts of the LM curve
bull Recall from Ch 11 that if expected inflation (Eπ) increases (decreases) the LM curve shifts down (up) by the exact same amount
bull Therefore if Eπ decreases r will increase but by a smaller amount
bull Therefore i = r + Eπ will decrease
IS
Y
rLM
r1
Y1
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
At this point you should be able to do problems 1 2 3 (a) ndash (f) 4 and 5 on pages 352 ndash 353 of the textbook Please try them
Monetary Policy
bull The practice of changing the quantity of money (M) in order to affect the macroeconomic outcome is called monetary policyndash an increase in the quantity of money (Muarr) is
called expansionary monetary policy andndash A decrease in the quantity of money (Mdarr) is
called contractionary monetary policy
Shifts of the LM curvebull When the central bank of a
country makes changes to the quantity of money (M)ndash only the LM curve changes
and ndash the real interest rate (r)
changes in the opposite direction
ndash As expected inflation (Eπ) is assumed exogenous in the IS-LM model when the real interest rate (r) changes the nominal interest rate (i = r + Eπ) changes in the same direction
IS
Y
rLM
r1
Y1
Shifts of the LM curve
bull One can think of the central bank as ndash targeting M and
affecting r and i in the process or as
ndash targeting r andor i and adjusting M to achieve the target
IS
Y
rLM
r1
Y1
Monetary Policy Re-defined
bull Therefore one can re-define expansionary and contractionary monetary policy as followsndash Monetary policy is expansionary when the central
bank attempts to reduce interest rates (real and nominal) and
ndash Monetary policy is contractionary when the central bank attempts to increase the interest rates (real and nominal)
The Federal Funds Rate
bull 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
bull 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
bull The Federal Funds Rate is the interest rate that banks charge each other for overnight loans
bull If the Fed wishes the FFR to be 18 all it has to do is to announce that ndash it will lend money to any bank at 18 interest
andndash will pay 18 interest on deposits received from
any bank
The Federal Funds Ratebull 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 followsndash Monetary policy is expansionary when the Fed seeks
to reduce the federal funds rate andndash Monetary policy is contractionary when the Fed
seeks to increase the federal funds ratebull 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
bull We have seen that when faced with a recession the central bank can ndash Increase the money supply
(Muarr)ndash Thereby shifting the LM
curve rightndash Thereby reducing the real
interest rate (r = i minus Eπ darr) and the nominal interest rate (i = r + Eπdarr) and increasing GDP (Yuarr) to drag the economy out of the recession
IS
Y
rLM
r1
Y1
The Zero Lower Bound on Nominal Interest Rates
bull The problem is that there is a limit to how low the nominal interest rate can be
bull Nominal interest rates (such as the federal funds rate) cannot be negative
bull To deal with the 2008 economic crisis the Fed reduced the FFR to zero
bull But the recession persistedbull Unfortunately the Fed could
not reduce interest rates below zero monetary policy had reached its limit
IS
Y
rLM
r1
Y1
The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
The Zero Lower Bound on Nominal Interest Rates
bull r = i minus Eπbull iminimum = 0
bull Therefore rminimum = iminimum minus Eπ = 0 minus Eπ
bull Therefore rminimum = minus Eπ
bull For example if Eπ = minus3 then rminimum = minus Eπ = 3
IS
Y
rLM
r1
Y1
21
The Zero Lower Bound on Nominal Interest Rates
bull For example in the diagram the central bank will have to reduce the real interest rate to r = 21 in order to end the recession
bull But suppose expected inflation is Eπ = minus 3
bull Then the nominal interest rate would have to be brought down to i = r + Eπ = 21 ndash 30 = ndash 09
bull Which alas is impossible
IS
Y
rLM
r1
Y1
21
This example also shows how dangerous it can be if we have deflation and people begin to expect the deflation to continue
The Zero Lower Bound on Nominal Interest Rates
bull 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 bendash at the zero lower bound orndash in a liquidity trap
bull See page 350 of the textbook
The Zero Lower Bound on Nominal Interest Rates Solutions
bull When an economy is in a liquidity trap monetary policy cannot be used to reduce interest rates any further
bull But is there nothing else that can be done to bring the economy back to life
bull Yes there isbull Expansionary fiscal policy can be usedbull And therersquos 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
bull In my example ndash the central bank needs to reduce
the real interest rate to r = 21 to end the recession
ndash But expected inflation is Eπ = minus 3 ndash So the nominal interest rate would
have to be brought down to i = ndash 09 which alas is impossible
bull Recall that the LM curve shifts right if either M or Eπ increases
bull If the central bank promises to be irresponsible and to create rapid inflation in the future and if people believe its promise then Eπ will increase say from minus 3 to +1
bull Then the nominal interest rate required for full-employment will be i = r + Eπ = 21 + 10 = 31 which is definitely attainable
IS
Y
rLM
r1
Y1
21
The zero-lower-bound problem can be solved if the central bank can credibly promise to be irresponsible
The Zero Lower Bound on Nominal Interest Rates Solutions
bull Although this chapter assumes a closed economy in reality foreign trade does matter
bull So the central bank can ndash print domestic currency and ndash use it to buy foreign currency ndash thereby making the domestic currency cheaper
relative to the foreign currencyndash thereby stimulating exportsndash thereby ending the recession
The Zero Lower Bound on Nominal Interest Rates Solutions
bull 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
bull This would reduce long-term interest rates directly thereby stimulating spending by the borrowers
bull This strategymdashcalled quantitative easingmdashmay also end a recession
Interaction between monetary and fiscal policy
bull IS-LM Model Monetary and fiscal policy variables (M G and T ) are exogenous
bull Real world Monetary policymakers may adjust M in response to changes in fiscal policy or vice versa
bull Such responses by the central bank may affect the effectiveness of fiscal policy
The Fedrsquos response to G gt 0
bull Suppose the government increases Gbull Possible Fed responses
1 hold M constant2 hold r constant3 hold Y constant
bull In each case the effects of G on Yare differenthellip
When G increases the IS curve shifts right
IS1
Response 1 Hold M constant
Y
rLM
r1
Y1
IS2
Y2
r2
If Fed holds M constant then LM curve does not shift
As a result interest rates rise This has a crowding-out effect Consequently GDP increases but not a lot
If Congress raises G the IS curve shifts right
IS1
Response 2 Hold r constant
Y
rLM1
r1
Y1
IS2
Y2
r2
To keep r constant Fed increases M to shift LM curve right
3 1Y Y Y
0r
LM2
Y3
Results
IS1
Response 3 Hold Y constant
Y
rLM1
r1
IS2
Y2
r2
To keep Y constant Fed reduces M to shift LM curve left
0Y
3 1r r r
LM2
Results
Y1
r3
If Congress raises G the IS curve shifts right
At this point you should be able to do problem 7 on page 353 of the textbook Please try it
Estimates of fiscal policy multipliersfrom the DRI macroeconometric model
Assumption about monetary policy
Estimated value of Y G
Fed holds nominal interest rate constant
Fed holds money supply constant
193
060
Estimated value of Y T
119
026
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 amp services
Examples ndash stock market boom or crash
change in householdsrsquo wealth C
ndash change in business or consumer confidence or expectations I andor C
Shocks in the IS -LM model
LM shocks exogenous changes in the demand for money
Examplesndash a wave of credit card fraud increases demand
for moneyndash 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 of1 a boom in the stock market that makes consumers
wealthier2 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 rb determine what happens to C I and the
unemployment rate
CASE STUDY
THE US RECESSION OF 2001
The US Recession of 2001
bull 39 on 900bull 49 on 801bull 63 on 603bull 50 on 705
The US Recession of 2001
bull Growth of GDP was negative in the 1st and 3rd quarters of 2001
bull Thatrsquos essentially before 911
Recall IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
The US Recession of 2001bull Whybull Demand shocks moved the IS
curve leftndash The ldquotech bubblerdquo ended and
stocks fell 25 between 800 and 801
ndash 911 attacks led to a 12 fall in stock prices in one week and a huge rise in uncertainty
ndash Scandals at Enron WorldCom and other corporations led to stock price declines and a decline in trust and a rise in uncertainty
ndash Lower household wealth reduced Co and higher uncertainty reduced Io
IS
Y
rLM
r1
Y1
CASE STUDY
The US recession of 2001Causes 1) Stock market decline C
300
600
900
1200
1500
1995 1996 1997 1998 1999 2000 2001 2002 2003
Ind
ex
(19
42
= 1
00
) Standard amp Poorrsquos 500
The US Recession of 2001bull Fiscal stimulus moved IS curve
rightndash Major tax cuts were enacted in
2001 and 2003ndash Government spending was
boostedbull to rebuild NYC andbull to bail out the airline industry
bull Fed printed money and moved LM curve rightndash Interest rate on 3-month
Treasury bills fellbull 64 in 1100bull 33 in 801bull 09 in 703
IS1
Y
rLM1
r1
Y1
IS2
LM2
Y3
All three toolsmdashG T and Mmdashwere used
CASE STUDY
The US recession of 2001bull Monetary policy response shifted LM curve right
Three-month T-Bill Rate
Three-month T-Bill Rate
0
1
2
3
4
5
6
7
010
120
0004
02
2000
070
320
0010
03
2000
010
320
0104
05
2001
070
620
0110
06
2001
010
620
0204
08
2002
070
920
0210
09
2002
010
920
0304
11
2003
Skip
bull I am skipping section 11-2
THE GREAT DEPRESSION
The Great Depression
Unemployment (right scale)
Real GNP(left scale)
120
140
160
180
200
220
240
1929 1931 1933 1935 1937 1939
billi
ons
of 1
958
dolla
rs
0
5
10
15
20
25
30
perc
ent o
f lab
or fo
rce
THE SPENDING HYPOTHESIS
Shocks to the IS curvebull asserts that the
Depression was largely due to an exogenous fall in the demand for goods and services ndash a leftward shift of the IS curve
bull evidence output and interest rates both fell in early 1930s which is what a leftward IS shift would cause
IS
Y
rLM
r1
Y1
THE SPENDING HYPOTHESIS
Reasons for the IS shiftbull Stock market crash exogenous C
ndash Oct-Dec 1929 SampP 500 fell 17ndash Oct 1929-Dec 1933 SampP 500 fell 71
bull Drop in investmentndash ldquocorrectionrdquo after overbuilding in the 1920sndash widespread bank failures in early 1930s made it harder
to obtain financing for investmentbull Contractionary fiscal policy
ndash Politicians raised tax rates in 1932 and cut spending to combat increasing deficits
THE MONEY HYPOTHESIS
A shock to the LM curvebull asserts that the Depression was largely due to
huge fall in the money supplybull evidence M1 fell 25 during 1929-33 bull But two problems with this hypothesis
ndash P fell even more so MP actually rose slightly during 1929-31
ndash nominal interest rates fell which is the opposite of what a leftward LM shift would cause
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull asserts that the severity of the Depression
was due to a huge deflation ndash P fell 25 during 1929-33
bull This deflation was probably caused by the fall in M so perhaps money played an important role after all
bull In what ways does a deflation affect the economy
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The stabilizing effects of deflationbull P (MP ) LM shifts right Ybull Pigou effect
P (MP )
consumersrsquo wealth
C
IS shifts right
Y
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects
of expected deflation E
bull LM curve shifts leftr and I (r ) planned expenditure income and output
bull Also the nominal interest rate decreases (idarr) ndash see IS-LM predictions grid
IS
Y
rLM
r1
Y1
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects of unexpected deflation
debt-deflation theoryP (if unexpected)
transfers purchasing power from borrowers to lenders
borrowers spend less lenders spend more if borrowersrsquo propensity to spend is larger than
lendersrsquo then aggregate spending falls the IS curve shifts left and Y falls
The evidence on output and nominal interest rates
bull Note that other than the money hypothesis all the other hypothesesmdashthe spending hypothesis the debt-deflation hypothesis and the deflationary expectations hypothesismdashpredict falling real GDP and falling nominal interest rates
bull This is exactly what happened in the early stages of the Great Depression
bull The spending hypothesis and the debt-deflation hypothesis both predict falling real interest rates whereas the deflationary expectations hypothesis predicts rising real interest rates
bull Therefore evidence on real interest rates is crucial in identifying suitable explanations for the Great Depression
Why another Depression is unlikelybull Policymakers (or their advisors) now know much more
about macroeconomicsndash The Fed knows better than to let M fall so much
especially during a contractionndash Fiscal policymakers know better than to raise
taxes or cut spending during a contractionbull Federal deposit insurance makes widespread bank
failures very unlikely
bull Automatic stabilizers make fiscal policy expansionary during an economic downturn
THE FINANCIAL CRISIS AND ECONOMIC DOWNTURN OF 2008 AND 2009
CASE STUDYThe 2008-09 Financial Crisis amp Recession
bull 2009 Real GDP fell unemployment rate approached 10
bull Important factors in the crisisndash early 2000s Federal Reserve interest rate policy ndash sub-prime mortgage crisisndash bursting of house price bubble rising foreclosure
ratesndash falling stock pricesndash failing financial institutionsndash declining consumer confidence drop in spending on
consumer durables and investment goods
A Too-Brief and Too-Simple Explanation
bull The price of housing had risen to unsustainable levels
bull When home prices inevitably crashed people suddenly felt poor and cut back their spending plans
bull This fall in planned expenditure brought about the Great Recession of 2008-09
The Housing Bubble Inflates then Deflates
bull The SampP Case-Shiller 20-City Home Price Index went from ndash 100 in Jan 2000 tondash 20654 in April 2006 tondash 14095 in May 2009 tondash 14216 in Dec 2010
bull Why did the housing bubble inflate
The Housing Bubble Reasons
bull The Fed kept the interest rates too low for too long
bull Securitization technology got a lot fancier in the mortgage bond market
bull The government regulators were sleepingbull Pretty much everybody believed that home
prices could never fall
The Housing Bubble Low FFR
bull The Fed had reduced the Federal Funds Rate to fight the Recession of 2001
bull After that recession ended the Fed continued to keep interest rates low until 2004ndash The Fed was watching inflation which remained
tame Consequently the Fed saw little reason to raise interest rates
ndash The Fed did not believe that housing prices had formed a bubble hellip until it was blindingly obvious
The Housing Bubble Securitization
bull In the past people with money did not like to lend money to home buyers because such loans were risky and had unreliable returns
bull 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
bull The financial sector was regulated by people who were ideologically opposed to regulation
bull They turned a blind eye to even the worst lending practices
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
Shifts of the LM curve
IS
Y
rLM
r1
Y1
Shifts of the LM curve
bull Similarly the LM curve shifts left if there isndash a decrease in MP or Eπ
orndash an increase in Lo
bull As a result Y decreases and r increases
IS
Y
rLM
r1
Y1
Shifts of the LM curve
Shifts of the LM curve
bull Recall from Ch 11 that if expected inflation (Eπ) increases (decreases) the LM curve shifts down (up) by the exact same amount
bull Therefore if Eπ decreases r will increase but by a smaller amount
bull Therefore i = r + Eπ will decrease
IS
Y
rLM
r1
Y1
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
At this point you should be able to do problems 1 2 3 (a) ndash (f) 4 and 5 on pages 352 ndash 353 of the textbook Please try them
Monetary Policy
bull The practice of changing the quantity of money (M) in order to affect the macroeconomic outcome is called monetary policyndash an increase in the quantity of money (Muarr) is
called expansionary monetary policy andndash A decrease in the quantity of money (Mdarr) is
called contractionary monetary policy
Shifts of the LM curvebull When the central bank of a
country makes changes to the quantity of money (M)ndash only the LM curve changes
and ndash the real interest rate (r)
changes in the opposite direction
ndash As expected inflation (Eπ) is assumed exogenous in the IS-LM model when the real interest rate (r) changes the nominal interest rate (i = r + Eπ) changes in the same direction
IS
Y
rLM
r1
Y1
Shifts of the LM curve
bull One can think of the central bank as ndash targeting M and
affecting r and i in the process or as
ndash targeting r andor i and adjusting M to achieve the target
IS
Y
rLM
r1
Y1
Monetary Policy Re-defined
bull Therefore one can re-define expansionary and contractionary monetary policy as followsndash Monetary policy is expansionary when the central
bank attempts to reduce interest rates (real and nominal) and
ndash Monetary policy is contractionary when the central bank attempts to increase the interest rates (real and nominal)
The Federal Funds Rate
bull 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
bull 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
bull The Federal Funds Rate is the interest rate that banks charge each other for overnight loans
bull If the Fed wishes the FFR to be 18 all it has to do is to announce that ndash it will lend money to any bank at 18 interest
andndash will pay 18 interest on deposits received from
any bank
The Federal Funds Ratebull 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 followsndash Monetary policy is expansionary when the Fed seeks
to reduce the federal funds rate andndash Monetary policy is contractionary when the Fed
seeks to increase the federal funds ratebull 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
bull We have seen that when faced with a recession the central bank can ndash Increase the money supply
(Muarr)ndash Thereby shifting the LM
curve rightndash Thereby reducing the real
interest rate (r = i minus Eπ darr) and the nominal interest rate (i = r + Eπdarr) and increasing GDP (Yuarr) to drag the economy out of the recession
IS
Y
rLM
r1
Y1
The Zero Lower Bound on Nominal Interest Rates
bull The problem is that there is a limit to how low the nominal interest rate can be
bull Nominal interest rates (such as the federal funds rate) cannot be negative
bull To deal with the 2008 economic crisis the Fed reduced the FFR to zero
bull But the recession persistedbull Unfortunately the Fed could
not reduce interest rates below zero monetary policy had reached its limit
IS
Y
rLM
r1
Y1
The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
The Zero Lower Bound on Nominal Interest Rates
bull r = i minus Eπbull iminimum = 0
bull Therefore rminimum = iminimum minus Eπ = 0 minus Eπ
bull Therefore rminimum = minus Eπ
bull For example if Eπ = minus3 then rminimum = minus Eπ = 3
IS
Y
rLM
r1
Y1
21
The Zero Lower Bound on Nominal Interest Rates
bull For example in the diagram the central bank will have to reduce the real interest rate to r = 21 in order to end the recession
bull But suppose expected inflation is Eπ = minus 3
bull Then the nominal interest rate would have to be brought down to i = r + Eπ = 21 ndash 30 = ndash 09
bull Which alas is impossible
IS
Y
rLM
r1
Y1
21
This example also shows how dangerous it can be if we have deflation and people begin to expect the deflation to continue
The Zero Lower Bound on Nominal Interest Rates
bull 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 bendash at the zero lower bound orndash in a liquidity trap
bull See page 350 of the textbook
The Zero Lower Bound on Nominal Interest Rates Solutions
bull When an economy is in a liquidity trap monetary policy cannot be used to reduce interest rates any further
bull But is there nothing else that can be done to bring the economy back to life
bull Yes there isbull Expansionary fiscal policy can be usedbull And therersquos 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
bull In my example ndash the central bank needs to reduce
the real interest rate to r = 21 to end the recession
ndash But expected inflation is Eπ = minus 3 ndash So the nominal interest rate would
have to be brought down to i = ndash 09 which alas is impossible
bull Recall that the LM curve shifts right if either M or Eπ increases
bull If the central bank promises to be irresponsible and to create rapid inflation in the future and if people believe its promise then Eπ will increase say from minus 3 to +1
bull Then the nominal interest rate required for full-employment will be i = r + Eπ = 21 + 10 = 31 which is definitely attainable
IS
Y
rLM
r1
Y1
21
The zero-lower-bound problem can be solved if the central bank can credibly promise to be irresponsible
The Zero Lower Bound on Nominal Interest Rates Solutions
bull Although this chapter assumes a closed economy in reality foreign trade does matter
bull So the central bank can ndash print domestic currency and ndash use it to buy foreign currency ndash thereby making the domestic currency cheaper
relative to the foreign currencyndash thereby stimulating exportsndash thereby ending the recession
The Zero Lower Bound on Nominal Interest Rates Solutions
bull 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
bull This would reduce long-term interest rates directly thereby stimulating spending by the borrowers
bull This strategymdashcalled quantitative easingmdashmay also end a recession
Interaction between monetary and fiscal policy
bull IS-LM Model Monetary and fiscal policy variables (M G and T ) are exogenous
bull Real world Monetary policymakers may adjust M in response to changes in fiscal policy or vice versa
bull Such responses by the central bank may affect the effectiveness of fiscal policy
The Fedrsquos response to G gt 0
bull Suppose the government increases Gbull Possible Fed responses
1 hold M constant2 hold r constant3 hold Y constant
bull In each case the effects of G on Yare differenthellip
When G increases the IS curve shifts right
IS1
Response 1 Hold M constant
Y
rLM
r1
Y1
IS2
Y2
r2
If Fed holds M constant then LM curve does not shift
As a result interest rates rise This has a crowding-out effect Consequently GDP increases but not a lot
If Congress raises G the IS curve shifts right
IS1
Response 2 Hold r constant
Y
rLM1
r1
Y1
IS2
Y2
r2
To keep r constant Fed increases M to shift LM curve right
3 1Y Y Y
0r
LM2
Y3
Results
IS1
Response 3 Hold Y constant
Y
rLM1
r1
IS2
Y2
r2
To keep Y constant Fed reduces M to shift LM curve left
0Y
3 1r r r
LM2
Results
Y1
r3
If Congress raises G the IS curve shifts right
At this point you should be able to do problem 7 on page 353 of the textbook Please try it
Estimates of fiscal policy multipliersfrom the DRI macroeconometric model
Assumption about monetary policy
Estimated value of Y G
Fed holds nominal interest rate constant
Fed holds money supply constant
193
060
Estimated value of Y T
119
026
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 amp services
Examples ndash stock market boom or crash
change in householdsrsquo wealth C
ndash change in business or consumer confidence or expectations I andor C
Shocks in the IS -LM model
LM shocks exogenous changes in the demand for money
Examplesndash a wave of credit card fraud increases demand
for moneyndash 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 of1 a boom in the stock market that makes consumers
wealthier2 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 rb determine what happens to C I and the
unemployment rate
CASE STUDY
THE US RECESSION OF 2001
The US Recession of 2001
bull 39 on 900bull 49 on 801bull 63 on 603bull 50 on 705
The US Recession of 2001
bull Growth of GDP was negative in the 1st and 3rd quarters of 2001
bull Thatrsquos essentially before 911
Recall IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
The US Recession of 2001bull Whybull Demand shocks moved the IS
curve leftndash The ldquotech bubblerdquo ended and
stocks fell 25 between 800 and 801
ndash 911 attacks led to a 12 fall in stock prices in one week and a huge rise in uncertainty
ndash Scandals at Enron WorldCom and other corporations led to stock price declines and a decline in trust and a rise in uncertainty
ndash Lower household wealth reduced Co and higher uncertainty reduced Io
IS
Y
rLM
r1
Y1
CASE STUDY
The US recession of 2001Causes 1) Stock market decline C
300
600
900
1200
1500
1995 1996 1997 1998 1999 2000 2001 2002 2003
Ind
ex
(19
42
= 1
00
) Standard amp Poorrsquos 500
The US Recession of 2001bull Fiscal stimulus moved IS curve
rightndash Major tax cuts were enacted in
2001 and 2003ndash Government spending was
boostedbull to rebuild NYC andbull to bail out the airline industry
bull Fed printed money and moved LM curve rightndash Interest rate on 3-month
Treasury bills fellbull 64 in 1100bull 33 in 801bull 09 in 703
IS1
Y
rLM1
r1
Y1
IS2
LM2
Y3
All three toolsmdashG T and Mmdashwere used
CASE STUDY
The US recession of 2001bull Monetary policy response shifted LM curve right
Three-month T-Bill Rate
Three-month T-Bill Rate
0
1
2
3
4
5
6
7
010
120
0004
02
2000
070
320
0010
03
2000
010
320
0104
05
2001
070
620
0110
06
2001
010
620
0204
08
2002
070
920
0210
09
2002
010
920
0304
11
2003
Skip
bull I am skipping section 11-2
THE GREAT DEPRESSION
The Great Depression
Unemployment (right scale)
Real GNP(left scale)
120
140
160
180
200
220
240
1929 1931 1933 1935 1937 1939
billi
ons
of 1
958
dolla
rs
0
5
10
15
20
25
30
perc
ent o
f lab
or fo
rce
THE SPENDING HYPOTHESIS
Shocks to the IS curvebull asserts that the
Depression was largely due to an exogenous fall in the demand for goods and services ndash a leftward shift of the IS curve
bull evidence output and interest rates both fell in early 1930s which is what a leftward IS shift would cause
IS
Y
rLM
r1
Y1
THE SPENDING HYPOTHESIS
Reasons for the IS shiftbull Stock market crash exogenous C
ndash Oct-Dec 1929 SampP 500 fell 17ndash Oct 1929-Dec 1933 SampP 500 fell 71
bull Drop in investmentndash ldquocorrectionrdquo after overbuilding in the 1920sndash widespread bank failures in early 1930s made it harder
to obtain financing for investmentbull Contractionary fiscal policy
ndash Politicians raised tax rates in 1932 and cut spending to combat increasing deficits
THE MONEY HYPOTHESIS
A shock to the LM curvebull asserts that the Depression was largely due to
huge fall in the money supplybull evidence M1 fell 25 during 1929-33 bull But two problems with this hypothesis
ndash P fell even more so MP actually rose slightly during 1929-31
ndash nominal interest rates fell which is the opposite of what a leftward LM shift would cause
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull asserts that the severity of the Depression
was due to a huge deflation ndash P fell 25 during 1929-33
bull This deflation was probably caused by the fall in M so perhaps money played an important role after all
bull In what ways does a deflation affect the economy
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The stabilizing effects of deflationbull P (MP ) LM shifts right Ybull Pigou effect
P (MP )
consumersrsquo wealth
C
IS shifts right
Y
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects
of expected deflation E
bull LM curve shifts leftr and I (r ) planned expenditure income and output
bull Also the nominal interest rate decreases (idarr) ndash see IS-LM predictions grid
IS
Y
rLM
r1
Y1
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects of unexpected deflation
debt-deflation theoryP (if unexpected)
transfers purchasing power from borrowers to lenders
borrowers spend less lenders spend more if borrowersrsquo propensity to spend is larger than
lendersrsquo then aggregate spending falls the IS curve shifts left and Y falls
The evidence on output and nominal interest rates
bull Note that other than the money hypothesis all the other hypothesesmdashthe spending hypothesis the debt-deflation hypothesis and the deflationary expectations hypothesismdashpredict falling real GDP and falling nominal interest rates
bull This is exactly what happened in the early stages of the Great Depression
bull The spending hypothesis and the debt-deflation hypothesis both predict falling real interest rates whereas the deflationary expectations hypothesis predicts rising real interest rates
bull Therefore evidence on real interest rates is crucial in identifying suitable explanations for the Great Depression
Why another Depression is unlikelybull Policymakers (or their advisors) now know much more
about macroeconomicsndash The Fed knows better than to let M fall so much
especially during a contractionndash Fiscal policymakers know better than to raise
taxes or cut spending during a contractionbull Federal deposit insurance makes widespread bank
failures very unlikely
bull Automatic stabilizers make fiscal policy expansionary during an economic downturn
THE FINANCIAL CRISIS AND ECONOMIC DOWNTURN OF 2008 AND 2009
CASE STUDYThe 2008-09 Financial Crisis amp Recession
bull 2009 Real GDP fell unemployment rate approached 10
bull Important factors in the crisisndash early 2000s Federal Reserve interest rate policy ndash sub-prime mortgage crisisndash bursting of house price bubble rising foreclosure
ratesndash falling stock pricesndash failing financial institutionsndash declining consumer confidence drop in spending on
consumer durables and investment goods
A Too-Brief and Too-Simple Explanation
bull The price of housing had risen to unsustainable levels
bull When home prices inevitably crashed people suddenly felt poor and cut back their spending plans
bull This fall in planned expenditure brought about the Great Recession of 2008-09
The Housing Bubble Inflates then Deflates
bull The SampP Case-Shiller 20-City Home Price Index went from ndash 100 in Jan 2000 tondash 20654 in April 2006 tondash 14095 in May 2009 tondash 14216 in Dec 2010
bull Why did the housing bubble inflate
The Housing Bubble Reasons
bull The Fed kept the interest rates too low for too long
bull Securitization technology got a lot fancier in the mortgage bond market
bull The government regulators were sleepingbull Pretty much everybody believed that home
prices could never fall
The Housing Bubble Low FFR
bull The Fed had reduced the Federal Funds Rate to fight the Recession of 2001
bull After that recession ended the Fed continued to keep interest rates low until 2004ndash The Fed was watching inflation which remained
tame Consequently the Fed saw little reason to raise interest rates
ndash The Fed did not believe that housing prices had formed a bubble hellip until it was blindingly obvious
The Housing Bubble Securitization
bull In the past people with money did not like to lend money to home buyers because such loans were risky and had unreliable returns
bull 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
bull The financial sector was regulated by people who were ideologically opposed to regulation
bull They turned a blind eye to even the worst lending practices
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
Shifts of the LM curve
bull Similarly the LM curve shifts left if there isndash a decrease in MP or Eπ
orndash an increase in Lo
bull As a result Y decreases and r increases
IS
Y
rLM
r1
Y1
Shifts of the LM curve
Shifts of the LM curve
bull Recall from Ch 11 that if expected inflation (Eπ) increases (decreases) the LM curve shifts down (up) by the exact same amount
bull Therefore if Eπ decreases r will increase but by a smaller amount
bull Therefore i = r + Eπ will decrease
IS
Y
rLM
r1
Y1
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
At this point you should be able to do problems 1 2 3 (a) ndash (f) 4 and 5 on pages 352 ndash 353 of the textbook Please try them
Monetary Policy
bull The practice of changing the quantity of money (M) in order to affect the macroeconomic outcome is called monetary policyndash an increase in the quantity of money (Muarr) is
called expansionary monetary policy andndash A decrease in the quantity of money (Mdarr) is
called contractionary monetary policy
Shifts of the LM curvebull When the central bank of a
country makes changes to the quantity of money (M)ndash only the LM curve changes
and ndash the real interest rate (r)
changes in the opposite direction
ndash As expected inflation (Eπ) is assumed exogenous in the IS-LM model when the real interest rate (r) changes the nominal interest rate (i = r + Eπ) changes in the same direction
IS
Y
rLM
r1
Y1
Shifts of the LM curve
bull One can think of the central bank as ndash targeting M and
affecting r and i in the process or as
ndash targeting r andor i and adjusting M to achieve the target
IS
Y
rLM
r1
Y1
Monetary Policy Re-defined
bull Therefore one can re-define expansionary and contractionary monetary policy as followsndash Monetary policy is expansionary when the central
bank attempts to reduce interest rates (real and nominal) and
ndash Monetary policy is contractionary when the central bank attempts to increase the interest rates (real and nominal)
The Federal Funds Rate
bull 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
bull 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
bull The Federal Funds Rate is the interest rate that banks charge each other for overnight loans
bull If the Fed wishes the FFR to be 18 all it has to do is to announce that ndash it will lend money to any bank at 18 interest
andndash will pay 18 interest on deposits received from
any bank
The Federal Funds Ratebull 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 followsndash Monetary policy is expansionary when the Fed seeks
to reduce the federal funds rate andndash Monetary policy is contractionary when the Fed
seeks to increase the federal funds ratebull 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
bull We have seen that when faced with a recession the central bank can ndash Increase the money supply
(Muarr)ndash Thereby shifting the LM
curve rightndash Thereby reducing the real
interest rate (r = i minus Eπ darr) and the nominal interest rate (i = r + Eπdarr) and increasing GDP (Yuarr) to drag the economy out of the recession
IS
Y
rLM
r1
Y1
The Zero Lower Bound on Nominal Interest Rates
bull The problem is that there is a limit to how low the nominal interest rate can be
bull Nominal interest rates (such as the federal funds rate) cannot be negative
bull To deal with the 2008 economic crisis the Fed reduced the FFR to zero
bull But the recession persistedbull Unfortunately the Fed could
not reduce interest rates below zero monetary policy had reached its limit
IS
Y
rLM
r1
Y1
The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
The Zero Lower Bound on Nominal Interest Rates
bull r = i minus Eπbull iminimum = 0
bull Therefore rminimum = iminimum minus Eπ = 0 minus Eπ
bull Therefore rminimum = minus Eπ
bull For example if Eπ = minus3 then rminimum = minus Eπ = 3
IS
Y
rLM
r1
Y1
21
The Zero Lower Bound on Nominal Interest Rates
bull For example in the diagram the central bank will have to reduce the real interest rate to r = 21 in order to end the recession
bull But suppose expected inflation is Eπ = minus 3
bull Then the nominal interest rate would have to be brought down to i = r + Eπ = 21 ndash 30 = ndash 09
bull Which alas is impossible
IS
Y
rLM
r1
Y1
21
This example also shows how dangerous it can be if we have deflation and people begin to expect the deflation to continue
The Zero Lower Bound on Nominal Interest Rates
bull 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 bendash at the zero lower bound orndash in a liquidity trap
bull See page 350 of the textbook
The Zero Lower Bound on Nominal Interest Rates Solutions
bull When an economy is in a liquidity trap monetary policy cannot be used to reduce interest rates any further
bull But is there nothing else that can be done to bring the economy back to life
bull Yes there isbull Expansionary fiscal policy can be usedbull And therersquos 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
bull In my example ndash the central bank needs to reduce
the real interest rate to r = 21 to end the recession
ndash But expected inflation is Eπ = minus 3 ndash So the nominal interest rate would
have to be brought down to i = ndash 09 which alas is impossible
bull Recall that the LM curve shifts right if either M or Eπ increases
bull If the central bank promises to be irresponsible and to create rapid inflation in the future and if people believe its promise then Eπ will increase say from minus 3 to +1
bull Then the nominal interest rate required for full-employment will be i = r + Eπ = 21 + 10 = 31 which is definitely attainable
IS
Y
rLM
r1
Y1
21
The zero-lower-bound problem can be solved if the central bank can credibly promise to be irresponsible
The Zero Lower Bound on Nominal Interest Rates Solutions
bull Although this chapter assumes a closed economy in reality foreign trade does matter
bull So the central bank can ndash print domestic currency and ndash use it to buy foreign currency ndash thereby making the domestic currency cheaper
relative to the foreign currencyndash thereby stimulating exportsndash thereby ending the recession
The Zero Lower Bound on Nominal Interest Rates Solutions
bull 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
bull This would reduce long-term interest rates directly thereby stimulating spending by the borrowers
bull This strategymdashcalled quantitative easingmdashmay also end a recession
Interaction between monetary and fiscal policy
bull IS-LM Model Monetary and fiscal policy variables (M G and T ) are exogenous
bull Real world Monetary policymakers may adjust M in response to changes in fiscal policy or vice versa
bull Such responses by the central bank may affect the effectiveness of fiscal policy
The Fedrsquos response to G gt 0
bull Suppose the government increases Gbull Possible Fed responses
1 hold M constant2 hold r constant3 hold Y constant
bull In each case the effects of G on Yare differenthellip
When G increases the IS curve shifts right
IS1
Response 1 Hold M constant
Y
rLM
r1
Y1
IS2
Y2
r2
If Fed holds M constant then LM curve does not shift
As a result interest rates rise This has a crowding-out effect Consequently GDP increases but not a lot
If Congress raises G the IS curve shifts right
IS1
Response 2 Hold r constant
Y
rLM1
r1
Y1
IS2
Y2
r2
To keep r constant Fed increases M to shift LM curve right
3 1Y Y Y
0r
LM2
Y3
Results
IS1
Response 3 Hold Y constant
Y
rLM1
r1
IS2
Y2
r2
To keep Y constant Fed reduces M to shift LM curve left
0Y
3 1r r r
LM2
Results
Y1
r3
If Congress raises G the IS curve shifts right
At this point you should be able to do problem 7 on page 353 of the textbook Please try it
Estimates of fiscal policy multipliersfrom the DRI macroeconometric model
Assumption about monetary policy
Estimated value of Y G
Fed holds nominal interest rate constant
Fed holds money supply constant
193
060
Estimated value of Y T
119
026
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 amp services
Examples ndash stock market boom or crash
change in householdsrsquo wealth C
ndash change in business or consumer confidence or expectations I andor C
Shocks in the IS -LM model
LM shocks exogenous changes in the demand for money
Examplesndash a wave of credit card fraud increases demand
for moneyndash 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 of1 a boom in the stock market that makes consumers
wealthier2 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 rb determine what happens to C I and the
unemployment rate
CASE STUDY
THE US RECESSION OF 2001
The US Recession of 2001
bull 39 on 900bull 49 on 801bull 63 on 603bull 50 on 705
The US Recession of 2001
bull Growth of GDP was negative in the 1st and 3rd quarters of 2001
bull Thatrsquos essentially before 911
Recall IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
The US Recession of 2001bull Whybull Demand shocks moved the IS
curve leftndash The ldquotech bubblerdquo ended and
stocks fell 25 between 800 and 801
ndash 911 attacks led to a 12 fall in stock prices in one week and a huge rise in uncertainty
ndash Scandals at Enron WorldCom and other corporations led to stock price declines and a decline in trust and a rise in uncertainty
ndash Lower household wealth reduced Co and higher uncertainty reduced Io
IS
Y
rLM
r1
Y1
CASE STUDY
The US recession of 2001Causes 1) Stock market decline C
300
600
900
1200
1500
1995 1996 1997 1998 1999 2000 2001 2002 2003
Ind
ex
(19
42
= 1
00
) Standard amp Poorrsquos 500
The US Recession of 2001bull Fiscal stimulus moved IS curve
rightndash Major tax cuts were enacted in
2001 and 2003ndash Government spending was
boostedbull to rebuild NYC andbull to bail out the airline industry
bull Fed printed money and moved LM curve rightndash Interest rate on 3-month
Treasury bills fellbull 64 in 1100bull 33 in 801bull 09 in 703
IS1
Y
rLM1
r1
Y1
IS2
LM2
Y3
All three toolsmdashG T and Mmdashwere used
CASE STUDY
The US recession of 2001bull Monetary policy response shifted LM curve right
Three-month T-Bill Rate
Three-month T-Bill Rate
0
1
2
3
4
5
6
7
010
120
0004
02
2000
070
320
0010
03
2000
010
320
0104
05
2001
070
620
0110
06
2001
010
620
0204
08
2002
070
920
0210
09
2002
010
920
0304
11
2003
Skip
bull I am skipping section 11-2
THE GREAT DEPRESSION
The Great Depression
Unemployment (right scale)
Real GNP(left scale)
120
140
160
180
200
220
240
1929 1931 1933 1935 1937 1939
billi
ons
of 1
958
dolla
rs
0
5
10
15
20
25
30
perc
ent o
f lab
or fo
rce
THE SPENDING HYPOTHESIS
Shocks to the IS curvebull asserts that the
Depression was largely due to an exogenous fall in the demand for goods and services ndash a leftward shift of the IS curve
bull evidence output and interest rates both fell in early 1930s which is what a leftward IS shift would cause
IS
Y
rLM
r1
Y1
THE SPENDING HYPOTHESIS
Reasons for the IS shiftbull Stock market crash exogenous C
ndash Oct-Dec 1929 SampP 500 fell 17ndash Oct 1929-Dec 1933 SampP 500 fell 71
bull Drop in investmentndash ldquocorrectionrdquo after overbuilding in the 1920sndash widespread bank failures in early 1930s made it harder
to obtain financing for investmentbull Contractionary fiscal policy
ndash Politicians raised tax rates in 1932 and cut spending to combat increasing deficits
THE MONEY HYPOTHESIS
A shock to the LM curvebull asserts that the Depression was largely due to
huge fall in the money supplybull evidence M1 fell 25 during 1929-33 bull But two problems with this hypothesis
ndash P fell even more so MP actually rose slightly during 1929-31
ndash nominal interest rates fell which is the opposite of what a leftward LM shift would cause
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull asserts that the severity of the Depression
was due to a huge deflation ndash P fell 25 during 1929-33
bull This deflation was probably caused by the fall in M so perhaps money played an important role after all
bull In what ways does a deflation affect the economy
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The stabilizing effects of deflationbull P (MP ) LM shifts right Ybull Pigou effect
P (MP )
consumersrsquo wealth
C
IS shifts right
Y
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects
of expected deflation E
bull LM curve shifts leftr and I (r ) planned expenditure income and output
bull Also the nominal interest rate decreases (idarr) ndash see IS-LM predictions grid
IS
Y
rLM
r1
Y1
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects of unexpected deflation
debt-deflation theoryP (if unexpected)
transfers purchasing power from borrowers to lenders
borrowers spend less lenders spend more if borrowersrsquo propensity to spend is larger than
lendersrsquo then aggregate spending falls the IS curve shifts left and Y falls
The evidence on output and nominal interest rates
bull Note that other than the money hypothesis all the other hypothesesmdashthe spending hypothesis the debt-deflation hypothesis and the deflationary expectations hypothesismdashpredict falling real GDP and falling nominal interest rates
bull This is exactly what happened in the early stages of the Great Depression
bull The spending hypothesis and the debt-deflation hypothesis both predict falling real interest rates whereas the deflationary expectations hypothesis predicts rising real interest rates
bull Therefore evidence on real interest rates is crucial in identifying suitable explanations for the Great Depression
Why another Depression is unlikelybull Policymakers (or their advisors) now know much more
about macroeconomicsndash The Fed knows better than to let M fall so much
especially during a contractionndash Fiscal policymakers know better than to raise
taxes or cut spending during a contractionbull Federal deposit insurance makes widespread bank
failures very unlikely
bull Automatic stabilizers make fiscal policy expansionary during an economic downturn
THE FINANCIAL CRISIS AND ECONOMIC DOWNTURN OF 2008 AND 2009
CASE STUDYThe 2008-09 Financial Crisis amp Recession
bull 2009 Real GDP fell unemployment rate approached 10
bull Important factors in the crisisndash early 2000s Federal Reserve interest rate policy ndash sub-prime mortgage crisisndash bursting of house price bubble rising foreclosure
ratesndash falling stock pricesndash failing financial institutionsndash declining consumer confidence drop in spending on
consumer durables and investment goods
A Too-Brief and Too-Simple Explanation
bull The price of housing had risen to unsustainable levels
bull When home prices inevitably crashed people suddenly felt poor and cut back their spending plans
bull This fall in planned expenditure brought about the Great Recession of 2008-09
The Housing Bubble Inflates then Deflates
bull The SampP Case-Shiller 20-City Home Price Index went from ndash 100 in Jan 2000 tondash 20654 in April 2006 tondash 14095 in May 2009 tondash 14216 in Dec 2010
bull Why did the housing bubble inflate
The Housing Bubble Reasons
bull The Fed kept the interest rates too low for too long
bull Securitization technology got a lot fancier in the mortgage bond market
bull The government regulators were sleepingbull Pretty much everybody believed that home
prices could never fall
The Housing Bubble Low FFR
bull The Fed had reduced the Federal Funds Rate to fight the Recession of 2001
bull After that recession ended the Fed continued to keep interest rates low until 2004ndash The Fed was watching inflation which remained
tame Consequently the Fed saw little reason to raise interest rates
ndash The Fed did not believe that housing prices had formed a bubble hellip until it was blindingly obvious
The Housing Bubble Securitization
bull In the past people with money did not like to lend money to home buyers because such loans were risky and had unreliable returns
bull 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
bull The financial sector was regulated by people who were ideologically opposed to regulation
bull They turned a blind eye to even the worst lending practices
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
Shifts of the LM curve
Shifts of the LM curve
bull Recall from Ch 11 that if expected inflation (Eπ) increases (decreases) the LM curve shifts down (up) by the exact same amount
bull Therefore if Eπ decreases r will increase but by a smaller amount
bull Therefore i = r + Eπ will decrease
IS
Y
rLM
r1
Y1
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
At this point you should be able to do problems 1 2 3 (a) ndash (f) 4 and 5 on pages 352 ndash 353 of the textbook Please try them
Monetary Policy
bull The practice of changing the quantity of money (M) in order to affect the macroeconomic outcome is called monetary policyndash an increase in the quantity of money (Muarr) is
called expansionary monetary policy andndash A decrease in the quantity of money (Mdarr) is
called contractionary monetary policy
Shifts of the LM curvebull When the central bank of a
country makes changes to the quantity of money (M)ndash only the LM curve changes
and ndash the real interest rate (r)
changes in the opposite direction
ndash As expected inflation (Eπ) is assumed exogenous in the IS-LM model when the real interest rate (r) changes the nominal interest rate (i = r + Eπ) changes in the same direction
IS
Y
rLM
r1
Y1
Shifts of the LM curve
bull One can think of the central bank as ndash targeting M and
affecting r and i in the process or as
ndash targeting r andor i and adjusting M to achieve the target
IS
Y
rLM
r1
Y1
Monetary Policy Re-defined
bull Therefore one can re-define expansionary and contractionary monetary policy as followsndash Monetary policy is expansionary when the central
bank attempts to reduce interest rates (real and nominal) and
ndash Monetary policy is contractionary when the central bank attempts to increase the interest rates (real and nominal)
The Federal Funds Rate
bull 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
bull 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
bull The Federal Funds Rate is the interest rate that banks charge each other for overnight loans
bull If the Fed wishes the FFR to be 18 all it has to do is to announce that ndash it will lend money to any bank at 18 interest
andndash will pay 18 interest on deposits received from
any bank
The Federal Funds Ratebull 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 followsndash Monetary policy is expansionary when the Fed seeks
to reduce the federal funds rate andndash Monetary policy is contractionary when the Fed
seeks to increase the federal funds ratebull 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
bull We have seen that when faced with a recession the central bank can ndash Increase the money supply
(Muarr)ndash Thereby shifting the LM
curve rightndash Thereby reducing the real
interest rate (r = i minus Eπ darr) and the nominal interest rate (i = r + Eπdarr) and increasing GDP (Yuarr) to drag the economy out of the recession
IS
Y
rLM
r1
Y1
The Zero Lower Bound on Nominal Interest Rates
bull The problem is that there is a limit to how low the nominal interest rate can be
bull Nominal interest rates (such as the federal funds rate) cannot be negative
bull To deal with the 2008 economic crisis the Fed reduced the FFR to zero
bull But the recession persistedbull Unfortunately the Fed could
not reduce interest rates below zero monetary policy had reached its limit
IS
Y
rLM
r1
Y1
The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
The Zero Lower Bound on Nominal Interest Rates
bull r = i minus Eπbull iminimum = 0
bull Therefore rminimum = iminimum minus Eπ = 0 minus Eπ
bull Therefore rminimum = minus Eπ
bull For example if Eπ = minus3 then rminimum = minus Eπ = 3
IS
Y
rLM
r1
Y1
21
The Zero Lower Bound on Nominal Interest Rates
bull For example in the diagram the central bank will have to reduce the real interest rate to r = 21 in order to end the recession
bull But suppose expected inflation is Eπ = minus 3
bull Then the nominal interest rate would have to be brought down to i = r + Eπ = 21 ndash 30 = ndash 09
bull Which alas is impossible
IS
Y
rLM
r1
Y1
21
This example also shows how dangerous it can be if we have deflation and people begin to expect the deflation to continue
The Zero Lower Bound on Nominal Interest Rates
bull 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 bendash at the zero lower bound orndash in a liquidity trap
bull See page 350 of the textbook
The Zero Lower Bound on Nominal Interest Rates Solutions
bull When an economy is in a liquidity trap monetary policy cannot be used to reduce interest rates any further
bull But is there nothing else that can be done to bring the economy back to life
bull Yes there isbull Expansionary fiscal policy can be usedbull And therersquos 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
bull In my example ndash the central bank needs to reduce
the real interest rate to r = 21 to end the recession
ndash But expected inflation is Eπ = minus 3 ndash So the nominal interest rate would
have to be brought down to i = ndash 09 which alas is impossible
bull Recall that the LM curve shifts right if either M or Eπ increases
bull If the central bank promises to be irresponsible and to create rapid inflation in the future and if people believe its promise then Eπ will increase say from minus 3 to +1
bull Then the nominal interest rate required for full-employment will be i = r + Eπ = 21 + 10 = 31 which is definitely attainable
IS
Y
rLM
r1
Y1
21
The zero-lower-bound problem can be solved if the central bank can credibly promise to be irresponsible
The Zero Lower Bound on Nominal Interest Rates Solutions
bull Although this chapter assumes a closed economy in reality foreign trade does matter
bull So the central bank can ndash print domestic currency and ndash use it to buy foreign currency ndash thereby making the domestic currency cheaper
relative to the foreign currencyndash thereby stimulating exportsndash thereby ending the recession
The Zero Lower Bound on Nominal Interest Rates Solutions
bull 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
bull This would reduce long-term interest rates directly thereby stimulating spending by the borrowers
bull This strategymdashcalled quantitative easingmdashmay also end a recession
Interaction between monetary and fiscal policy
bull IS-LM Model Monetary and fiscal policy variables (M G and T ) are exogenous
bull Real world Monetary policymakers may adjust M in response to changes in fiscal policy or vice versa
bull Such responses by the central bank may affect the effectiveness of fiscal policy
The Fedrsquos response to G gt 0
bull Suppose the government increases Gbull Possible Fed responses
1 hold M constant2 hold r constant3 hold Y constant
bull In each case the effects of G on Yare differenthellip
When G increases the IS curve shifts right
IS1
Response 1 Hold M constant
Y
rLM
r1
Y1
IS2
Y2
r2
If Fed holds M constant then LM curve does not shift
As a result interest rates rise This has a crowding-out effect Consequently GDP increases but not a lot
If Congress raises G the IS curve shifts right
IS1
Response 2 Hold r constant
Y
rLM1
r1
Y1
IS2
Y2
r2
To keep r constant Fed increases M to shift LM curve right
3 1Y Y Y
0r
LM2
Y3
Results
IS1
Response 3 Hold Y constant
Y
rLM1
r1
IS2
Y2
r2
To keep Y constant Fed reduces M to shift LM curve left
0Y
3 1r r r
LM2
Results
Y1
r3
If Congress raises G the IS curve shifts right
At this point you should be able to do problem 7 on page 353 of the textbook Please try it
Estimates of fiscal policy multipliersfrom the DRI macroeconometric model
Assumption about monetary policy
Estimated value of Y G
Fed holds nominal interest rate constant
Fed holds money supply constant
193
060
Estimated value of Y T
119
026
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 amp services
Examples ndash stock market boom or crash
change in householdsrsquo wealth C
ndash change in business or consumer confidence or expectations I andor C
Shocks in the IS -LM model
LM shocks exogenous changes in the demand for money
Examplesndash a wave of credit card fraud increases demand
for moneyndash 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 of1 a boom in the stock market that makes consumers
wealthier2 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 rb determine what happens to C I and the
unemployment rate
CASE STUDY
THE US RECESSION OF 2001
The US Recession of 2001
bull 39 on 900bull 49 on 801bull 63 on 603bull 50 on 705
The US Recession of 2001
bull Growth of GDP was negative in the 1st and 3rd quarters of 2001
bull Thatrsquos essentially before 911
Recall IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
The US Recession of 2001bull Whybull Demand shocks moved the IS
curve leftndash The ldquotech bubblerdquo ended and
stocks fell 25 between 800 and 801
ndash 911 attacks led to a 12 fall in stock prices in one week and a huge rise in uncertainty
ndash Scandals at Enron WorldCom and other corporations led to stock price declines and a decline in trust and a rise in uncertainty
ndash Lower household wealth reduced Co and higher uncertainty reduced Io
IS
Y
rLM
r1
Y1
CASE STUDY
The US recession of 2001Causes 1) Stock market decline C
300
600
900
1200
1500
1995 1996 1997 1998 1999 2000 2001 2002 2003
Ind
ex
(19
42
= 1
00
) Standard amp Poorrsquos 500
The US Recession of 2001bull Fiscal stimulus moved IS curve
rightndash Major tax cuts were enacted in
2001 and 2003ndash Government spending was
boostedbull to rebuild NYC andbull to bail out the airline industry
bull Fed printed money and moved LM curve rightndash Interest rate on 3-month
Treasury bills fellbull 64 in 1100bull 33 in 801bull 09 in 703
IS1
Y
rLM1
r1
Y1
IS2
LM2
Y3
All three toolsmdashG T and Mmdashwere used
CASE STUDY
The US recession of 2001bull Monetary policy response shifted LM curve right
Three-month T-Bill Rate
Three-month T-Bill Rate
0
1
2
3
4
5
6
7
010
120
0004
02
2000
070
320
0010
03
2000
010
320
0104
05
2001
070
620
0110
06
2001
010
620
0204
08
2002
070
920
0210
09
2002
010
920
0304
11
2003
Skip
bull I am skipping section 11-2
THE GREAT DEPRESSION
The Great Depression
Unemployment (right scale)
Real GNP(left scale)
120
140
160
180
200
220
240
1929 1931 1933 1935 1937 1939
billi
ons
of 1
958
dolla
rs
0
5
10
15
20
25
30
perc
ent o
f lab
or fo
rce
THE SPENDING HYPOTHESIS
Shocks to the IS curvebull asserts that the
Depression was largely due to an exogenous fall in the demand for goods and services ndash a leftward shift of the IS curve
bull evidence output and interest rates both fell in early 1930s which is what a leftward IS shift would cause
IS
Y
rLM
r1
Y1
THE SPENDING HYPOTHESIS
Reasons for the IS shiftbull Stock market crash exogenous C
ndash Oct-Dec 1929 SampP 500 fell 17ndash Oct 1929-Dec 1933 SampP 500 fell 71
bull Drop in investmentndash ldquocorrectionrdquo after overbuilding in the 1920sndash widespread bank failures in early 1930s made it harder
to obtain financing for investmentbull Contractionary fiscal policy
ndash Politicians raised tax rates in 1932 and cut spending to combat increasing deficits
THE MONEY HYPOTHESIS
A shock to the LM curvebull asserts that the Depression was largely due to
huge fall in the money supplybull evidence M1 fell 25 during 1929-33 bull But two problems with this hypothesis
ndash P fell even more so MP actually rose slightly during 1929-31
ndash nominal interest rates fell which is the opposite of what a leftward LM shift would cause
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull asserts that the severity of the Depression
was due to a huge deflation ndash P fell 25 during 1929-33
bull This deflation was probably caused by the fall in M so perhaps money played an important role after all
bull In what ways does a deflation affect the economy
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The stabilizing effects of deflationbull P (MP ) LM shifts right Ybull Pigou effect
P (MP )
consumersrsquo wealth
C
IS shifts right
Y
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects
of expected deflation E
bull LM curve shifts leftr and I (r ) planned expenditure income and output
bull Also the nominal interest rate decreases (idarr) ndash see IS-LM predictions grid
IS
Y
rLM
r1
Y1
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects of unexpected deflation
debt-deflation theoryP (if unexpected)
transfers purchasing power from borrowers to lenders
borrowers spend less lenders spend more if borrowersrsquo propensity to spend is larger than
lendersrsquo then aggregate spending falls the IS curve shifts left and Y falls
The evidence on output and nominal interest rates
bull Note that other than the money hypothesis all the other hypothesesmdashthe spending hypothesis the debt-deflation hypothesis and the deflationary expectations hypothesismdashpredict falling real GDP and falling nominal interest rates
bull This is exactly what happened in the early stages of the Great Depression
bull The spending hypothesis and the debt-deflation hypothesis both predict falling real interest rates whereas the deflationary expectations hypothesis predicts rising real interest rates
bull Therefore evidence on real interest rates is crucial in identifying suitable explanations for the Great Depression
Why another Depression is unlikelybull Policymakers (or their advisors) now know much more
about macroeconomicsndash The Fed knows better than to let M fall so much
especially during a contractionndash Fiscal policymakers know better than to raise
taxes or cut spending during a contractionbull Federal deposit insurance makes widespread bank
failures very unlikely
bull Automatic stabilizers make fiscal policy expansionary during an economic downturn
THE FINANCIAL CRISIS AND ECONOMIC DOWNTURN OF 2008 AND 2009
CASE STUDYThe 2008-09 Financial Crisis amp Recession
bull 2009 Real GDP fell unemployment rate approached 10
bull Important factors in the crisisndash early 2000s Federal Reserve interest rate policy ndash sub-prime mortgage crisisndash bursting of house price bubble rising foreclosure
ratesndash falling stock pricesndash failing financial institutionsndash declining consumer confidence drop in spending on
consumer durables and investment goods
A Too-Brief and Too-Simple Explanation
bull The price of housing had risen to unsustainable levels
bull When home prices inevitably crashed people suddenly felt poor and cut back their spending plans
bull This fall in planned expenditure brought about the Great Recession of 2008-09
The Housing Bubble Inflates then Deflates
bull The SampP Case-Shiller 20-City Home Price Index went from ndash 100 in Jan 2000 tondash 20654 in April 2006 tondash 14095 in May 2009 tondash 14216 in Dec 2010
bull Why did the housing bubble inflate
The Housing Bubble Reasons
bull The Fed kept the interest rates too low for too long
bull Securitization technology got a lot fancier in the mortgage bond market
bull The government regulators were sleepingbull Pretty much everybody believed that home
prices could never fall
The Housing Bubble Low FFR
bull The Fed had reduced the Federal Funds Rate to fight the Recession of 2001
bull After that recession ended the Fed continued to keep interest rates low until 2004ndash The Fed was watching inflation which remained
tame Consequently the Fed saw little reason to raise interest rates
ndash The Fed did not believe that housing prices had formed a bubble hellip until it was blindingly obvious
The Housing Bubble Securitization
bull In the past people with money did not like to lend money to home buyers because such loans were risky and had unreliable returns
bull 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
bull The financial sector was regulated by people who were ideologically opposed to regulation
bull They turned a blind eye to even the worst lending practices
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
Shifts of the LM curve
bull Recall from Ch 11 that if expected inflation (Eπ) increases (decreases) the LM curve shifts down (up) by the exact same amount
bull Therefore if Eπ decreases r will increase but by a smaller amount
bull Therefore i = r + Eπ will decrease
IS
Y
rLM
r1
Y1
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
At this point you should be able to do problems 1 2 3 (a) ndash (f) 4 and 5 on pages 352 ndash 353 of the textbook Please try them
Monetary Policy
bull The practice of changing the quantity of money (M) in order to affect the macroeconomic outcome is called monetary policyndash an increase in the quantity of money (Muarr) is
called expansionary monetary policy andndash A decrease in the quantity of money (Mdarr) is
called contractionary monetary policy
Shifts of the LM curvebull When the central bank of a
country makes changes to the quantity of money (M)ndash only the LM curve changes
and ndash the real interest rate (r)
changes in the opposite direction
ndash As expected inflation (Eπ) is assumed exogenous in the IS-LM model when the real interest rate (r) changes the nominal interest rate (i = r + Eπ) changes in the same direction
IS
Y
rLM
r1
Y1
Shifts of the LM curve
bull One can think of the central bank as ndash targeting M and
affecting r and i in the process or as
ndash targeting r andor i and adjusting M to achieve the target
IS
Y
rLM
r1
Y1
Monetary Policy Re-defined
bull Therefore one can re-define expansionary and contractionary monetary policy as followsndash Monetary policy is expansionary when the central
bank attempts to reduce interest rates (real and nominal) and
ndash Monetary policy is contractionary when the central bank attempts to increase the interest rates (real and nominal)
The Federal Funds Rate
bull 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
bull 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
bull The Federal Funds Rate is the interest rate that banks charge each other for overnight loans
bull If the Fed wishes the FFR to be 18 all it has to do is to announce that ndash it will lend money to any bank at 18 interest
andndash will pay 18 interest on deposits received from
any bank
The Federal Funds Ratebull 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 followsndash Monetary policy is expansionary when the Fed seeks
to reduce the federal funds rate andndash Monetary policy is contractionary when the Fed
seeks to increase the federal funds ratebull 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
bull We have seen that when faced with a recession the central bank can ndash Increase the money supply
(Muarr)ndash Thereby shifting the LM
curve rightndash Thereby reducing the real
interest rate (r = i minus Eπ darr) and the nominal interest rate (i = r + Eπdarr) and increasing GDP (Yuarr) to drag the economy out of the recession
IS
Y
rLM
r1
Y1
The Zero Lower Bound on Nominal Interest Rates
bull The problem is that there is a limit to how low the nominal interest rate can be
bull Nominal interest rates (such as the federal funds rate) cannot be negative
bull To deal with the 2008 economic crisis the Fed reduced the FFR to zero
bull But the recession persistedbull Unfortunately the Fed could
not reduce interest rates below zero monetary policy had reached its limit
IS
Y
rLM
r1
Y1
The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
The Zero Lower Bound on Nominal Interest Rates
bull r = i minus Eπbull iminimum = 0
bull Therefore rminimum = iminimum minus Eπ = 0 minus Eπ
bull Therefore rminimum = minus Eπ
bull For example if Eπ = minus3 then rminimum = minus Eπ = 3
IS
Y
rLM
r1
Y1
21
The Zero Lower Bound on Nominal Interest Rates
bull For example in the diagram the central bank will have to reduce the real interest rate to r = 21 in order to end the recession
bull But suppose expected inflation is Eπ = minus 3
bull Then the nominal interest rate would have to be brought down to i = r + Eπ = 21 ndash 30 = ndash 09
bull Which alas is impossible
IS
Y
rLM
r1
Y1
21
This example also shows how dangerous it can be if we have deflation and people begin to expect the deflation to continue
The Zero Lower Bound on Nominal Interest Rates
bull 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 bendash at the zero lower bound orndash in a liquidity trap
bull See page 350 of the textbook
The Zero Lower Bound on Nominal Interest Rates Solutions
bull When an economy is in a liquidity trap monetary policy cannot be used to reduce interest rates any further
bull But is there nothing else that can be done to bring the economy back to life
bull Yes there isbull Expansionary fiscal policy can be usedbull And therersquos 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
bull In my example ndash the central bank needs to reduce
the real interest rate to r = 21 to end the recession
ndash But expected inflation is Eπ = minus 3 ndash So the nominal interest rate would
have to be brought down to i = ndash 09 which alas is impossible
bull Recall that the LM curve shifts right if either M or Eπ increases
bull If the central bank promises to be irresponsible and to create rapid inflation in the future and if people believe its promise then Eπ will increase say from minus 3 to +1
bull Then the nominal interest rate required for full-employment will be i = r + Eπ = 21 + 10 = 31 which is definitely attainable
IS
Y
rLM
r1
Y1
21
The zero-lower-bound problem can be solved if the central bank can credibly promise to be irresponsible
The Zero Lower Bound on Nominal Interest Rates Solutions
bull Although this chapter assumes a closed economy in reality foreign trade does matter
bull So the central bank can ndash print domestic currency and ndash use it to buy foreign currency ndash thereby making the domestic currency cheaper
relative to the foreign currencyndash thereby stimulating exportsndash thereby ending the recession
The Zero Lower Bound on Nominal Interest Rates Solutions
bull 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
bull This would reduce long-term interest rates directly thereby stimulating spending by the borrowers
bull This strategymdashcalled quantitative easingmdashmay also end a recession
Interaction between monetary and fiscal policy
bull IS-LM Model Monetary and fiscal policy variables (M G and T ) are exogenous
bull Real world Monetary policymakers may adjust M in response to changes in fiscal policy or vice versa
bull Such responses by the central bank may affect the effectiveness of fiscal policy
The Fedrsquos response to G gt 0
bull Suppose the government increases Gbull Possible Fed responses
1 hold M constant2 hold r constant3 hold Y constant
bull In each case the effects of G on Yare differenthellip
When G increases the IS curve shifts right
IS1
Response 1 Hold M constant
Y
rLM
r1
Y1
IS2
Y2
r2
If Fed holds M constant then LM curve does not shift
As a result interest rates rise This has a crowding-out effect Consequently GDP increases but not a lot
If Congress raises G the IS curve shifts right
IS1
Response 2 Hold r constant
Y
rLM1
r1
Y1
IS2
Y2
r2
To keep r constant Fed increases M to shift LM curve right
3 1Y Y Y
0r
LM2
Y3
Results
IS1
Response 3 Hold Y constant
Y
rLM1
r1
IS2
Y2
r2
To keep Y constant Fed reduces M to shift LM curve left
0Y
3 1r r r
LM2
Results
Y1
r3
If Congress raises G the IS curve shifts right
At this point you should be able to do problem 7 on page 353 of the textbook Please try it
Estimates of fiscal policy multipliersfrom the DRI macroeconometric model
Assumption about monetary policy
Estimated value of Y G
Fed holds nominal interest rate constant
Fed holds money supply constant
193
060
Estimated value of Y T
119
026
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 amp services
Examples ndash stock market boom or crash
change in householdsrsquo wealth C
ndash change in business or consumer confidence or expectations I andor C
Shocks in the IS -LM model
LM shocks exogenous changes in the demand for money
Examplesndash a wave of credit card fraud increases demand
for moneyndash 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 of1 a boom in the stock market that makes consumers
wealthier2 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 rb determine what happens to C I and the
unemployment rate
CASE STUDY
THE US RECESSION OF 2001
The US Recession of 2001
bull 39 on 900bull 49 on 801bull 63 on 603bull 50 on 705
The US Recession of 2001
bull Growth of GDP was negative in the 1st and 3rd quarters of 2001
bull Thatrsquos essentially before 911
Recall IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
The US Recession of 2001bull Whybull Demand shocks moved the IS
curve leftndash The ldquotech bubblerdquo ended and
stocks fell 25 between 800 and 801
ndash 911 attacks led to a 12 fall in stock prices in one week and a huge rise in uncertainty
ndash Scandals at Enron WorldCom and other corporations led to stock price declines and a decline in trust and a rise in uncertainty
ndash Lower household wealth reduced Co and higher uncertainty reduced Io
IS
Y
rLM
r1
Y1
CASE STUDY
The US recession of 2001Causes 1) Stock market decline C
300
600
900
1200
1500
1995 1996 1997 1998 1999 2000 2001 2002 2003
Ind
ex
(19
42
= 1
00
) Standard amp Poorrsquos 500
The US Recession of 2001bull Fiscal stimulus moved IS curve
rightndash Major tax cuts were enacted in
2001 and 2003ndash Government spending was
boostedbull to rebuild NYC andbull to bail out the airline industry
bull Fed printed money and moved LM curve rightndash Interest rate on 3-month
Treasury bills fellbull 64 in 1100bull 33 in 801bull 09 in 703
IS1
Y
rLM1
r1
Y1
IS2
LM2
Y3
All three toolsmdashG T and Mmdashwere used
CASE STUDY
The US recession of 2001bull Monetary policy response shifted LM curve right
Three-month T-Bill Rate
Three-month T-Bill Rate
0
1
2
3
4
5
6
7
010
120
0004
02
2000
070
320
0010
03
2000
010
320
0104
05
2001
070
620
0110
06
2001
010
620
0204
08
2002
070
920
0210
09
2002
010
920
0304
11
2003
Skip
bull I am skipping section 11-2
THE GREAT DEPRESSION
The Great Depression
Unemployment (right scale)
Real GNP(left scale)
120
140
160
180
200
220
240
1929 1931 1933 1935 1937 1939
billi
ons
of 1
958
dolla
rs
0
5
10
15
20
25
30
perc
ent o
f lab
or fo
rce
THE SPENDING HYPOTHESIS
Shocks to the IS curvebull asserts that the
Depression was largely due to an exogenous fall in the demand for goods and services ndash a leftward shift of the IS curve
bull evidence output and interest rates both fell in early 1930s which is what a leftward IS shift would cause
IS
Y
rLM
r1
Y1
THE SPENDING HYPOTHESIS
Reasons for the IS shiftbull Stock market crash exogenous C
ndash Oct-Dec 1929 SampP 500 fell 17ndash Oct 1929-Dec 1933 SampP 500 fell 71
bull Drop in investmentndash ldquocorrectionrdquo after overbuilding in the 1920sndash widespread bank failures in early 1930s made it harder
to obtain financing for investmentbull Contractionary fiscal policy
ndash Politicians raised tax rates in 1932 and cut spending to combat increasing deficits
THE MONEY HYPOTHESIS
A shock to the LM curvebull asserts that the Depression was largely due to
huge fall in the money supplybull evidence M1 fell 25 during 1929-33 bull But two problems with this hypothesis
ndash P fell even more so MP actually rose slightly during 1929-31
ndash nominal interest rates fell which is the opposite of what a leftward LM shift would cause
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull asserts that the severity of the Depression
was due to a huge deflation ndash P fell 25 during 1929-33
bull This deflation was probably caused by the fall in M so perhaps money played an important role after all
bull In what ways does a deflation affect the economy
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The stabilizing effects of deflationbull P (MP ) LM shifts right Ybull Pigou effect
P (MP )
consumersrsquo wealth
C
IS shifts right
Y
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects
of expected deflation E
bull LM curve shifts leftr and I (r ) planned expenditure income and output
bull Also the nominal interest rate decreases (idarr) ndash see IS-LM predictions grid
IS
Y
rLM
r1
Y1
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects of unexpected deflation
debt-deflation theoryP (if unexpected)
transfers purchasing power from borrowers to lenders
borrowers spend less lenders spend more if borrowersrsquo propensity to spend is larger than
lendersrsquo then aggregate spending falls the IS curve shifts left and Y falls
The evidence on output and nominal interest rates
bull Note that other than the money hypothesis all the other hypothesesmdashthe spending hypothesis the debt-deflation hypothesis and the deflationary expectations hypothesismdashpredict falling real GDP and falling nominal interest rates
bull This is exactly what happened in the early stages of the Great Depression
bull The spending hypothesis and the debt-deflation hypothesis both predict falling real interest rates whereas the deflationary expectations hypothesis predicts rising real interest rates
bull Therefore evidence on real interest rates is crucial in identifying suitable explanations for the Great Depression
Why another Depression is unlikelybull Policymakers (or their advisors) now know much more
about macroeconomicsndash The Fed knows better than to let M fall so much
especially during a contractionndash Fiscal policymakers know better than to raise
taxes or cut spending during a contractionbull Federal deposit insurance makes widespread bank
failures very unlikely
bull Automatic stabilizers make fiscal policy expansionary during an economic downturn
THE FINANCIAL CRISIS AND ECONOMIC DOWNTURN OF 2008 AND 2009
CASE STUDYThe 2008-09 Financial Crisis amp Recession
bull 2009 Real GDP fell unemployment rate approached 10
bull Important factors in the crisisndash early 2000s Federal Reserve interest rate policy ndash sub-prime mortgage crisisndash bursting of house price bubble rising foreclosure
ratesndash falling stock pricesndash failing financial institutionsndash declining consumer confidence drop in spending on
consumer durables and investment goods
A Too-Brief and Too-Simple Explanation
bull The price of housing had risen to unsustainable levels
bull When home prices inevitably crashed people suddenly felt poor and cut back their spending plans
bull This fall in planned expenditure brought about the Great Recession of 2008-09
The Housing Bubble Inflates then Deflates
bull The SampP Case-Shiller 20-City Home Price Index went from ndash 100 in Jan 2000 tondash 20654 in April 2006 tondash 14095 in May 2009 tondash 14216 in Dec 2010
bull Why did the housing bubble inflate
The Housing Bubble Reasons
bull The Fed kept the interest rates too low for too long
bull Securitization technology got a lot fancier in the mortgage bond market
bull The government regulators were sleepingbull Pretty much everybody believed that home
prices could never fall
The Housing Bubble Low FFR
bull The Fed had reduced the Federal Funds Rate to fight the Recession of 2001
bull After that recession ended the Fed continued to keep interest rates low until 2004ndash The Fed was watching inflation which remained
tame Consequently the Fed saw little reason to raise interest rates
ndash The Fed did not believe that housing prices had formed a bubble hellip until it was blindingly obvious
The Housing Bubble Securitization
bull In the past people with money did not like to lend money to home buyers because such loans were risky and had unreliable returns
bull 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
bull The financial sector was regulated by people who were ideologically opposed to regulation
bull They turned a blind eye to even the worst lending practices
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
At this point you should be able to do problems 1 2 3 (a) ndash (f) 4 and 5 on pages 352 ndash 353 of the textbook Please try them
Monetary Policy
bull The practice of changing the quantity of money (M) in order to affect the macroeconomic outcome is called monetary policyndash an increase in the quantity of money (Muarr) is
called expansionary monetary policy andndash A decrease in the quantity of money (Mdarr) is
called contractionary monetary policy
Shifts of the LM curvebull When the central bank of a
country makes changes to the quantity of money (M)ndash only the LM curve changes
and ndash the real interest rate (r)
changes in the opposite direction
ndash As expected inflation (Eπ) is assumed exogenous in the IS-LM model when the real interest rate (r) changes the nominal interest rate (i = r + Eπ) changes in the same direction
IS
Y
rLM
r1
Y1
Shifts of the LM curve
bull One can think of the central bank as ndash targeting M and
affecting r and i in the process or as
ndash targeting r andor i and adjusting M to achieve the target
IS
Y
rLM
r1
Y1
Monetary Policy Re-defined
bull Therefore one can re-define expansionary and contractionary monetary policy as followsndash Monetary policy is expansionary when the central
bank attempts to reduce interest rates (real and nominal) and
ndash Monetary policy is contractionary when the central bank attempts to increase the interest rates (real and nominal)
The Federal Funds Rate
bull 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
bull 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
bull The Federal Funds Rate is the interest rate that banks charge each other for overnight loans
bull If the Fed wishes the FFR to be 18 all it has to do is to announce that ndash it will lend money to any bank at 18 interest
andndash will pay 18 interest on deposits received from
any bank
The Federal Funds Ratebull 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 followsndash Monetary policy is expansionary when the Fed seeks
to reduce the federal funds rate andndash Monetary policy is contractionary when the Fed
seeks to increase the federal funds ratebull 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
bull We have seen that when faced with a recession the central bank can ndash Increase the money supply
(Muarr)ndash Thereby shifting the LM
curve rightndash Thereby reducing the real
interest rate (r = i minus Eπ darr) and the nominal interest rate (i = r + Eπdarr) and increasing GDP (Yuarr) to drag the economy out of the recession
IS
Y
rLM
r1
Y1
The Zero Lower Bound on Nominal Interest Rates
bull The problem is that there is a limit to how low the nominal interest rate can be
bull Nominal interest rates (such as the federal funds rate) cannot be negative
bull To deal with the 2008 economic crisis the Fed reduced the FFR to zero
bull But the recession persistedbull Unfortunately the Fed could
not reduce interest rates below zero monetary policy had reached its limit
IS
Y
rLM
r1
Y1
The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
The Zero Lower Bound on Nominal Interest Rates
bull r = i minus Eπbull iminimum = 0
bull Therefore rminimum = iminimum minus Eπ = 0 minus Eπ
bull Therefore rminimum = minus Eπ
bull For example if Eπ = minus3 then rminimum = minus Eπ = 3
IS
Y
rLM
r1
Y1
21
The Zero Lower Bound on Nominal Interest Rates
bull For example in the diagram the central bank will have to reduce the real interest rate to r = 21 in order to end the recession
bull But suppose expected inflation is Eπ = minus 3
bull Then the nominal interest rate would have to be brought down to i = r + Eπ = 21 ndash 30 = ndash 09
bull Which alas is impossible
IS
Y
rLM
r1
Y1
21
This example also shows how dangerous it can be if we have deflation and people begin to expect the deflation to continue
The Zero Lower Bound on Nominal Interest Rates
bull 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 bendash at the zero lower bound orndash in a liquidity trap
bull See page 350 of the textbook
The Zero Lower Bound on Nominal Interest Rates Solutions
bull When an economy is in a liquidity trap monetary policy cannot be used to reduce interest rates any further
bull But is there nothing else that can be done to bring the economy back to life
bull Yes there isbull Expansionary fiscal policy can be usedbull And therersquos 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
bull In my example ndash the central bank needs to reduce
the real interest rate to r = 21 to end the recession
ndash But expected inflation is Eπ = minus 3 ndash So the nominal interest rate would
have to be brought down to i = ndash 09 which alas is impossible
bull Recall that the LM curve shifts right if either M or Eπ increases
bull If the central bank promises to be irresponsible and to create rapid inflation in the future and if people believe its promise then Eπ will increase say from minus 3 to +1
bull Then the nominal interest rate required for full-employment will be i = r + Eπ = 21 + 10 = 31 which is definitely attainable
IS
Y
rLM
r1
Y1
21
The zero-lower-bound problem can be solved if the central bank can credibly promise to be irresponsible
The Zero Lower Bound on Nominal Interest Rates Solutions
bull Although this chapter assumes a closed economy in reality foreign trade does matter
bull So the central bank can ndash print domestic currency and ndash use it to buy foreign currency ndash thereby making the domestic currency cheaper
relative to the foreign currencyndash thereby stimulating exportsndash thereby ending the recession
The Zero Lower Bound on Nominal Interest Rates Solutions
bull 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
bull This would reduce long-term interest rates directly thereby stimulating spending by the borrowers
bull This strategymdashcalled quantitative easingmdashmay also end a recession
Interaction between monetary and fiscal policy
bull IS-LM Model Monetary and fiscal policy variables (M G and T ) are exogenous
bull Real world Monetary policymakers may adjust M in response to changes in fiscal policy or vice versa
bull Such responses by the central bank may affect the effectiveness of fiscal policy
The Fedrsquos response to G gt 0
bull Suppose the government increases Gbull Possible Fed responses
1 hold M constant2 hold r constant3 hold Y constant
bull In each case the effects of G on Yare differenthellip
When G increases the IS curve shifts right
IS1
Response 1 Hold M constant
Y
rLM
r1
Y1
IS2
Y2
r2
If Fed holds M constant then LM curve does not shift
As a result interest rates rise This has a crowding-out effect Consequently GDP increases but not a lot
If Congress raises G the IS curve shifts right
IS1
Response 2 Hold r constant
Y
rLM1
r1
Y1
IS2
Y2
r2
To keep r constant Fed increases M to shift LM curve right
3 1Y Y Y
0r
LM2
Y3
Results
IS1
Response 3 Hold Y constant
Y
rLM1
r1
IS2
Y2
r2
To keep Y constant Fed reduces M to shift LM curve left
0Y
3 1r r r
LM2
Results
Y1
r3
If Congress raises G the IS curve shifts right
At this point you should be able to do problem 7 on page 353 of the textbook Please try it
Estimates of fiscal policy multipliersfrom the DRI macroeconometric model
Assumption about monetary policy
Estimated value of Y G
Fed holds nominal interest rate constant
Fed holds money supply constant
193
060
Estimated value of Y T
119
026
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 amp services
Examples ndash stock market boom or crash
change in householdsrsquo wealth C
ndash change in business or consumer confidence or expectations I andor C
Shocks in the IS -LM model
LM shocks exogenous changes in the demand for money
Examplesndash a wave of credit card fraud increases demand
for moneyndash 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 of1 a boom in the stock market that makes consumers
wealthier2 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 rb determine what happens to C I and the
unemployment rate
CASE STUDY
THE US RECESSION OF 2001
The US Recession of 2001
bull 39 on 900bull 49 on 801bull 63 on 603bull 50 on 705
The US Recession of 2001
bull Growth of GDP was negative in the 1st and 3rd quarters of 2001
bull Thatrsquos essentially before 911
Recall IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
The US Recession of 2001bull Whybull Demand shocks moved the IS
curve leftndash The ldquotech bubblerdquo ended and
stocks fell 25 between 800 and 801
ndash 911 attacks led to a 12 fall in stock prices in one week and a huge rise in uncertainty
ndash Scandals at Enron WorldCom and other corporations led to stock price declines and a decline in trust and a rise in uncertainty
ndash Lower household wealth reduced Co and higher uncertainty reduced Io
IS
Y
rLM
r1
Y1
CASE STUDY
The US recession of 2001Causes 1) Stock market decline C
300
600
900
1200
1500
1995 1996 1997 1998 1999 2000 2001 2002 2003
Ind
ex
(19
42
= 1
00
) Standard amp Poorrsquos 500
The US Recession of 2001bull Fiscal stimulus moved IS curve
rightndash Major tax cuts were enacted in
2001 and 2003ndash Government spending was
boostedbull to rebuild NYC andbull to bail out the airline industry
bull Fed printed money and moved LM curve rightndash Interest rate on 3-month
Treasury bills fellbull 64 in 1100bull 33 in 801bull 09 in 703
IS1
Y
rLM1
r1
Y1
IS2
LM2
Y3
All three toolsmdashG T and Mmdashwere used
CASE STUDY
The US recession of 2001bull Monetary policy response shifted LM curve right
Three-month T-Bill Rate
Three-month T-Bill Rate
0
1
2
3
4
5
6
7
010
120
0004
02
2000
070
320
0010
03
2000
010
320
0104
05
2001
070
620
0110
06
2001
010
620
0204
08
2002
070
920
0210
09
2002
010
920
0304
11
2003
Skip
bull I am skipping section 11-2
THE GREAT DEPRESSION
The Great Depression
Unemployment (right scale)
Real GNP(left scale)
120
140
160
180
200
220
240
1929 1931 1933 1935 1937 1939
billi
ons
of 1
958
dolla
rs
0
5
10
15
20
25
30
perc
ent o
f lab
or fo
rce
THE SPENDING HYPOTHESIS
Shocks to the IS curvebull asserts that the
Depression was largely due to an exogenous fall in the demand for goods and services ndash a leftward shift of the IS curve
bull evidence output and interest rates both fell in early 1930s which is what a leftward IS shift would cause
IS
Y
rLM
r1
Y1
THE SPENDING HYPOTHESIS
Reasons for the IS shiftbull Stock market crash exogenous C
ndash Oct-Dec 1929 SampP 500 fell 17ndash Oct 1929-Dec 1933 SampP 500 fell 71
bull Drop in investmentndash ldquocorrectionrdquo after overbuilding in the 1920sndash widespread bank failures in early 1930s made it harder
to obtain financing for investmentbull Contractionary fiscal policy
ndash Politicians raised tax rates in 1932 and cut spending to combat increasing deficits
THE MONEY HYPOTHESIS
A shock to the LM curvebull asserts that the Depression was largely due to
huge fall in the money supplybull evidence M1 fell 25 during 1929-33 bull But two problems with this hypothesis
ndash P fell even more so MP actually rose slightly during 1929-31
ndash nominal interest rates fell which is the opposite of what a leftward LM shift would cause
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull asserts that the severity of the Depression
was due to a huge deflation ndash P fell 25 during 1929-33
bull This deflation was probably caused by the fall in M so perhaps money played an important role after all
bull In what ways does a deflation affect the economy
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The stabilizing effects of deflationbull P (MP ) LM shifts right Ybull Pigou effect
P (MP )
consumersrsquo wealth
C
IS shifts right
Y
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects
of expected deflation E
bull LM curve shifts leftr and I (r ) planned expenditure income and output
bull Also the nominal interest rate decreases (idarr) ndash see IS-LM predictions grid
IS
Y
rLM
r1
Y1
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects of unexpected deflation
debt-deflation theoryP (if unexpected)
transfers purchasing power from borrowers to lenders
borrowers spend less lenders spend more if borrowersrsquo propensity to spend is larger than
lendersrsquo then aggregate spending falls the IS curve shifts left and Y falls
The evidence on output and nominal interest rates
bull Note that other than the money hypothesis all the other hypothesesmdashthe spending hypothesis the debt-deflation hypothesis and the deflationary expectations hypothesismdashpredict falling real GDP and falling nominal interest rates
bull This is exactly what happened in the early stages of the Great Depression
bull The spending hypothesis and the debt-deflation hypothesis both predict falling real interest rates whereas the deflationary expectations hypothesis predicts rising real interest rates
bull Therefore evidence on real interest rates is crucial in identifying suitable explanations for the Great Depression
Why another Depression is unlikelybull Policymakers (or their advisors) now know much more
about macroeconomicsndash The Fed knows better than to let M fall so much
especially during a contractionndash Fiscal policymakers know better than to raise
taxes or cut spending during a contractionbull Federal deposit insurance makes widespread bank
failures very unlikely
bull Automatic stabilizers make fiscal policy expansionary during an economic downturn
THE FINANCIAL CRISIS AND ECONOMIC DOWNTURN OF 2008 AND 2009
CASE STUDYThe 2008-09 Financial Crisis amp Recession
bull 2009 Real GDP fell unemployment rate approached 10
bull Important factors in the crisisndash early 2000s Federal Reserve interest rate policy ndash sub-prime mortgage crisisndash bursting of house price bubble rising foreclosure
ratesndash falling stock pricesndash failing financial institutionsndash declining consumer confidence drop in spending on
consumer durables and investment goods
A Too-Brief and Too-Simple Explanation
bull The price of housing had risen to unsustainable levels
bull When home prices inevitably crashed people suddenly felt poor and cut back their spending plans
bull This fall in planned expenditure brought about the Great Recession of 2008-09
The Housing Bubble Inflates then Deflates
bull The SampP Case-Shiller 20-City Home Price Index went from ndash 100 in Jan 2000 tondash 20654 in April 2006 tondash 14095 in May 2009 tondash 14216 in Dec 2010
bull Why did the housing bubble inflate
The Housing Bubble Reasons
bull The Fed kept the interest rates too low for too long
bull Securitization technology got a lot fancier in the mortgage bond market
bull The government regulators were sleepingbull Pretty much everybody believed that home
prices could never fall
The Housing Bubble Low FFR
bull The Fed had reduced the Federal Funds Rate to fight the Recession of 2001
bull After that recession ended the Fed continued to keep interest rates low until 2004ndash The Fed was watching inflation which remained
tame Consequently the Fed saw little reason to raise interest rates
ndash The Fed did not believe that housing prices had formed a bubble hellip until it was blindingly obvious
The Housing Bubble Securitization
bull In the past people with money did not like to lend money to home buyers because such loans were risky and had unreliable returns
bull 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
bull The financial sector was regulated by people who were ideologically opposed to regulation
bull They turned a blind eye to even the worst lending practices
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
Monetary Policy
bull The practice of changing the quantity of money (M) in order to affect the macroeconomic outcome is called monetary policyndash an increase in the quantity of money (Muarr) is
called expansionary monetary policy andndash A decrease in the quantity of money (Mdarr) is
called contractionary monetary policy
Shifts of the LM curvebull When the central bank of a
country makes changes to the quantity of money (M)ndash only the LM curve changes
and ndash the real interest rate (r)
changes in the opposite direction
ndash As expected inflation (Eπ) is assumed exogenous in the IS-LM model when the real interest rate (r) changes the nominal interest rate (i = r + Eπ) changes in the same direction
IS
Y
rLM
r1
Y1
Shifts of the LM curve
bull One can think of the central bank as ndash targeting M and
affecting r and i in the process or as
ndash targeting r andor i and adjusting M to achieve the target
IS
Y
rLM
r1
Y1
Monetary Policy Re-defined
bull Therefore one can re-define expansionary and contractionary monetary policy as followsndash Monetary policy is expansionary when the central
bank attempts to reduce interest rates (real and nominal) and
ndash Monetary policy is contractionary when the central bank attempts to increase the interest rates (real and nominal)
The Federal Funds Rate
bull 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
bull 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
bull The Federal Funds Rate is the interest rate that banks charge each other for overnight loans
bull If the Fed wishes the FFR to be 18 all it has to do is to announce that ndash it will lend money to any bank at 18 interest
andndash will pay 18 interest on deposits received from
any bank
The Federal Funds Ratebull 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 followsndash Monetary policy is expansionary when the Fed seeks
to reduce the federal funds rate andndash Monetary policy is contractionary when the Fed
seeks to increase the federal funds ratebull 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
bull We have seen that when faced with a recession the central bank can ndash Increase the money supply
(Muarr)ndash Thereby shifting the LM
curve rightndash Thereby reducing the real
interest rate (r = i minus Eπ darr) and the nominal interest rate (i = r + Eπdarr) and increasing GDP (Yuarr) to drag the economy out of the recession
IS
Y
rLM
r1
Y1
The Zero Lower Bound on Nominal Interest Rates
bull The problem is that there is a limit to how low the nominal interest rate can be
bull Nominal interest rates (such as the federal funds rate) cannot be negative
bull To deal with the 2008 economic crisis the Fed reduced the FFR to zero
bull But the recession persistedbull Unfortunately the Fed could
not reduce interest rates below zero monetary policy had reached its limit
IS
Y
rLM
r1
Y1
The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
The Zero Lower Bound on Nominal Interest Rates
bull r = i minus Eπbull iminimum = 0
bull Therefore rminimum = iminimum minus Eπ = 0 minus Eπ
bull Therefore rminimum = minus Eπ
bull For example if Eπ = minus3 then rminimum = minus Eπ = 3
IS
Y
rLM
r1
Y1
21
The Zero Lower Bound on Nominal Interest Rates
bull For example in the diagram the central bank will have to reduce the real interest rate to r = 21 in order to end the recession
bull But suppose expected inflation is Eπ = minus 3
bull Then the nominal interest rate would have to be brought down to i = r + Eπ = 21 ndash 30 = ndash 09
bull Which alas is impossible
IS
Y
rLM
r1
Y1
21
This example also shows how dangerous it can be if we have deflation and people begin to expect the deflation to continue
The Zero Lower Bound on Nominal Interest Rates
bull 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 bendash at the zero lower bound orndash in a liquidity trap
bull See page 350 of the textbook
The Zero Lower Bound on Nominal Interest Rates Solutions
bull When an economy is in a liquidity trap monetary policy cannot be used to reduce interest rates any further
bull But is there nothing else that can be done to bring the economy back to life
bull Yes there isbull Expansionary fiscal policy can be usedbull And therersquos 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
bull In my example ndash the central bank needs to reduce
the real interest rate to r = 21 to end the recession
ndash But expected inflation is Eπ = minus 3 ndash So the nominal interest rate would
have to be brought down to i = ndash 09 which alas is impossible
bull Recall that the LM curve shifts right if either M or Eπ increases
bull If the central bank promises to be irresponsible and to create rapid inflation in the future and if people believe its promise then Eπ will increase say from minus 3 to +1
bull Then the nominal interest rate required for full-employment will be i = r + Eπ = 21 + 10 = 31 which is definitely attainable
IS
Y
rLM
r1
Y1
21
The zero-lower-bound problem can be solved if the central bank can credibly promise to be irresponsible
The Zero Lower Bound on Nominal Interest Rates Solutions
bull Although this chapter assumes a closed economy in reality foreign trade does matter
bull So the central bank can ndash print domestic currency and ndash use it to buy foreign currency ndash thereby making the domestic currency cheaper
relative to the foreign currencyndash thereby stimulating exportsndash thereby ending the recession
The Zero Lower Bound on Nominal Interest Rates Solutions
bull 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
bull This would reduce long-term interest rates directly thereby stimulating spending by the borrowers
bull This strategymdashcalled quantitative easingmdashmay also end a recession
Interaction between monetary and fiscal policy
bull IS-LM Model Monetary and fiscal policy variables (M G and T ) are exogenous
bull Real world Monetary policymakers may adjust M in response to changes in fiscal policy or vice versa
bull Such responses by the central bank may affect the effectiveness of fiscal policy
The Fedrsquos response to G gt 0
bull Suppose the government increases Gbull Possible Fed responses
1 hold M constant2 hold r constant3 hold Y constant
bull In each case the effects of G on Yare differenthellip
When G increases the IS curve shifts right
IS1
Response 1 Hold M constant
Y
rLM
r1
Y1
IS2
Y2
r2
If Fed holds M constant then LM curve does not shift
As a result interest rates rise This has a crowding-out effect Consequently GDP increases but not a lot
If Congress raises G the IS curve shifts right
IS1
Response 2 Hold r constant
Y
rLM1
r1
Y1
IS2
Y2
r2
To keep r constant Fed increases M to shift LM curve right
3 1Y Y Y
0r
LM2
Y3
Results
IS1
Response 3 Hold Y constant
Y
rLM1
r1
IS2
Y2
r2
To keep Y constant Fed reduces M to shift LM curve left
0Y
3 1r r r
LM2
Results
Y1
r3
If Congress raises G the IS curve shifts right
At this point you should be able to do problem 7 on page 353 of the textbook Please try it
Estimates of fiscal policy multipliersfrom the DRI macroeconometric model
Assumption about monetary policy
Estimated value of Y G
Fed holds nominal interest rate constant
Fed holds money supply constant
193
060
Estimated value of Y T
119
026
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 amp services
Examples ndash stock market boom or crash
change in householdsrsquo wealth C
ndash change in business or consumer confidence or expectations I andor C
Shocks in the IS -LM model
LM shocks exogenous changes in the demand for money
Examplesndash a wave of credit card fraud increases demand
for moneyndash 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 of1 a boom in the stock market that makes consumers
wealthier2 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 rb determine what happens to C I and the
unemployment rate
CASE STUDY
THE US RECESSION OF 2001
The US Recession of 2001
bull 39 on 900bull 49 on 801bull 63 on 603bull 50 on 705
The US Recession of 2001
bull Growth of GDP was negative in the 1st and 3rd quarters of 2001
bull Thatrsquos essentially before 911
Recall IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
The US Recession of 2001bull Whybull Demand shocks moved the IS
curve leftndash The ldquotech bubblerdquo ended and
stocks fell 25 between 800 and 801
ndash 911 attacks led to a 12 fall in stock prices in one week and a huge rise in uncertainty
ndash Scandals at Enron WorldCom and other corporations led to stock price declines and a decline in trust and a rise in uncertainty
ndash Lower household wealth reduced Co and higher uncertainty reduced Io
IS
Y
rLM
r1
Y1
CASE STUDY
The US recession of 2001Causes 1) Stock market decline C
300
600
900
1200
1500
1995 1996 1997 1998 1999 2000 2001 2002 2003
Ind
ex
(19
42
= 1
00
) Standard amp Poorrsquos 500
The US Recession of 2001bull Fiscal stimulus moved IS curve
rightndash Major tax cuts were enacted in
2001 and 2003ndash Government spending was
boostedbull to rebuild NYC andbull to bail out the airline industry
bull Fed printed money and moved LM curve rightndash Interest rate on 3-month
Treasury bills fellbull 64 in 1100bull 33 in 801bull 09 in 703
IS1
Y
rLM1
r1
Y1
IS2
LM2
Y3
All three toolsmdashG T and Mmdashwere used
CASE STUDY
The US recession of 2001bull Monetary policy response shifted LM curve right
Three-month T-Bill Rate
Three-month T-Bill Rate
0
1
2
3
4
5
6
7
010
120
0004
02
2000
070
320
0010
03
2000
010
320
0104
05
2001
070
620
0110
06
2001
010
620
0204
08
2002
070
920
0210
09
2002
010
920
0304
11
2003
Skip
bull I am skipping section 11-2
THE GREAT DEPRESSION
The Great Depression
Unemployment (right scale)
Real GNP(left scale)
120
140
160
180
200
220
240
1929 1931 1933 1935 1937 1939
billi
ons
of 1
958
dolla
rs
0
5
10
15
20
25
30
perc
ent o
f lab
or fo
rce
THE SPENDING HYPOTHESIS
Shocks to the IS curvebull asserts that the
Depression was largely due to an exogenous fall in the demand for goods and services ndash a leftward shift of the IS curve
bull evidence output and interest rates both fell in early 1930s which is what a leftward IS shift would cause
IS
Y
rLM
r1
Y1
THE SPENDING HYPOTHESIS
Reasons for the IS shiftbull Stock market crash exogenous C
ndash Oct-Dec 1929 SampP 500 fell 17ndash Oct 1929-Dec 1933 SampP 500 fell 71
bull Drop in investmentndash ldquocorrectionrdquo after overbuilding in the 1920sndash widespread bank failures in early 1930s made it harder
to obtain financing for investmentbull Contractionary fiscal policy
ndash Politicians raised tax rates in 1932 and cut spending to combat increasing deficits
THE MONEY HYPOTHESIS
A shock to the LM curvebull asserts that the Depression was largely due to
huge fall in the money supplybull evidence M1 fell 25 during 1929-33 bull But two problems with this hypothesis
ndash P fell even more so MP actually rose slightly during 1929-31
ndash nominal interest rates fell which is the opposite of what a leftward LM shift would cause
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull asserts that the severity of the Depression
was due to a huge deflation ndash P fell 25 during 1929-33
bull This deflation was probably caused by the fall in M so perhaps money played an important role after all
bull In what ways does a deflation affect the economy
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The stabilizing effects of deflationbull P (MP ) LM shifts right Ybull Pigou effect
P (MP )
consumersrsquo wealth
C
IS shifts right
Y
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects
of expected deflation E
bull LM curve shifts leftr and I (r ) planned expenditure income and output
bull Also the nominal interest rate decreases (idarr) ndash see IS-LM predictions grid
IS
Y
rLM
r1
Y1
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects of unexpected deflation
debt-deflation theoryP (if unexpected)
transfers purchasing power from borrowers to lenders
borrowers spend less lenders spend more if borrowersrsquo propensity to spend is larger than
lendersrsquo then aggregate spending falls the IS curve shifts left and Y falls
The evidence on output and nominal interest rates
bull Note that other than the money hypothesis all the other hypothesesmdashthe spending hypothesis the debt-deflation hypothesis and the deflationary expectations hypothesismdashpredict falling real GDP and falling nominal interest rates
bull This is exactly what happened in the early stages of the Great Depression
bull The spending hypothesis and the debt-deflation hypothesis both predict falling real interest rates whereas the deflationary expectations hypothesis predicts rising real interest rates
bull Therefore evidence on real interest rates is crucial in identifying suitable explanations for the Great Depression
Why another Depression is unlikelybull Policymakers (or their advisors) now know much more
about macroeconomicsndash The Fed knows better than to let M fall so much
especially during a contractionndash Fiscal policymakers know better than to raise
taxes or cut spending during a contractionbull Federal deposit insurance makes widespread bank
failures very unlikely
bull Automatic stabilizers make fiscal policy expansionary during an economic downturn
THE FINANCIAL CRISIS AND ECONOMIC DOWNTURN OF 2008 AND 2009
CASE STUDYThe 2008-09 Financial Crisis amp Recession
bull 2009 Real GDP fell unemployment rate approached 10
bull Important factors in the crisisndash early 2000s Federal Reserve interest rate policy ndash sub-prime mortgage crisisndash bursting of house price bubble rising foreclosure
ratesndash falling stock pricesndash failing financial institutionsndash declining consumer confidence drop in spending on
consumer durables and investment goods
A Too-Brief and Too-Simple Explanation
bull The price of housing had risen to unsustainable levels
bull When home prices inevitably crashed people suddenly felt poor and cut back their spending plans
bull This fall in planned expenditure brought about the Great Recession of 2008-09
The Housing Bubble Inflates then Deflates
bull The SampP Case-Shiller 20-City Home Price Index went from ndash 100 in Jan 2000 tondash 20654 in April 2006 tondash 14095 in May 2009 tondash 14216 in Dec 2010
bull Why did the housing bubble inflate
The Housing Bubble Reasons
bull The Fed kept the interest rates too low for too long
bull Securitization technology got a lot fancier in the mortgage bond market
bull The government regulators were sleepingbull Pretty much everybody believed that home
prices could never fall
The Housing Bubble Low FFR
bull The Fed had reduced the Federal Funds Rate to fight the Recession of 2001
bull After that recession ended the Fed continued to keep interest rates low until 2004ndash The Fed was watching inflation which remained
tame Consequently the Fed saw little reason to raise interest rates
ndash The Fed did not believe that housing prices had formed a bubble hellip until it was blindingly obvious
The Housing Bubble Securitization
bull In the past people with money did not like to lend money to home buyers because such loans were risky and had unreliable returns
bull 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
bull The financial sector was regulated by people who were ideologically opposed to regulation
bull They turned a blind eye to even the worst lending practices
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
Shifts of the LM curvebull When the central bank of a
country makes changes to the quantity of money (M)ndash only the LM curve changes
and ndash the real interest rate (r)
changes in the opposite direction
ndash As expected inflation (Eπ) is assumed exogenous in the IS-LM model when the real interest rate (r) changes the nominal interest rate (i = r + Eπ) changes in the same direction
IS
Y
rLM
r1
Y1
Shifts of the LM curve
bull One can think of the central bank as ndash targeting M and
affecting r and i in the process or as
ndash targeting r andor i and adjusting M to achieve the target
IS
Y
rLM
r1
Y1
Monetary Policy Re-defined
bull Therefore one can re-define expansionary and contractionary monetary policy as followsndash Monetary policy is expansionary when the central
bank attempts to reduce interest rates (real and nominal) and
ndash Monetary policy is contractionary when the central bank attempts to increase the interest rates (real and nominal)
The Federal Funds Rate
bull 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
bull 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
bull The Federal Funds Rate is the interest rate that banks charge each other for overnight loans
bull If the Fed wishes the FFR to be 18 all it has to do is to announce that ndash it will lend money to any bank at 18 interest
andndash will pay 18 interest on deposits received from
any bank
The Federal Funds Ratebull 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 followsndash Monetary policy is expansionary when the Fed seeks
to reduce the federal funds rate andndash Monetary policy is contractionary when the Fed
seeks to increase the federal funds ratebull 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
bull We have seen that when faced with a recession the central bank can ndash Increase the money supply
(Muarr)ndash Thereby shifting the LM
curve rightndash Thereby reducing the real
interest rate (r = i minus Eπ darr) and the nominal interest rate (i = r + Eπdarr) and increasing GDP (Yuarr) to drag the economy out of the recession
IS
Y
rLM
r1
Y1
The Zero Lower Bound on Nominal Interest Rates
bull The problem is that there is a limit to how low the nominal interest rate can be
bull Nominal interest rates (such as the federal funds rate) cannot be negative
bull To deal with the 2008 economic crisis the Fed reduced the FFR to zero
bull But the recession persistedbull Unfortunately the Fed could
not reduce interest rates below zero monetary policy had reached its limit
IS
Y
rLM
r1
Y1
The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
The Zero Lower Bound on Nominal Interest Rates
bull r = i minus Eπbull iminimum = 0
bull Therefore rminimum = iminimum minus Eπ = 0 minus Eπ
bull Therefore rminimum = minus Eπ
bull For example if Eπ = minus3 then rminimum = minus Eπ = 3
IS
Y
rLM
r1
Y1
21
The Zero Lower Bound on Nominal Interest Rates
bull For example in the diagram the central bank will have to reduce the real interest rate to r = 21 in order to end the recession
bull But suppose expected inflation is Eπ = minus 3
bull Then the nominal interest rate would have to be brought down to i = r + Eπ = 21 ndash 30 = ndash 09
bull Which alas is impossible
IS
Y
rLM
r1
Y1
21
This example also shows how dangerous it can be if we have deflation and people begin to expect the deflation to continue
The Zero Lower Bound on Nominal Interest Rates
bull 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 bendash at the zero lower bound orndash in a liquidity trap
bull See page 350 of the textbook
The Zero Lower Bound on Nominal Interest Rates Solutions
bull When an economy is in a liquidity trap monetary policy cannot be used to reduce interest rates any further
bull But is there nothing else that can be done to bring the economy back to life
bull Yes there isbull Expansionary fiscal policy can be usedbull And therersquos 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
bull In my example ndash the central bank needs to reduce
the real interest rate to r = 21 to end the recession
ndash But expected inflation is Eπ = minus 3 ndash So the nominal interest rate would
have to be brought down to i = ndash 09 which alas is impossible
bull Recall that the LM curve shifts right if either M or Eπ increases
bull If the central bank promises to be irresponsible and to create rapid inflation in the future and if people believe its promise then Eπ will increase say from minus 3 to +1
bull Then the nominal interest rate required for full-employment will be i = r + Eπ = 21 + 10 = 31 which is definitely attainable
IS
Y
rLM
r1
Y1
21
The zero-lower-bound problem can be solved if the central bank can credibly promise to be irresponsible
The Zero Lower Bound on Nominal Interest Rates Solutions
bull Although this chapter assumes a closed economy in reality foreign trade does matter
bull So the central bank can ndash print domestic currency and ndash use it to buy foreign currency ndash thereby making the domestic currency cheaper
relative to the foreign currencyndash thereby stimulating exportsndash thereby ending the recession
The Zero Lower Bound on Nominal Interest Rates Solutions
bull 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
bull This would reduce long-term interest rates directly thereby stimulating spending by the borrowers
bull This strategymdashcalled quantitative easingmdashmay also end a recession
Interaction between monetary and fiscal policy
bull IS-LM Model Monetary and fiscal policy variables (M G and T ) are exogenous
bull Real world Monetary policymakers may adjust M in response to changes in fiscal policy or vice versa
bull Such responses by the central bank may affect the effectiveness of fiscal policy
The Fedrsquos response to G gt 0
bull Suppose the government increases Gbull Possible Fed responses
1 hold M constant2 hold r constant3 hold Y constant
bull In each case the effects of G on Yare differenthellip
When G increases the IS curve shifts right
IS1
Response 1 Hold M constant
Y
rLM
r1
Y1
IS2
Y2
r2
If Fed holds M constant then LM curve does not shift
As a result interest rates rise This has a crowding-out effect Consequently GDP increases but not a lot
If Congress raises G the IS curve shifts right
IS1
Response 2 Hold r constant
Y
rLM1
r1
Y1
IS2
Y2
r2
To keep r constant Fed increases M to shift LM curve right
3 1Y Y Y
0r
LM2
Y3
Results
IS1
Response 3 Hold Y constant
Y
rLM1
r1
IS2
Y2
r2
To keep Y constant Fed reduces M to shift LM curve left
0Y
3 1r r r
LM2
Results
Y1
r3
If Congress raises G the IS curve shifts right
At this point you should be able to do problem 7 on page 353 of the textbook Please try it
Estimates of fiscal policy multipliersfrom the DRI macroeconometric model
Assumption about monetary policy
Estimated value of Y G
Fed holds nominal interest rate constant
Fed holds money supply constant
193
060
Estimated value of Y T
119
026
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 amp services
Examples ndash stock market boom or crash
change in householdsrsquo wealth C
ndash change in business or consumer confidence or expectations I andor C
Shocks in the IS -LM model
LM shocks exogenous changes in the demand for money
Examplesndash a wave of credit card fraud increases demand
for moneyndash 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 of1 a boom in the stock market that makes consumers
wealthier2 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 rb determine what happens to C I and the
unemployment rate
CASE STUDY
THE US RECESSION OF 2001
The US Recession of 2001
bull 39 on 900bull 49 on 801bull 63 on 603bull 50 on 705
The US Recession of 2001
bull Growth of GDP was negative in the 1st and 3rd quarters of 2001
bull Thatrsquos essentially before 911
Recall IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
The US Recession of 2001bull Whybull Demand shocks moved the IS
curve leftndash The ldquotech bubblerdquo ended and
stocks fell 25 between 800 and 801
ndash 911 attacks led to a 12 fall in stock prices in one week and a huge rise in uncertainty
ndash Scandals at Enron WorldCom and other corporations led to stock price declines and a decline in trust and a rise in uncertainty
ndash Lower household wealth reduced Co and higher uncertainty reduced Io
IS
Y
rLM
r1
Y1
CASE STUDY
The US recession of 2001Causes 1) Stock market decline C
300
600
900
1200
1500
1995 1996 1997 1998 1999 2000 2001 2002 2003
Ind
ex
(19
42
= 1
00
) Standard amp Poorrsquos 500
The US Recession of 2001bull Fiscal stimulus moved IS curve
rightndash Major tax cuts were enacted in
2001 and 2003ndash Government spending was
boostedbull to rebuild NYC andbull to bail out the airline industry
bull Fed printed money and moved LM curve rightndash Interest rate on 3-month
Treasury bills fellbull 64 in 1100bull 33 in 801bull 09 in 703
IS1
Y
rLM1
r1
Y1
IS2
LM2
Y3
All three toolsmdashG T and Mmdashwere used
CASE STUDY
The US recession of 2001bull Monetary policy response shifted LM curve right
Three-month T-Bill Rate
Three-month T-Bill Rate
0
1
2
3
4
5
6
7
010
120
0004
02
2000
070
320
0010
03
2000
010
320
0104
05
2001
070
620
0110
06
2001
010
620
0204
08
2002
070
920
0210
09
2002
010
920
0304
11
2003
Skip
bull I am skipping section 11-2
THE GREAT DEPRESSION
The Great Depression
Unemployment (right scale)
Real GNP(left scale)
120
140
160
180
200
220
240
1929 1931 1933 1935 1937 1939
billi
ons
of 1
958
dolla
rs
0
5
10
15
20
25
30
perc
ent o
f lab
or fo
rce
THE SPENDING HYPOTHESIS
Shocks to the IS curvebull asserts that the
Depression was largely due to an exogenous fall in the demand for goods and services ndash a leftward shift of the IS curve
bull evidence output and interest rates both fell in early 1930s which is what a leftward IS shift would cause
IS
Y
rLM
r1
Y1
THE SPENDING HYPOTHESIS
Reasons for the IS shiftbull Stock market crash exogenous C
ndash Oct-Dec 1929 SampP 500 fell 17ndash Oct 1929-Dec 1933 SampP 500 fell 71
bull Drop in investmentndash ldquocorrectionrdquo after overbuilding in the 1920sndash widespread bank failures in early 1930s made it harder
to obtain financing for investmentbull Contractionary fiscal policy
ndash Politicians raised tax rates in 1932 and cut spending to combat increasing deficits
THE MONEY HYPOTHESIS
A shock to the LM curvebull asserts that the Depression was largely due to
huge fall in the money supplybull evidence M1 fell 25 during 1929-33 bull But two problems with this hypothesis
ndash P fell even more so MP actually rose slightly during 1929-31
ndash nominal interest rates fell which is the opposite of what a leftward LM shift would cause
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull asserts that the severity of the Depression
was due to a huge deflation ndash P fell 25 during 1929-33
bull This deflation was probably caused by the fall in M so perhaps money played an important role after all
bull In what ways does a deflation affect the economy
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The stabilizing effects of deflationbull P (MP ) LM shifts right Ybull Pigou effect
P (MP )
consumersrsquo wealth
C
IS shifts right
Y
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects
of expected deflation E
bull LM curve shifts leftr and I (r ) planned expenditure income and output
bull Also the nominal interest rate decreases (idarr) ndash see IS-LM predictions grid
IS
Y
rLM
r1
Y1
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects of unexpected deflation
debt-deflation theoryP (if unexpected)
transfers purchasing power from borrowers to lenders
borrowers spend less lenders spend more if borrowersrsquo propensity to spend is larger than
lendersrsquo then aggregate spending falls the IS curve shifts left and Y falls
The evidence on output and nominal interest rates
bull Note that other than the money hypothesis all the other hypothesesmdashthe spending hypothesis the debt-deflation hypothesis and the deflationary expectations hypothesismdashpredict falling real GDP and falling nominal interest rates
bull This is exactly what happened in the early stages of the Great Depression
bull The spending hypothesis and the debt-deflation hypothesis both predict falling real interest rates whereas the deflationary expectations hypothesis predicts rising real interest rates
bull Therefore evidence on real interest rates is crucial in identifying suitable explanations for the Great Depression
Why another Depression is unlikelybull Policymakers (or their advisors) now know much more
about macroeconomicsndash The Fed knows better than to let M fall so much
especially during a contractionndash Fiscal policymakers know better than to raise
taxes or cut spending during a contractionbull Federal deposit insurance makes widespread bank
failures very unlikely
bull Automatic stabilizers make fiscal policy expansionary during an economic downturn
THE FINANCIAL CRISIS AND ECONOMIC DOWNTURN OF 2008 AND 2009
CASE STUDYThe 2008-09 Financial Crisis amp Recession
bull 2009 Real GDP fell unemployment rate approached 10
bull Important factors in the crisisndash early 2000s Federal Reserve interest rate policy ndash sub-prime mortgage crisisndash bursting of house price bubble rising foreclosure
ratesndash falling stock pricesndash failing financial institutionsndash declining consumer confidence drop in spending on
consumer durables and investment goods
A Too-Brief and Too-Simple Explanation
bull The price of housing had risen to unsustainable levels
bull When home prices inevitably crashed people suddenly felt poor and cut back their spending plans
bull This fall in planned expenditure brought about the Great Recession of 2008-09
The Housing Bubble Inflates then Deflates
bull The SampP Case-Shiller 20-City Home Price Index went from ndash 100 in Jan 2000 tondash 20654 in April 2006 tondash 14095 in May 2009 tondash 14216 in Dec 2010
bull Why did the housing bubble inflate
The Housing Bubble Reasons
bull The Fed kept the interest rates too low for too long
bull Securitization technology got a lot fancier in the mortgage bond market
bull The government regulators were sleepingbull Pretty much everybody believed that home
prices could never fall
The Housing Bubble Low FFR
bull The Fed had reduced the Federal Funds Rate to fight the Recession of 2001
bull After that recession ended the Fed continued to keep interest rates low until 2004ndash The Fed was watching inflation which remained
tame Consequently the Fed saw little reason to raise interest rates
ndash The Fed did not believe that housing prices had formed a bubble hellip until it was blindingly obvious
The Housing Bubble Securitization
bull In the past people with money did not like to lend money to home buyers because such loans were risky and had unreliable returns
bull 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
bull The financial sector was regulated by people who were ideologically opposed to regulation
bull They turned a blind eye to even the worst lending practices
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
Shifts of the LM curve
bull One can think of the central bank as ndash targeting M and
affecting r and i in the process or as
ndash targeting r andor i and adjusting M to achieve the target
IS
Y
rLM
r1
Y1
Monetary Policy Re-defined
bull Therefore one can re-define expansionary and contractionary monetary policy as followsndash Monetary policy is expansionary when the central
bank attempts to reduce interest rates (real and nominal) and
ndash Monetary policy is contractionary when the central bank attempts to increase the interest rates (real and nominal)
The Federal Funds Rate
bull 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
bull 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
bull The Federal Funds Rate is the interest rate that banks charge each other for overnight loans
bull If the Fed wishes the FFR to be 18 all it has to do is to announce that ndash it will lend money to any bank at 18 interest
andndash will pay 18 interest on deposits received from
any bank
The Federal Funds Ratebull 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 followsndash Monetary policy is expansionary when the Fed seeks
to reduce the federal funds rate andndash Monetary policy is contractionary when the Fed
seeks to increase the federal funds ratebull 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
bull We have seen that when faced with a recession the central bank can ndash Increase the money supply
(Muarr)ndash Thereby shifting the LM
curve rightndash Thereby reducing the real
interest rate (r = i minus Eπ darr) and the nominal interest rate (i = r + Eπdarr) and increasing GDP (Yuarr) to drag the economy out of the recession
IS
Y
rLM
r1
Y1
The Zero Lower Bound on Nominal Interest Rates
bull The problem is that there is a limit to how low the nominal interest rate can be
bull Nominal interest rates (such as the federal funds rate) cannot be negative
bull To deal with the 2008 economic crisis the Fed reduced the FFR to zero
bull But the recession persistedbull Unfortunately the Fed could
not reduce interest rates below zero monetary policy had reached its limit
IS
Y
rLM
r1
Y1
The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
The Zero Lower Bound on Nominal Interest Rates
bull r = i minus Eπbull iminimum = 0
bull Therefore rminimum = iminimum minus Eπ = 0 minus Eπ
bull Therefore rminimum = minus Eπ
bull For example if Eπ = minus3 then rminimum = minus Eπ = 3
IS
Y
rLM
r1
Y1
21
The Zero Lower Bound on Nominal Interest Rates
bull For example in the diagram the central bank will have to reduce the real interest rate to r = 21 in order to end the recession
bull But suppose expected inflation is Eπ = minus 3
bull Then the nominal interest rate would have to be brought down to i = r + Eπ = 21 ndash 30 = ndash 09
bull Which alas is impossible
IS
Y
rLM
r1
Y1
21
This example also shows how dangerous it can be if we have deflation and people begin to expect the deflation to continue
The Zero Lower Bound on Nominal Interest Rates
bull 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 bendash at the zero lower bound orndash in a liquidity trap
bull See page 350 of the textbook
The Zero Lower Bound on Nominal Interest Rates Solutions
bull When an economy is in a liquidity trap monetary policy cannot be used to reduce interest rates any further
bull But is there nothing else that can be done to bring the economy back to life
bull Yes there isbull Expansionary fiscal policy can be usedbull And therersquos 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
bull In my example ndash the central bank needs to reduce
the real interest rate to r = 21 to end the recession
ndash But expected inflation is Eπ = minus 3 ndash So the nominal interest rate would
have to be brought down to i = ndash 09 which alas is impossible
bull Recall that the LM curve shifts right if either M or Eπ increases
bull If the central bank promises to be irresponsible and to create rapid inflation in the future and if people believe its promise then Eπ will increase say from minus 3 to +1
bull Then the nominal interest rate required for full-employment will be i = r + Eπ = 21 + 10 = 31 which is definitely attainable
IS
Y
rLM
r1
Y1
21
The zero-lower-bound problem can be solved if the central bank can credibly promise to be irresponsible
The Zero Lower Bound on Nominal Interest Rates Solutions
bull Although this chapter assumes a closed economy in reality foreign trade does matter
bull So the central bank can ndash print domestic currency and ndash use it to buy foreign currency ndash thereby making the domestic currency cheaper
relative to the foreign currencyndash thereby stimulating exportsndash thereby ending the recession
The Zero Lower Bound on Nominal Interest Rates Solutions
bull 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
bull This would reduce long-term interest rates directly thereby stimulating spending by the borrowers
bull This strategymdashcalled quantitative easingmdashmay also end a recession
Interaction between monetary and fiscal policy
bull IS-LM Model Monetary and fiscal policy variables (M G and T ) are exogenous
bull Real world Monetary policymakers may adjust M in response to changes in fiscal policy or vice versa
bull Such responses by the central bank may affect the effectiveness of fiscal policy
The Fedrsquos response to G gt 0
bull Suppose the government increases Gbull Possible Fed responses
1 hold M constant2 hold r constant3 hold Y constant
bull In each case the effects of G on Yare differenthellip
When G increases the IS curve shifts right
IS1
Response 1 Hold M constant
Y
rLM
r1
Y1
IS2
Y2
r2
If Fed holds M constant then LM curve does not shift
As a result interest rates rise This has a crowding-out effect Consequently GDP increases but not a lot
If Congress raises G the IS curve shifts right
IS1
Response 2 Hold r constant
Y
rLM1
r1
Y1
IS2
Y2
r2
To keep r constant Fed increases M to shift LM curve right
3 1Y Y Y
0r
LM2
Y3
Results
IS1
Response 3 Hold Y constant
Y
rLM1
r1
IS2
Y2
r2
To keep Y constant Fed reduces M to shift LM curve left
0Y
3 1r r r
LM2
Results
Y1
r3
If Congress raises G the IS curve shifts right
At this point you should be able to do problem 7 on page 353 of the textbook Please try it
Estimates of fiscal policy multipliersfrom the DRI macroeconometric model
Assumption about monetary policy
Estimated value of Y G
Fed holds nominal interest rate constant
Fed holds money supply constant
193
060
Estimated value of Y T
119
026
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 amp services
Examples ndash stock market boom or crash
change in householdsrsquo wealth C
ndash change in business or consumer confidence or expectations I andor C
Shocks in the IS -LM model
LM shocks exogenous changes in the demand for money
Examplesndash a wave of credit card fraud increases demand
for moneyndash 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 of1 a boom in the stock market that makes consumers
wealthier2 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 rb determine what happens to C I and the
unemployment rate
CASE STUDY
THE US RECESSION OF 2001
The US Recession of 2001
bull 39 on 900bull 49 on 801bull 63 on 603bull 50 on 705
The US Recession of 2001
bull Growth of GDP was negative in the 1st and 3rd quarters of 2001
bull Thatrsquos essentially before 911
Recall IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
The US Recession of 2001bull Whybull Demand shocks moved the IS
curve leftndash The ldquotech bubblerdquo ended and
stocks fell 25 between 800 and 801
ndash 911 attacks led to a 12 fall in stock prices in one week and a huge rise in uncertainty
ndash Scandals at Enron WorldCom and other corporations led to stock price declines and a decline in trust and a rise in uncertainty
ndash Lower household wealth reduced Co and higher uncertainty reduced Io
IS
Y
rLM
r1
Y1
CASE STUDY
The US recession of 2001Causes 1) Stock market decline C
300
600
900
1200
1500
1995 1996 1997 1998 1999 2000 2001 2002 2003
Ind
ex
(19
42
= 1
00
) Standard amp Poorrsquos 500
The US Recession of 2001bull Fiscal stimulus moved IS curve
rightndash Major tax cuts were enacted in
2001 and 2003ndash Government spending was
boostedbull to rebuild NYC andbull to bail out the airline industry
bull Fed printed money and moved LM curve rightndash Interest rate on 3-month
Treasury bills fellbull 64 in 1100bull 33 in 801bull 09 in 703
IS1
Y
rLM1
r1
Y1
IS2
LM2
Y3
All three toolsmdashG T and Mmdashwere used
CASE STUDY
The US recession of 2001bull Monetary policy response shifted LM curve right
Three-month T-Bill Rate
Three-month T-Bill Rate
0
1
2
3
4
5
6
7
010
120
0004
02
2000
070
320
0010
03
2000
010
320
0104
05
2001
070
620
0110
06
2001
010
620
0204
08
2002
070
920
0210
09
2002
010
920
0304
11
2003
Skip
bull I am skipping section 11-2
THE GREAT DEPRESSION
The Great Depression
Unemployment (right scale)
Real GNP(left scale)
120
140
160
180
200
220
240
1929 1931 1933 1935 1937 1939
billi
ons
of 1
958
dolla
rs
0
5
10
15
20
25
30
perc
ent o
f lab
or fo
rce
THE SPENDING HYPOTHESIS
Shocks to the IS curvebull asserts that the
Depression was largely due to an exogenous fall in the demand for goods and services ndash a leftward shift of the IS curve
bull evidence output and interest rates both fell in early 1930s which is what a leftward IS shift would cause
IS
Y
rLM
r1
Y1
THE SPENDING HYPOTHESIS
Reasons for the IS shiftbull Stock market crash exogenous C
ndash Oct-Dec 1929 SampP 500 fell 17ndash Oct 1929-Dec 1933 SampP 500 fell 71
bull Drop in investmentndash ldquocorrectionrdquo after overbuilding in the 1920sndash widespread bank failures in early 1930s made it harder
to obtain financing for investmentbull Contractionary fiscal policy
ndash Politicians raised tax rates in 1932 and cut spending to combat increasing deficits
THE MONEY HYPOTHESIS
A shock to the LM curvebull asserts that the Depression was largely due to
huge fall in the money supplybull evidence M1 fell 25 during 1929-33 bull But two problems with this hypothesis
ndash P fell even more so MP actually rose slightly during 1929-31
ndash nominal interest rates fell which is the opposite of what a leftward LM shift would cause
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull asserts that the severity of the Depression
was due to a huge deflation ndash P fell 25 during 1929-33
bull This deflation was probably caused by the fall in M so perhaps money played an important role after all
bull In what ways does a deflation affect the economy
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The stabilizing effects of deflationbull P (MP ) LM shifts right Ybull Pigou effect
P (MP )
consumersrsquo wealth
C
IS shifts right
Y
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects
of expected deflation E
bull LM curve shifts leftr and I (r ) planned expenditure income and output
bull Also the nominal interest rate decreases (idarr) ndash see IS-LM predictions grid
IS
Y
rLM
r1
Y1
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects of unexpected deflation
debt-deflation theoryP (if unexpected)
transfers purchasing power from borrowers to lenders
borrowers spend less lenders spend more if borrowersrsquo propensity to spend is larger than
lendersrsquo then aggregate spending falls the IS curve shifts left and Y falls
The evidence on output and nominal interest rates
bull Note that other than the money hypothesis all the other hypothesesmdashthe spending hypothesis the debt-deflation hypothesis and the deflationary expectations hypothesismdashpredict falling real GDP and falling nominal interest rates
bull This is exactly what happened in the early stages of the Great Depression
bull The spending hypothesis and the debt-deflation hypothesis both predict falling real interest rates whereas the deflationary expectations hypothesis predicts rising real interest rates
bull Therefore evidence on real interest rates is crucial in identifying suitable explanations for the Great Depression
Why another Depression is unlikelybull Policymakers (or their advisors) now know much more
about macroeconomicsndash The Fed knows better than to let M fall so much
especially during a contractionndash Fiscal policymakers know better than to raise
taxes or cut spending during a contractionbull Federal deposit insurance makes widespread bank
failures very unlikely
bull Automatic stabilizers make fiscal policy expansionary during an economic downturn
THE FINANCIAL CRISIS AND ECONOMIC DOWNTURN OF 2008 AND 2009
CASE STUDYThe 2008-09 Financial Crisis amp Recession
bull 2009 Real GDP fell unemployment rate approached 10
bull Important factors in the crisisndash early 2000s Federal Reserve interest rate policy ndash sub-prime mortgage crisisndash bursting of house price bubble rising foreclosure
ratesndash falling stock pricesndash failing financial institutionsndash declining consumer confidence drop in spending on
consumer durables and investment goods
A Too-Brief and Too-Simple Explanation
bull The price of housing had risen to unsustainable levels
bull When home prices inevitably crashed people suddenly felt poor and cut back their spending plans
bull This fall in planned expenditure brought about the Great Recession of 2008-09
The Housing Bubble Inflates then Deflates
bull The SampP Case-Shiller 20-City Home Price Index went from ndash 100 in Jan 2000 tondash 20654 in April 2006 tondash 14095 in May 2009 tondash 14216 in Dec 2010
bull Why did the housing bubble inflate
The Housing Bubble Reasons
bull The Fed kept the interest rates too low for too long
bull Securitization technology got a lot fancier in the mortgage bond market
bull The government regulators were sleepingbull Pretty much everybody believed that home
prices could never fall
The Housing Bubble Low FFR
bull The Fed had reduced the Federal Funds Rate to fight the Recession of 2001
bull After that recession ended the Fed continued to keep interest rates low until 2004ndash The Fed was watching inflation which remained
tame Consequently the Fed saw little reason to raise interest rates
ndash The Fed did not believe that housing prices had formed a bubble hellip until it was blindingly obvious
The Housing Bubble Securitization
bull In the past people with money did not like to lend money to home buyers because such loans were risky and had unreliable returns
bull 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
bull The financial sector was regulated by people who were ideologically opposed to regulation
bull They turned a blind eye to even the worst lending practices
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
Monetary Policy Re-defined
bull Therefore one can re-define expansionary and contractionary monetary policy as followsndash Monetary policy is expansionary when the central
bank attempts to reduce interest rates (real and nominal) and
ndash Monetary policy is contractionary when the central bank attempts to increase the interest rates (real and nominal)
The Federal Funds Rate
bull 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
bull 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
bull The Federal Funds Rate is the interest rate that banks charge each other for overnight loans
bull If the Fed wishes the FFR to be 18 all it has to do is to announce that ndash it will lend money to any bank at 18 interest
andndash will pay 18 interest on deposits received from
any bank
The Federal Funds Ratebull 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 followsndash Monetary policy is expansionary when the Fed seeks
to reduce the federal funds rate andndash Monetary policy is contractionary when the Fed
seeks to increase the federal funds ratebull 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
bull We have seen that when faced with a recession the central bank can ndash Increase the money supply
(Muarr)ndash Thereby shifting the LM
curve rightndash Thereby reducing the real
interest rate (r = i minus Eπ darr) and the nominal interest rate (i = r + Eπdarr) and increasing GDP (Yuarr) to drag the economy out of the recession
IS
Y
rLM
r1
Y1
The Zero Lower Bound on Nominal Interest Rates
bull The problem is that there is a limit to how low the nominal interest rate can be
bull Nominal interest rates (such as the federal funds rate) cannot be negative
bull To deal with the 2008 economic crisis the Fed reduced the FFR to zero
bull But the recession persistedbull Unfortunately the Fed could
not reduce interest rates below zero monetary policy had reached its limit
IS
Y
rLM
r1
Y1
The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
The Zero Lower Bound on Nominal Interest Rates
bull r = i minus Eπbull iminimum = 0
bull Therefore rminimum = iminimum minus Eπ = 0 minus Eπ
bull Therefore rminimum = minus Eπ
bull For example if Eπ = minus3 then rminimum = minus Eπ = 3
IS
Y
rLM
r1
Y1
21
The Zero Lower Bound on Nominal Interest Rates
bull For example in the diagram the central bank will have to reduce the real interest rate to r = 21 in order to end the recession
bull But suppose expected inflation is Eπ = minus 3
bull Then the nominal interest rate would have to be brought down to i = r + Eπ = 21 ndash 30 = ndash 09
bull Which alas is impossible
IS
Y
rLM
r1
Y1
21
This example also shows how dangerous it can be if we have deflation and people begin to expect the deflation to continue
The Zero Lower Bound on Nominal Interest Rates
bull 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 bendash at the zero lower bound orndash in a liquidity trap
bull See page 350 of the textbook
The Zero Lower Bound on Nominal Interest Rates Solutions
bull When an economy is in a liquidity trap monetary policy cannot be used to reduce interest rates any further
bull But is there nothing else that can be done to bring the economy back to life
bull Yes there isbull Expansionary fiscal policy can be usedbull And therersquos 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
bull In my example ndash the central bank needs to reduce
the real interest rate to r = 21 to end the recession
ndash But expected inflation is Eπ = minus 3 ndash So the nominal interest rate would
have to be brought down to i = ndash 09 which alas is impossible
bull Recall that the LM curve shifts right if either M or Eπ increases
bull If the central bank promises to be irresponsible and to create rapid inflation in the future and if people believe its promise then Eπ will increase say from minus 3 to +1
bull Then the nominal interest rate required for full-employment will be i = r + Eπ = 21 + 10 = 31 which is definitely attainable
IS
Y
rLM
r1
Y1
21
The zero-lower-bound problem can be solved if the central bank can credibly promise to be irresponsible
The Zero Lower Bound on Nominal Interest Rates Solutions
bull Although this chapter assumes a closed economy in reality foreign trade does matter
bull So the central bank can ndash print domestic currency and ndash use it to buy foreign currency ndash thereby making the domestic currency cheaper
relative to the foreign currencyndash thereby stimulating exportsndash thereby ending the recession
The Zero Lower Bound on Nominal Interest Rates Solutions
bull 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
bull This would reduce long-term interest rates directly thereby stimulating spending by the borrowers
bull This strategymdashcalled quantitative easingmdashmay also end a recession
Interaction between monetary and fiscal policy
bull IS-LM Model Monetary and fiscal policy variables (M G and T ) are exogenous
bull Real world Monetary policymakers may adjust M in response to changes in fiscal policy or vice versa
bull Such responses by the central bank may affect the effectiveness of fiscal policy
The Fedrsquos response to G gt 0
bull Suppose the government increases Gbull Possible Fed responses
1 hold M constant2 hold r constant3 hold Y constant
bull In each case the effects of G on Yare differenthellip
When G increases the IS curve shifts right
IS1
Response 1 Hold M constant
Y
rLM
r1
Y1
IS2
Y2
r2
If Fed holds M constant then LM curve does not shift
As a result interest rates rise This has a crowding-out effect Consequently GDP increases but not a lot
If Congress raises G the IS curve shifts right
IS1
Response 2 Hold r constant
Y
rLM1
r1
Y1
IS2
Y2
r2
To keep r constant Fed increases M to shift LM curve right
3 1Y Y Y
0r
LM2
Y3
Results
IS1
Response 3 Hold Y constant
Y
rLM1
r1
IS2
Y2
r2
To keep Y constant Fed reduces M to shift LM curve left
0Y
3 1r r r
LM2
Results
Y1
r3
If Congress raises G the IS curve shifts right
At this point you should be able to do problem 7 on page 353 of the textbook Please try it
Estimates of fiscal policy multipliersfrom the DRI macroeconometric model
Assumption about monetary policy
Estimated value of Y G
Fed holds nominal interest rate constant
Fed holds money supply constant
193
060
Estimated value of Y T
119
026
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 amp services
Examples ndash stock market boom or crash
change in householdsrsquo wealth C
ndash change in business or consumer confidence or expectations I andor C
Shocks in the IS -LM model
LM shocks exogenous changes in the demand for money
Examplesndash a wave of credit card fraud increases demand
for moneyndash 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 of1 a boom in the stock market that makes consumers
wealthier2 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 rb determine what happens to C I and the
unemployment rate
CASE STUDY
THE US RECESSION OF 2001
The US Recession of 2001
bull 39 on 900bull 49 on 801bull 63 on 603bull 50 on 705
The US Recession of 2001
bull Growth of GDP was negative in the 1st and 3rd quarters of 2001
bull Thatrsquos essentially before 911
Recall IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
The US Recession of 2001bull Whybull Demand shocks moved the IS
curve leftndash The ldquotech bubblerdquo ended and
stocks fell 25 between 800 and 801
ndash 911 attacks led to a 12 fall in stock prices in one week and a huge rise in uncertainty
ndash Scandals at Enron WorldCom and other corporations led to stock price declines and a decline in trust and a rise in uncertainty
ndash Lower household wealth reduced Co and higher uncertainty reduced Io
IS
Y
rLM
r1
Y1
CASE STUDY
The US recession of 2001Causes 1) Stock market decline C
300
600
900
1200
1500
1995 1996 1997 1998 1999 2000 2001 2002 2003
Ind
ex
(19
42
= 1
00
) Standard amp Poorrsquos 500
The US Recession of 2001bull Fiscal stimulus moved IS curve
rightndash Major tax cuts were enacted in
2001 and 2003ndash Government spending was
boostedbull to rebuild NYC andbull to bail out the airline industry
bull Fed printed money and moved LM curve rightndash Interest rate on 3-month
Treasury bills fellbull 64 in 1100bull 33 in 801bull 09 in 703
IS1
Y
rLM1
r1
Y1
IS2
LM2
Y3
All three toolsmdashG T and Mmdashwere used
CASE STUDY
The US recession of 2001bull Monetary policy response shifted LM curve right
Three-month T-Bill Rate
Three-month T-Bill Rate
0
1
2
3
4
5
6
7
010
120
0004
02
2000
070
320
0010
03
2000
010
320
0104
05
2001
070
620
0110
06
2001
010
620
0204
08
2002
070
920
0210
09
2002
010
920
0304
11
2003
Skip
bull I am skipping section 11-2
THE GREAT DEPRESSION
The Great Depression
Unemployment (right scale)
Real GNP(left scale)
120
140
160
180
200
220
240
1929 1931 1933 1935 1937 1939
billi
ons
of 1
958
dolla
rs
0
5
10
15
20
25
30
perc
ent o
f lab
or fo
rce
THE SPENDING HYPOTHESIS
Shocks to the IS curvebull asserts that the
Depression was largely due to an exogenous fall in the demand for goods and services ndash a leftward shift of the IS curve
bull evidence output and interest rates both fell in early 1930s which is what a leftward IS shift would cause
IS
Y
rLM
r1
Y1
THE SPENDING HYPOTHESIS
Reasons for the IS shiftbull Stock market crash exogenous C
ndash Oct-Dec 1929 SampP 500 fell 17ndash Oct 1929-Dec 1933 SampP 500 fell 71
bull Drop in investmentndash ldquocorrectionrdquo after overbuilding in the 1920sndash widespread bank failures in early 1930s made it harder
to obtain financing for investmentbull Contractionary fiscal policy
ndash Politicians raised tax rates in 1932 and cut spending to combat increasing deficits
THE MONEY HYPOTHESIS
A shock to the LM curvebull asserts that the Depression was largely due to
huge fall in the money supplybull evidence M1 fell 25 during 1929-33 bull But two problems with this hypothesis
ndash P fell even more so MP actually rose slightly during 1929-31
ndash nominal interest rates fell which is the opposite of what a leftward LM shift would cause
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull asserts that the severity of the Depression
was due to a huge deflation ndash P fell 25 during 1929-33
bull This deflation was probably caused by the fall in M so perhaps money played an important role after all
bull In what ways does a deflation affect the economy
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The stabilizing effects of deflationbull P (MP ) LM shifts right Ybull Pigou effect
P (MP )
consumersrsquo wealth
C
IS shifts right
Y
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects
of expected deflation E
bull LM curve shifts leftr and I (r ) planned expenditure income and output
bull Also the nominal interest rate decreases (idarr) ndash see IS-LM predictions grid
IS
Y
rLM
r1
Y1
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects of unexpected deflation
debt-deflation theoryP (if unexpected)
transfers purchasing power from borrowers to lenders
borrowers spend less lenders spend more if borrowersrsquo propensity to spend is larger than
lendersrsquo then aggregate spending falls the IS curve shifts left and Y falls
The evidence on output and nominal interest rates
bull Note that other than the money hypothesis all the other hypothesesmdashthe spending hypothesis the debt-deflation hypothesis and the deflationary expectations hypothesismdashpredict falling real GDP and falling nominal interest rates
bull This is exactly what happened in the early stages of the Great Depression
bull The spending hypothesis and the debt-deflation hypothesis both predict falling real interest rates whereas the deflationary expectations hypothesis predicts rising real interest rates
bull Therefore evidence on real interest rates is crucial in identifying suitable explanations for the Great Depression
Why another Depression is unlikelybull Policymakers (or their advisors) now know much more
about macroeconomicsndash The Fed knows better than to let M fall so much
especially during a contractionndash Fiscal policymakers know better than to raise
taxes or cut spending during a contractionbull Federal deposit insurance makes widespread bank
failures very unlikely
bull Automatic stabilizers make fiscal policy expansionary during an economic downturn
THE FINANCIAL CRISIS AND ECONOMIC DOWNTURN OF 2008 AND 2009
CASE STUDYThe 2008-09 Financial Crisis amp Recession
bull 2009 Real GDP fell unemployment rate approached 10
bull Important factors in the crisisndash early 2000s Federal Reserve interest rate policy ndash sub-prime mortgage crisisndash bursting of house price bubble rising foreclosure
ratesndash falling stock pricesndash failing financial institutionsndash declining consumer confidence drop in spending on
consumer durables and investment goods
A Too-Brief and Too-Simple Explanation
bull The price of housing had risen to unsustainable levels
bull When home prices inevitably crashed people suddenly felt poor and cut back their spending plans
bull This fall in planned expenditure brought about the Great Recession of 2008-09
The Housing Bubble Inflates then Deflates
bull The SampP Case-Shiller 20-City Home Price Index went from ndash 100 in Jan 2000 tondash 20654 in April 2006 tondash 14095 in May 2009 tondash 14216 in Dec 2010
bull Why did the housing bubble inflate
The Housing Bubble Reasons
bull The Fed kept the interest rates too low for too long
bull Securitization technology got a lot fancier in the mortgage bond market
bull The government regulators were sleepingbull Pretty much everybody believed that home
prices could never fall
The Housing Bubble Low FFR
bull The Fed had reduced the Federal Funds Rate to fight the Recession of 2001
bull After that recession ended the Fed continued to keep interest rates low until 2004ndash The Fed was watching inflation which remained
tame Consequently the Fed saw little reason to raise interest rates
ndash The Fed did not believe that housing prices had formed a bubble hellip until it was blindingly obvious
The Housing Bubble Securitization
bull In the past people with money did not like to lend money to home buyers because such loans were risky and had unreliable returns
bull 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
bull The financial sector was regulated by people who were ideologically opposed to regulation
bull They turned a blind eye to even the worst lending practices
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
The Federal Funds Rate
bull 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
bull 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
bull The Federal Funds Rate is the interest rate that banks charge each other for overnight loans
bull If the Fed wishes the FFR to be 18 all it has to do is to announce that ndash it will lend money to any bank at 18 interest
andndash will pay 18 interest on deposits received from
any bank
The Federal Funds Ratebull 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 followsndash Monetary policy is expansionary when the Fed seeks
to reduce the federal funds rate andndash Monetary policy is contractionary when the Fed
seeks to increase the federal funds ratebull 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
bull We have seen that when faced with a recession the central bank can ndash Increase the money supply
(Muarr)ndash Thereby shifting the LM
curve rightndash Thereby reducing the real
interest rate (r = i minus Eπ darr) and the nominal interest rate (i = r + Eπdarr) and increasing GDP (Yuarr) to drag the economy out of the recession
IS
Y
rLM
r1
Y1
The Zero Lower Bound on Nominal Interest Rates
bull The problem is that there is a limit to how low the nominal interest rate can be
bull Nominal interest rates (such as the federal funds rate) cannot be negative
bull To deal with the 2008 economic crisis the Fed reduced the FFR to zero
bull But the recession persistedbull Unfortunately the Fed could
not reduce interest rates below zero monetary policy had reached its limit
IS
Y
rLM
r1
Y1
The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
The Zero Lower Bound on Nominal Interest Rates
bull r = i minus Eπbull iminimum = 0
bull Therefore rminimum = iminimum minus Eπ = 0 minus Eπ
bull Therefore rminimum = minus Eπ
bull For example if Eπ = minus3 then rminimum = minus Eπ = 3
IS
Y
rLM
r1
Y1
21
The Zero Lower Bound on Nominal Interest Rates
bull For example in the diagram the central bank will have to reduce the real interest rate to r = 21 in order to end the recession
bull But suppose expected inflation is Eπ = minus 3
bull Then the nominal interest rate would have to be brought down to i = r + Eπ = 21 ndash 30 = ndash 09
bull Which alas is impossible
IS
Y
rLM
r1
Y1
21
This example also shows how dangerous it can be if we have deflation and people begin to expect the deflation to continue
The Zero Lower Bound on Nominal Interest Rates
bull 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 bendash at the zero lower bound orndash in a liquidity trap
bull See page 350 of the textbook
The Zero Lower Bound on Nominal Interest Rates Solutions
bull When an economy is in a liquidity trap monetary policy cannot be used to reduce interest rates any further
bull But is there nothing else that can be done to bring the economy back to life
bull Yes there isbull Expansionary fiscal policy can be usedbull And therersquos 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
bull In my example ndash the central bank needs to reduce
the real interest rate to r = 21 to end the recession
ndash But expected inflation is Eπ = minus 3 ndash So the nominal interest rate would
have to be brought down to i = ndash 09 which alas is impossible
bull Recall that the LM curve shifts right if either M or Eπ increases
bull If the central bank promises to be irresponsible and to create rapid inflation in the future and if people believe its promise then Eπ will increase say from minus 3 to +1
bull Then the nominal interest rate required for full-employment will be i = r + Eπ = 21 + 10 = 31 which is definitely attainable
IS
Y
rLM
r1
Y1
21
The zero-lower-bound problem can be solved if the central bank can credibly promise to be irresponsible
The Zero Lower Bound on Nominal Interest Rates Solutions
bull Although this chapter assumes a closed economy in reality foreign trade does matter
bull So the central bank can ndash print domestic currency and ndash use it to buy foreign currency ndash thereby making the domestic currency cheaper
relative to the foreign currencyndash thereby stimulating exportsndash thereby ending the recession
The Zero Lower Bound on Nominal Interest Rates Solutions
bull 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
bull This would reduce long-term interest rates directly thereby stimulating spending by the borrowers
bull This strategymdashcalled quantitative easingmdashmay also end a recession
Interaction between monetary and fiscal policy
bull IS-LM Model Monetary and fiscal policy variables (M G and T ) are exogenous
bull Real world Monetary policymakers may adjust M in response to changes in fiscal policy or vice versa
bull Such responses by the central bank may affect the effectiveness of fiscal policy
The Fedrsquos response to G gt 0
bull Suppose the government increases Gbull Possible Fed responses
1 hold M constant2 hold r constant3 hold Y constant
bull In each case the effects of G on Yare differenthellip
When G increases the IS curve shifts right
IS1
Response 1 Hold M constant
Y
rLM
r1
Y1
IS2
Y2
r2
If Fed holds M constant then LM curve does not shift
As a result interest rates rise This has a crowding-out effect Consequently GDP increases but not a lot
If Congress raises G the IS curve shifts right
IS1
Response 2 Hold r constant
Y
rLM1
r1
Y1
IS2
Y2
r2
To keep r constant Fed increases M to shift LM curve right
3 1Y Y Y
0r
LM2
Y3
Results
IS1
Response 3 Hold Y constant
Y
rLM1
r1
IS2
Y2
r2
To keep Y constant Fed reduces M to shift LM curve left
0Y
3 1r r r
LM2
Results
Y1
r3
If Congress raises G the IS curve shifts right
At this point you should be able to do problem 7 on page 353 of the textbook Please try it
Estimates of fiscal policy multipliersfrom the DRI macroeconometric model
Assumption about monetary policy
Estimated value of Y G
Fed holds nominal interest rate constant
Fed holds money supply constant
193
060
Estimated value of Y T
119
026
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 amp services
Examples ndash stock market boom or crash
change in householdsrsquo wealth C
ndash change in business or consumer confidence or expectations I andor C
Shocks in the IS -LM model
LM shocks exogenous changes in the demand for money
Examplesndash a wave of credit card fraud increases demand
for moneyndash 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 of1 a boom in the stock market that makes consumers
wealthier2 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 rb determine what happens to C I and the
unemployment rate
CASE STUDY
THE US RECESSION OF 2001
The US Recession of 2001
bull 39 on 900bull 49 on 801bull 63 on 603bull 50 on 705
The US Recession of 2001
bull Growth of GDP was negative in the 1st and 3rd quarters of 2001
bull Thatrsquos essentially before 911
Recall IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
The US Recession of 2001bull Whybull Demand shocks moved the IS
curve leftndash The ldquotech bubblerdquo ended and
stocks fell 25 between 800 and 801
ndash 911 attacks led to a 12 fall in stock prices in one week and a huge rise in uncertainty
ndash Scandals at Enron WorldCom and other corporations led to stock price declines and a decline in trust and a rise in uncertainty
ndash Lower household wealth reduced Co and higher uncertainty reduced Io
IS
Y
rLM
r1
Y1
CASE STUDY
The US recession of 2001Causes 1) Stock market decline C
300
600
900
1200
1500
1995 1996 1997 1998 1999 2000 2001 2002 2003
Ind
ex
(19
42
= 1
00
) Standard amp Poorrsquos 500
The US Recession of 2001bull Fiscal stimulus moved IS curve
rightndash Major tax cuts were enacted in
2001 and 2003ndash Government spending was
boostedbull to rebuild NYC andbull to bail out the airline industry
bull Fed printed money and moved LM curve rightndash Interest rate on 3-month
Treasury bills fellbull 64 in 1100bull 33 in 801bull 09 in 703
IS1
Y
rLM1
r1
Y1
IS2
LM2
Y3
All three toolsmdashG T and Mmdashwere used
CASE STUDY
The US recession of 2001bull Monetary policy response shifted LM curve right
Three-month T-Bill Rate
Three-month T-Bill Rate
0
1
2
3
4
5
6
7
010
120
0004
02
2000
070
320
0010
03
2000
010
320
0104
05
2001
070
620
0110
06
2001
010
620
0204
08
2002
070
920
0210
09
2002
010
920
0304
11
2003
Skip
bull I am skipping section 11-2
THE GREAT DEPRESSION
The Great Depression
Unemployment (right scale)
Real GNP(left scale)
120
140
160
180
200
220
240
1929 1931 1933 1935 1937 1939
billi
ons
of 1
958
dolla
rs
0
5
10
15
20
25
30
perc
ent o
f lab
or fo
rce
THE SPENDING HYPOTHESIS
Shocks to the IS curvebull asserts that the
Depression was largely due to an exogenous fall in the demand for goods and services ndash a leftward shift of the IS curve
bull evidence output and interest rates both fell in early 1930s which is what a leftward IS shift would cause
IS
Y
rLM
r1
Y1
THE SPENDING HYPOTHESIS
Reasons for the IS shiftbull Stock market crash exogenous C
ndash Oct-Dec 1929 SampP 500 fell 17ndash Oct 1929-Dec 1933 SampP 500 fell 71
bull Drop in investmentndash ldquocorrectionrdquo after overbuilding in the 1920sndash widespread bank failures in early 1930s made it harder
to obtain financing for investmentbull Contractionary fiscal policy
ndash Politicians raised tax rates in 1932 and cut spending to combat increasing deficits
THE MONEY HYPOTHESIS
A shock to the LM curvebull asserts that the Depression was largely due to
huge fall in the money supplybull evidence M1 fell 25 during 1929-33 bull But two problems with this hypothesis
ndash P fell even more so MP actually rose slightly during 1929-31
ndash nominal interest rates fell which is the opposite of what a leftward LM shift would cause
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull asserts that the severity of the Depression
was due to a huge deflation ndash P fell 25 during 1929-33
bull This deflation was probably caused by the fall in M so perhaps money played an important role after all
bull In what ways does a deflation affect the economy
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The stabilizing effects of deflationbull P (MP ) LM shifts right Ybull Pigou effect
P (MP )
consumersrsquo wealth
C
IS shifts right
Y
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects
of expected deflation E
bull LM curve shifts leftr and I (r ) planned expenditure income and output
bull Also the nominal interest rate decreases (idarr) ndash see IS-LM predictions grid
IS
Y
rLM
r1
Y1
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects of unexpected deflation
debt-deflation theoryP (if unexpected)
transfers purchasing power from borrowers to lenders
borrowers spend less lenders spend more if borrowersrsquo propensity to spend is larger than
lendersrsquo then aggregate spending falls the IS curve shifts left and Y falls
The evidence on output and nominal interest rates
bull Note that other than the money hypothesis all the other hypothesesmdashthe spending hypothesis the debt-deflation hypothesis and the deflationary expectations hypothesismdashpredict falling real GDP and falling nominal interest rates
bull This is exactly what happened in the early stages of the Great Depression
bull The spending hypothesis and the debt-deflation hypothesis both predict falling real interest rates whereas the deflationary expectations hypothesis predicts rising real interest rates
bull Therefore evidence on real interest rates is crucial in identifying suitable explanations for the Great Depression
Why another Depression is unlikelybull Policymakers (or their advisors) now know much more
about macroeconomicsndash The Fed knows better than to let M fall so much
especially during a contractionndash Fiscal policymakers know better than to raise
taxes or cut spending during a contractionbull Federal deposit insurance makes widespread bank
failures very unlikely
bull Automatic stabilizers make fiscal policy expansionary during an economic downturn
THE FINANCIAL CRISIS AND ECONOMIC DOWNTURN OF 2008 AND 2009
CASE STUDYThe 2008-09 Financial Crisis amp Recession
bull 2009 Real GDP fell unemployment rate approached 10
bull Important factors in the crisisndash early 2000s Federal Reserve interest rate policy ndash sub-prime mortgage crisisndash bursting of house price bubble rising foreclosure
ratesndash falling stock pricesndash failing financial institutionsndash declining consumer confidence drop in spending on
consumer durables and investment goods
A Too-Brief and Too-Simple Explanation
bull The price of housing had risen to unsustainable levels
bull When home prices inevitably crashed people suddenly felt poor and cut back their spending plans
bull This fall in planned expenditure brought about the Great Recession of 2008-09
The Housing Bubble Inflates then Deflates
bull The SampP Case-Shiller 20-City Home Price Index went from ndash 100 in Jan 2000 tondash 20654 in April 2006 tondash 14095 in May 2009 tondash 14216 in Dec 2010
bull Why did the housing bubble inflate
The Housing Bubble Reasons
bull The Fed kept the interest rates too low for too long
bull Securitization technology got a lot fancier in the mortgage bond market
bull The government regulators were sleepingbull Pretty much everybody believed that home
prices could never fall
The Housing Bubble Low FFR
bull The Fed had reduced the Federal Funds Rate to fight the Recession of 2001
bull After that recession ended the Fed continued to keep interest rates low until 2004ndash The Fed was watching inflation which remained
tame Consequently the Fed saw little reason to raise interest rates
ndash The Fed did not believe that housing prices had formed a bubble hellip until it was blindingly obvious
The Housing Bubble Securitization
bull In the past people with money did not like to lend money to home buyers because such loans were risky and had unreliable returns
bull 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
bull The financial sector was regulated by people who were ideologically opposed to regulation
bull They turned a blind eye to even the worst lending practices
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
The Federal Funds Rate
bull The Federal Funds Rate is the interest rate that banks charge each other for overnight loans
bull If the Fed wishes the FFR to be 18 all it has to do is to announce that ndash it will lend money to any bank at 18 interest
andndash will pay 18 interest on deposits received from
any bank
The Federal Funds Ratebull 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 followsndash Monetary policy is expansionary when the Fed seeks
to reduce the federal funds rate andndash Monetary policy is contractionary when the Fed
seeks to increase the federal funds ratebull 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
bull We have seen that when faced with a recession the central bank can ndash Increase the money supply
(Muarr)ndash Thereby shifting the LM
curve rightndash Thereby reducing the real
interest rate (r = i minus Eπ darr) and the nominal interest rate (i = r + Eπdarr) and increasing GDP (Yuarr) to drag the economy out of the recession
IS
Y
rLM
r1
Y1
The Zero Lower Bound on Nominal Interest Rates
bull The problem is that there is a limit to how low the nominal interest rate can be
bull Nominal interest rates (such as the federal funds rate) cannot be negative
bull To deal with the 2008 economic crisis the Fed reduced the FFR to zero
bull But the recession persistedbull Unfortunately the Fed could
not reduce interest rates below zero monetary policy had reached its limit
IS
Y
rLM
r1
Y1
The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
The Zero Lower Bound on Nominal Interest Rates
bull r = i minus Eπbull iminimum = 0
bull Therefore rminimum = iminimum minus Eπ = 0 minus Eπ
bull Therefore rminimum = minus Eπ
bull For example if Eπ = minus3 then rminimum = minus Eπ = 3
IS
Y
rLM
r1
Y1
21
The Zero Lower Bound on Nominal Interest Rates
bull For example in the diagram the central bank will have to reduce the real interest rate to r = 21 in order to end the recession
bull But suppose expected inflation is Eπ = minus 3
bull Then the nominal interest rate would have to be brought down to i = r + Eπ = 21 ndash 30 = ndash 09
bull Which alas is impossible
IS
Y
rLM
r1
Y1
21
This example also shows how dangerous it can be if we have deflation and people begin to expect the deflation to continue
The Zero Lower Bound on Nominal Interest Rates
bull 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 bendash at the zero lower bound orndash in a liquidity trap
bull See page 350 of the textbook
The Zero Lower Bound on Nominal Interest Rates Solutions
bull When an economy is in a liquidity trap monetary policy cannot be used to reduce interest rates any further
bull But is there nothing else that can be done to bring the economy back to life
bull Yes there isbull Expansionary fiscal policy can be usedbull And therersquos 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
bull In my example ndash the central bank needs to reduce
the real interest rate to r = 21 to end the recession
ndash But expected inflation is Eπ = minus 3 ndash So the nominal interest rate would
have to be brought down to i = ndash 09 which alas is impossible
bull Recall that the LM curve shifts right if either M or Eπ increases
bull If the central bank promises to be irresponsible and to create rapid inflation in the future and if people believe its promise then Eπ will increase say from minus 3 to +1
bull Then the nominal interest rate required for full-employment will be i = r + Eπ = 21 + 10 = 31 which is definitely attainable
IS
Y
rLM
r1
Y1
21
The zero-lower-bound problem can be solved if the central bank can credibly promise to be irresponsible
The Zero Lower Bound on Nominal Interest Rates Solutions
bull Although this chapter assumes a closed economy in reality foreign trade does matter
bull So the central bank can ndash print domestic currency and ndash use it to buy foreign currency ndash thereby making the domestic currency cheaper
relative to the foreign currencyndash thereby stimulating exportsndash thereby ending the recession
The Zero Lower Bound on Nominal Interest Rates Solutions
bull 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
bull This would reduce long-term interest rates directly thereby stimulating spending by the borrowers
bull This strategymdashcalled quantitative easingmdashmay also end a recession
Interaction between monetary and fiscal policy
bull IS-LM Model Monetary and fiscal policy variables (M G and T ) are exogenous
bull Real world Monetary policymakers may adjust M in response to changes in fiscal policy or vice versa
bull Such responses by the central bank may affect the effectiveness of fiscal policy
The Fedrsquos response to G gt 0
bull Suppose the government increases Gbull Possible Fed responses
1 hold M constant2 hold r constant3 hold Y constant
bull In each case the effects of G on Yare differenthellip
When G increases the IS curve shifts right
IS1
Response 1 Hold M constant
Y
rLM
r1
Y1
IS2
Y2
r2
If Fed holds M constant then LM curve does not shift
As a result interest rates rise This has a crowding-out effect Consequently GDP increases but not a lot
If Congress raises G the IS curve shifts right
IS1
Response 2 Hold r constant
Y
rLM1
r1
Y1
IS2
Y2
r2
To keep r constant Fed increases M to shift LM curve right
3 1Y Y Y
0r
LM2
Y3
Results
IS1
Response 3 Hold Y constant
Y
rLM1
r1
IS2
Y2
r2
To keep Y constant Fed reduces M to shift LM curve left
0Y
3 1r r r
LM2
Results
Y1
r3
If Congress raises G the IS curve shifts right
At this point you should be able to do problem 7 on page 353 of the textbook Please try it
Estimates of fiscal policy multipliersfrom the DRI macroeconometric model
Assumption about monetary policy
Estimated value of Y G
Fed holds nominal interest rate constant
Fed holds money supply constant
193
060
Estimated value of Y T
119
026
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 amp services
Examples ndash stock market boom or crash
change in householdsrsquo wealth C
ndash change in business or consumer confidence or expectations I andor C
Shocks in the IS -LM model
LM shocks exogenous changes in the demand for money
Examplesndash a wave of credit card fraud increases demand
for moneyndash 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 of1 a boom in the stock market that makes consumers
wealthier2 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 rb determine what happens to C I and the
unemployment rate
CASE STUDY
THE US RECESSION OF 2001
The US Recession of 2001
bull 39 on 900bull 49 on 801bull 63 on 603bull 50 on 705
The US Recession of 2001
bull Growth of GDP was negative in the 1st and 3rd quarters of 2001
bull Thatrsquos essentially before 911
Recall IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
The US Recession of 2001bull Whybull Demand shocks moved the IS
curve leftndash The ldquotech bubblerdquo ended and
stocks fell 25 between 800 and 801
ndash 911 attacks led to a 12 fall in stock prices in one week and a huge rise in uncertainty
ndash Scandals at Enron WorldCom and other corporations led to stock price declines and a decline in trust and a rise in uncertainty
ndash Lower household wealth reduced Co and higher uncertainty reduced Io
IS
Y
rLM
r1
Y1
CASE STUDY
The US recession of 2001Causes 1) Stock market decline C
300
600
900
1200
1500
1995 1996 1997 1998 1999 2000 2001 2002 2003
Ind
ex
(19
42
= 1
00
) Standard amp Poorrsquos 500
The US Recession of 2001bull Fiscal stimulus moved IS curve
rightndash Major tax cuts were enacted in
2001 and 2003ndash Government spending was
boostedbull to rebuild NYC andbull to bail out the airline industry
bull Fed printed money and moved LM curve rightndash Interest rate on 3-month
Treasury bills fellbull 64 in 1100bull 33 in 801bull 09 in 703
IS1
Y
rLM1
r1
Y1
IS2
LM2
Y3
All three toolsmdashG T and Mmdashwere used
CASE STUDY
The US recession of 2001bull Monetary policy response shifted LM curve right
Three-month T-Bill Rate
Three-month T-Bill Rate
0
1
2
3
4
5
6
7
010
120
0004
02
2000
070
320
0010
03
2000
010
320
0104
05
2001
070
620
0110
06
2001
010
620
0204
08
2002
070
920
0210
09
2002
010
920
0304
11
2003
Skip
bull I am skipping section 11-2
THE GREAT DEPRESSION
The Great Depression
Unemployment (right scale)
Real GNP(left scale)
120
140
160
180
200
220
240
1929 1931 1933 1935 1937 1939
billi
ons
of 1
958
dolla
rs
0
5
10
15
20
25
30
perc
ent o
f lab
or fo
rce
THE SPENDING HYPOTHESIS
Shocks to the IS curvebull asserts that the
Depression was largely due to an exogenous fall in the demand for goods and services ndash a leftward shift of the IS curve
bull evidence output and interest rates both fell in early 1930s which is what a leftward IS shift would cause
IS
Y
rLM
r1
Y1
THE SPENDING HYPOTHESIS
Reasons for the IS shiftbull Stock market crash exogenous C
ndash Oct-Dec 1929 SampP 500 fell 17ndash Oct 1929-Dec 1933 SampP 500 fell 71
bull Drop in investmentndash ldquocorrectionrdquo after overbuilding in the 1920sndash widespread bank failures in early 1930s made it harder
to obtain financing for investmentbull Contractionary fiscal policy
ndash Politicians raised tax rates in 1932 and cut spending to combat increasing deficits
THE MONEY HYPOTHESIS
A shock to the LM curvebull asserts that the Depression was largely due to
huge fall in the money supplybull evidence M1 fell 25 during 1929-33 bull But two problems with this hypothesis
ndash P fell even more so MP actually rose slightly during 1929-31
ndash nominal interest rates fell which is the opposite of what a leftward LM shift would cause
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull asserts that the severity of the Depression
was due to a huge deflation ndash P fell 25 during 1929-33
bull This deflation was probably caused by the fall in M so perhaps money played an important role after all
bull In what ways does a deflation affect the economy
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The stabilizing effects of deflationbull P (MP ) LM shifts right Ybull Pigou effect
P (MP )
consumersrsquo wealth
C
IS shifts right
Y
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects
of expected deflation E
bull LM curve shifts leftr and I (r ) planned expenditure income and output
bull Also the nominal interest rate decreases (idarr) ndash see IS-LM predictions grid
IS
Y
rLM
r1
Y1
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects of unexpected deflation
debt-deflation theoryP (if unexpected)
transfers purchasing power from borrowers to lenders
borrowers spend less lenders spend more if borrowersrsquo propensity to spend is larger than
lendersrsquo then aggregate spending falls the IS curve shifts left and Y falls
The evidence on output and nominal interest rates
bull Note that other than the money hypothesis all the other hypothesesmdashthe spending hypothesis the debt-deflation hypothesis and the deflationary expectations hypothesismdashpredict falling real GDP and falling nominal interest rates
bull This is exactly what happened in the early stages of the Great Depression
bull The spending hypothesis and the debt-deflation hypothesis both predict falling real interest rates whereas the deflationary expectations hypothesis predicts rising real interest rates
bull Therefore evidence on real interest rates is crucial in identifying suitable explanations for the Great Depression
Why another Depression is unlikelybull Policymakers (or their advisors) now know much more
about macroeconomicsndash The Fed knows better than to let M fall so much
especially during a contractionndash Fiscal policymakers know better than to raise
taxes or cut spending during a contractionbull Federal deposit insurance makes widespread bank
failures very unlikely
bull Automatic stabilizers make fiscal policy expansionary during an economic downturn
THE FINANCIAL CRISIS AND ECONOMIC DOWNTURN OF 2008 AND 2009
CASE STUDYThe 2008-09 Financial Crisis amp Recession
bull 2009 Real GDP fell unemployment rate approached 10
bull Important factors in the crisisndash early 2000s Federal Reserve interest rate policy ndash sub-prime mortgage crisisndash bursting of house price bubble rising foreclosure
ratesndash falling stock pricesndash failing financial institutionsndash declining consumer confidence drop in spending on
consumer durables and investment goods
A Too-Brief and Too-Simple Explanation
bull The price of housing had risen to unsustainable levels
bull When home prices inevitably crashed people suddenly felt poor and cut back their spending plans
bull This fall in planned expenditure brought about the Great Recession of 2008-09
The Housing Bubble Inflates then Deflates
bull The SampP Case-Shiller 20-City Home Price Index went from ndash 100 in Jan 2000 tondash 20654 in April 2006 tondash 14095 in May 2009 tondash 14216 in Dec 2010
bull Why did the housing bubble inflate
The Housing Bubble Reasons
bull The Fed kept the interest rates too low for too long
bull Securitization technology got a lot fancier in the mortgage bond market
bull The government regulators were sleepingbull Pretty much everybody believed that home
prices could never fall
The Housing Bubble Low FFR
bull The Fed had reduced the Federal Funds Rate to fight the Recession of 2001
bull After that recession ended the Fed continued to keep interest rates low until 2004ndash The Fed was watching inflation which remained
tame Consequently the Fed saw little reason to raise interest rates
ndash The Fed did not believe that housing prices had formed a bubble hellip until it was blindingly obvious
The Housing Bubble Securitization
bull In the past people with money did not like to lend money to home buyers because such loans were risky and had unreliable returns
bull 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
bull The financial sector was regulated by people who were ideologically opposed to regulation
bull They turned a blind eye to even the worst lending practices
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
The Federal Funds Ratebull 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 followsndash Monetary policy is expansionary when the Fed seeks
to reduce the federal funds rate andndash Monetary policy is contractionary when the Fed
seeks to increase the federal funds ratebull 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
bull We have seen that when faced with a recession the central bank can ndash Increase the money supply
(Muarr)ndash Thereby shifting the LM
curve rightndash Thereby reducing the real
interest rate (r = i minus Eπ darr) and the nominal interest rate (i = r + Eπdarr) and increasing GDP (Yuarr) to drag the economy out of the recession
IS
Y
rLM
r1
Y1
The Zero Lower Bound on Nominal Interest Rates
bull The problem is that there is a limit to how low the nominal interest rate can be
bull Nominal interest rates (such as the federal funds rate) cannot be negative
bull To deal with the 2008 economic crisis the Fed reduced the FFR to zero
bull But the recession persistedbull Unfortunately the Fed could
not reduce interest rates below zero monetary policy had reached its limit
IS
Y
rLM
r1
Y1
The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
The Zero Lower Bound on Nominal Interest Rates
bull r = i minus Eπbull iminimum = 0
bull Therefore rminimum = iminimum minus Eπ = 0 minus Eπ
bull Therefore rminimum = minus Eπ
bull For example if Eπ = minus3 then rminimum = minus Eπ = 3
IS
Y
rLM
r1
Y1
21
The Zero Lower Bound on Nominal Interest Rates
bull For example in the diagram the central bank will have to reduce the real interest rate to r = 21 in order to end the recession
bull But suppose expected inflation is Eπ = minus 3
bull Then the nominal interest rate would have to be brought down to i = r + Eπ = 21 ndash 30 = ndash 09
bull Which alas is impossible
IS
Y
rLM
r1
Y1
21
This example also shows how dangerous it can be if we have deflation and people begin to expect the deflation to continue
The Zero Lower Bound on Nominal Interest Rates
bull 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 bendash at the zero lower bound orndash in a liquidity trap
bull See page 350 of the textbook
The Zero Lower Bound on Nominal Interest Rates Solutions
bull When an economy is in a liquidity trap monetary policy cannot be used to reduce interest rates any further
bull But is there nothing else that can be done to bring the economy back to life
bull Yes there isbull Expansionary fiscal policy can be usedbull And therersquos 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
bull In my example ndash the central bank needs to reduce
the real interest rate to r = 21 to end the recession
ndash But expected inflation is Eπ = minus 3 ndash So the nominal interest rate would
have to be brought down to i = ndash 09 which alas is impossible
bull Recall that the LM curve shifts right if either M or Eπ increases
bull If the central bank promises to be irresponsible and to create rapid inflation in the future and if people believe its promise then Eπ will increase say from minus 3 to +1
bull Then the nominal interest rate required for full-employment will be i = r + Eπ = 21 + 10 = 31 which is definitely attainable
IS
Y
rLM
r1
Y1
21
The zero-lower-bound problem can be solved if the central bank can credibly promise to be irresponsible
The Zero Lower Bound on Nominal Interest Rates Solutions
bull Although this chapter assumes a closed economy in reality foreign trade does matter
bull So the central bank can ndash print domestic currency and ndash use it to buy foreign currency ndash thereby making the domestic currency cheaper
relative to the foreign currencyndash thereby stimulating exportsndash thereby ending the recession
The Zero Lower Bound on Nominal Interest Rates Solutions
bull 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
bull This would reduce long-term interest rates directly thereby stimulating spending by the borrowers
bull This strategymdashcalled quantitative easingmdashmay also end a recession
Interaction between monetary and fiscal policy
bull IS-LM Model Monetary and fiscal policy variables (M G and T ) are exogenous
bull Real world Monetary policymakers may adjust M in response to changes in fiscal policy or vice versa
bull Such responses by the central bank may affect the effectiveness of fiscal policy
The Fedrsquos response to G gt 0
bull Suppose the government increases Gbull Possible Fed responses
1 hold M constant2 hold r constant3 hold Y constant
bull In each case the effects of G on Yare differenthellip
When G increases the IS curve shifts right
IS1
Response 1 Hold M constant
Y
rLM
r1
Y1
IS2
Y2
r2
If Fed holds M constant then LM curve does not shift
As a result interest rates rise This has a crowding-out effect Consequently GDP increases but not a lot
If Congress raises G the IS curve shifts right
IS1
Response 2 Hold r constant
Y
rLM1
r1
Y1
IS2
Y2
r2
To keep r constant Fed increases M to shift LM curve right
3 1Y Y Y
0r
LM2
Y3
Results
IS1
Response 3 Hold Y constant
Y
rLM1
r1
IS2
Y2
r2
To keep Y constant Fed reduces M to shift LM curve left
0Y
3 1r r r
LM2
Results
Y1
r3
If Congress raises G the IS curve shifts right
At this point you should be able to do problem 7 on page 353 of the textbook Please try it
Estimates of fiscal policy multipliersfrom the DRI macroeconometric model
Assumption about monetary policy
Estimated value of Y G
Fed holds nominal interest rate constant
Fed holds money supply constant
193
060
Estimated value of Y T
119
026
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 amp services
Examples ndash stock market boom or crash
change in householdsrsquo wealth C
ndash change in business or consumer confidence or expectations I andor C
Shocks in the IS -LM model
LM shocks exogenous changes in the demand for money
Examplesndash a wave of credit card fraud increases demand
for moneyndash 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 of1 a boom in the stock market that makes consumers
wealthier2 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 rb determine what happens to C I and the
unemployment rate
CASE STUDY
THE US RECESSION OF 2001
The US Recession of 2001
bull 39 on 900bull 49 on 801bull 63 on 603bull 50 on 705
The US Recession of 2001
bull Growth of GDP was negative in the 1st and 3rd quarters of 2001
bull Thatrsquos essentially before 911
Recall IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
The US Recession of 2001bull Whybull Demand shocks moved the IS
curve leftndash The ldquotech bubblerdquo ended and
stocks fell 25 between 800 and 801
ndash 911 attacks led to a 12 fall in stock prices in one week and a huge rise in uncertainty
ndash Scandals at Enron WorldCom and other corporations led to stock price declines and a decline in trust and a rise in uncertainty
ndash Lower household wealth reduced Co and higher uncertainty reduced Io
IS
Y
rLM
r1
Y1
CASE STUDY
The US recession of 2001Causes 1) Stock market decline C
300
600
900
1200
1500
1995 1996 1997 1998 1999 2000 2001 2002 2003
Ind
ex
(19
42
= 1
00
) Standard amp Poorrsquos 500
The US Recession of 2001bull Fiscal stimulus moved IS curve
rightndash Major tax cuts were enacted in
2001 and 2003ndash Government spending was
boostedbull to rebuild NYC andbull to bail out the airline industry
bull Fed printed money and moved LM curve rightndash Interest rate on 3-month
Treasury bills fellbull 64 in 1100bull 33 in 801bull 09 in 703
IS1
Y
rLM1
r1
Y1
IS2
LM2
Y3
All three toolsmdashG T and Mmdashwere used
CASE STUDY
The US recession of 2001bull Monetary policy response shifted LM curve right
Three-month T-Bill Rate
Three-month T-Bill Rate
0
1
2
3
4
5
6
7
010
120
0004
02
2000
070
320
0010
03
2000
010
320
0104
05
2001
070
620
0110
06
2001
010
620
0204
08
2002
070
920
0210
09
2002
010
920
0304
11
2003
Skip
bull I am skipping section 11-2
THE GREAT DEPRESSION
The Great Depression
Unemployment (right scale)
Real GNP(left scale)
120
140
160
180
200
220
240
1929 1931 1933 1935 1937 1939
billi
ons
of 1
958
dolla
rs
0
5
10
15
20
25
30
perc
ent o
f lab
or fo
rce
THE SPENDING HYPOTHESIS
Shocks to the IS curvebull asserts that the
Depression was largely due to an exogenous fall in the demand for goods and services ndash a leftward shift of the IS curve
bull evidence output and interest rates both fell in early 1930s which is what a leftward IS shift would cause
IS
Y
rLM
r1
Y1
THE SPENDING HYPOTHESIS
Reasons for the IS shiftbull Stock market crash exogenous C
ndash Oct-Dec 1929 SampP 500 fell 17ndash Oct 1929-Dec 1933 SampP 500 fell 71
bull Drop in investmentndash ldquocorrectionrdquo after overbuilding in the 1920sndash widespread bank failures in early 1930s made it harder
to obtain financing for investmentbull Contractionary fiscal policy
ndash Politicians raised tax rates in 1932 and cut spending to combat increasing deficits
THE MONEY HYPOTHESIS
A shock to the LM curvebull asserts that the Depression was largely due to
huge fall in the money supplybull evidence M1 fell 25 during 1929-33 bull But two problems with this hypothesis
ndash P fell even more so MP actually rose slightly during 1929-31
ndash nominal interest rates fell which is the opposite of what a leftward LM shift would cause
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull asserts that the severity of the Depression
was due to a huge deflation ndash P fell 25 during 1929-33
bull This deflation was probably caused by the fall in M so perhaps money played an important role after all
bull In what ways does a deflation affect the economy
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The stabilizing effects of deflationbull P (MP ) LM shifts right Ybull Pigou effect
P (MP )
consumersrsquo wealth
C
IS shifts right
Y
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects
of expected deflation E
bull LM curve shifts leftr and I (r ) planned expenditure income and output
bull Also the nominal interest rate decreases (idarr) ndash see IS-LM predictions grid
IS
Y
rLM
r1
Y1
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects of unexpected deflation
debt-deflation theoryP (if unexpected)
transfers purchasing power from borrowers to lenders
borrowers spend less lenders spend more if borrowersrsquo propensity to spend is larger than
lendersrsquo then aggregate spending falls the IS curve shifts left and Y falls
The evidence on output and nominal interest rates
bull Note that other than the money hypothesis all the other hypothesesmdashthe spending hypothesis the debt-deflation hypothesis and the deflationary expectations hypothesismdashpredict falling real GDP and falling nominal interest rates
bull This is exactly what happened in the early stages of the Great Depression
bull The spending hypothesis and the debt-deflation hypothesis both predict falling real interest rates whereas the deflationary expectations hypothesis predicts rising real interest rates
bull Therefore evidence on real interest rates is crucial in identifying suitable explanations for the Great Depression
Why another Depression is unlikelybull Policymakers (or their advisors) now know much more
about macroeconomicsndash The Fed knows better than to let M fall so much
especially during a contractionndash Fiscal policymakers know better than to raise
taxes or cut spending during a contractionbull Federal deposit insurance makes widespread bank
failures very unlikely
bull Automatic stabilizers make fiscal policy expansionary during an economic downturn
THE FINANCIAL CRISIS AND ECONOMIC DOWNTURN OF 2008 AND 2009
CASE STUDYThe 2008-09 Financial Crisis amp Recession
bull 2009 Real GDP fell unemployment rate approached 10
bull Important factors in the crisisndash early 2000s Federal Reserve interest rate policy ndash sub-prime mortgage crisisndash bursting of house price bubble rising foreclosure
ratesndash falling stock pricesndash failing financial institutionsndash declining consumer confidence drop in spending on
consumer durables and investment goods
A Too-Brief and Too-Simple Explanation
bull The price of housing had risen to unsustainable levels
bull When home prices inevitably crashed people suddenly felt poor and cut back their spending plans
bull This fall in planned expenditure brought about the Great Recession of 2008-09
The Housing Bubble Inflates then Deflates
bull The SampP Case-Shiller 20-City Home Price Index went from ndash 100 in Jan 2000 tondash 20654 in April 2006 tondash 14095 in May 2009 tondash 14216 in Dec 2010
bull Why did the housing bubble inflate
The Housing Bubble Reasons
bull The Fed kept the interest rates too low for too long
bull Securitization technology got a lot fancier in the mortgage bond market
bull The government regulators were sleepingbull Pretty much everybody believed that home
prices could never fall
The Housing Bubble Low FFR
bull The Fed had reduced the Federal Funds Rate to fight the Recession of 2001
bull After that recession ended the Fed continued to keep interest rates low until 2004ndash The Fed was watching inflation which remained
tame Consequently the Fed saw little reason to raise interest rates
ndash The Fed did not believe that housing prices had formed a bubble hellip until it was blindingly obvious
The Housing Bubble Securitization
bull In the past people with money did not like to lend money to home buyers because such loans were risky and had unreliable returns
bull 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
bull The financial sector was regulated by people who were ideologically opposed to regulation
bull They turned a blind eye to even the worst lending practices
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
The Zero Lower Bound on Nominal Interest Rates
bull We have seen that when faced with a recession the central bank can ndash Increase the money supply
(Muarr)ndash Thereby shifting the LM
curve rightndash Thereby reducing the real
interest rate (r = i minus Eπ darr) and the nominal interest rate (i = r + Eπdarr) and increasing GDP (Yuarr) to drag the economy out of the recession
IS
Y
rLM
r1
Y1
The Zero Lower Bound on Nominal Interest Rates
bull The problem is that there is a limit to how low the nominal interest rate can be
bull Nominal interest rates (such as the federal funds rate) cannot be negative
bull To deal with the 2008 economic crisis the Fed reduced the FFR to zero
bull But the recession persistedbull Unfortunately the Fed could
not reduce interest rates below zero monetary policy had reached its limit
IS
Y
rLM
r1
Y1
The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
The Zero Lower Bound on Nominal Interest Rates
bull r = i minus Eπbull iminimum = 0
bull Therefore rminimum = iminimum minus Eπ = 0 minus Eπ
bull Therefore rminimum = minus Eπ
bull For example if Eπ = minus3 then rminimum = minus Eπ = 3
IS
Y
rLM
r1
Y1
21
The Zero Lower Bound on Nominal Interest Rates
bull For example in the diagram the central bank will have to reduce the real interest rate to r = 21 in order to end the recession
bull But suppose expected inflation is Eπ = minus 3
bull Then the nominal interest rate would have to be brought down to i = r + Eπ = 21 ndash 30 = ndash 09
bull Which alas is impossible
IS
Y
rLM
r1
Y1
21
This example also shows how dangerous it can be if we have deflation and people begin to expect the deflation to continue
The Zero Lower Bound on Nominal Interest Rates
bull 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 bendash at the zero lower bound orndash in a liquidity trap
bull See page 350 of the textbook
The Zero Lower Bound on Nominal Interest Rates Solutions
bull When an economy is in a liquidity trap monetary policy cannot be used to reduce interest rates any further
bull But is there nothing else that can be done to bring the economy back to life
bull Yes there isbull Expansionary fiscal policy can be usedbull And therersquos 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
bull In my example ndash the central bank needs to reduce
the real interest rate to r = 21 to end the recession
ndash But expected inflation is Eπ = minus 3 ndash So the nominal interest rate would
have to be brought down to i = ndash 09 which alas is impossible
bull Recall that the LM curve shifts right if either M or Eπ increases
bull If the central bank promises to be irresponsible and to create rapid inflation in the future and if people believe its promise then Eπ will increase say from minus 3 to +1
bull Then the nominal interest rate required for full-employment will be i = r + Eπ = 21 + 10 = 31 which is definitely attainable
IS
Y
rLM
r1
Y1
21
The zero-lower-bound problem can be solved if the central bank can credibly promise to be irresponsible
The Zero Lower Bound on Nominal Interest Rates Solutions
bull Although this chapter assumes a closed economy in reality foreign trade does matter
bull So the central bank can ndash print domestic currency and ndash use it to buy foreign currency ndash thereby making the domestic currency cheaper
relative to the foreign currencyndash thereby stimulating exportsndash thereby ending the recession
The Zero Lower Bound on Nominal Interest Rates Solutions
bull 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
bull This would reduce long-term interest rates directly thereby stimulating spending by the borrowers
bull This strategymdashcalled quantitative easingmdashmay also end a recession
Interaction between monetary and fiscal policy
bull IS-LM Model Monetary and fiscal policy variables (M G and T ) are exogenous
bull Real world Monetary policymakers may adjust M in response to changes in fiscal policy or vice versa
bull Such responses by the central bank may affect the effectiveness of fiscal policy
The Fedrsquos response to G gt 0
bull Suppose the government increases Gbull Possible Fed responses
1 hold M constant2 hold r constant3 hold Y constant
bull In each case the effects of G on Yare differenthellip
When G increases the IS curve shifts right
IS1
Response 1 Hold M constant
Y
rLM
r1
Y1
IS2
Y2
r2
If Fed holds M constant then LM curve does not shift
As a result interest rates rise This has a crowding-out effect Consequently GDP increases but not a lot
If Congress raises G the IS curve shifts right
IS1
Response 2 Hold r constant
Y
rLM1
r1
Y1
IS2
Y2
r2
To keep r constant Fed increases M to shift LM curve right
3 1Y Y Y
0r
LM2
Y3
Results
IS1
Response 3 Hold Y constant
Y
rLM1
r1
IS2
Y2
r2
To keep Y constant Fed reduces M to shift LM curve left
0Y
3 1r r r
LM2
Results
Y1
r3
If Congress raises G the IS curve shifts right
At this point you should be able to do problem 7 on page 353 of the textbook Please try it
Estimates of fiscal policy multipliersfrom the DRI macroeconometric model
Assumption about monetary policy
Estimated value of Y G
Fed holds nominal interest rate constant
Fed holds money supply constant
193
060
Estimated value of Y T
119
026
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 amp services
Examples ndash stock market boom or crash
change in householdsrsquo wealth C
ndash change in business or consumer confidence or expectations I andor C
Shocks in the IS -LM model
LM shocks exogenous changes in the demand for money
Examplesndash a wave of credit card fraud increases demand
for moneyndash 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 of1 a boom in the stock market that makes consumers
wealthier2 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 rb determine what happens to C I and the
unemployment rate
CASE STUDY
THE US RECESSION OF 2001
The US Recession of 2001
bull 39 on 900bull 49 on 801bull 63 on 603bull 50 on 705
The US Recession of 2001
bull Growth of GDP was negative in the 1st and 3rd quarters of 2001
bull Thatrsquos essentially before 911
Recall IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
The US Recession of 2001bull Whybull Demand shocks moved the IS
curve leftndash The ldquotech bubblerdquo ended and
stocks fell 25 between 800 and 801
ndash 911 attacks led to a 12 fall in stock prices in one week and a huge rise in uncertainty
ndash Scandals at Enron WorldCom and other corporations led to stock price declines and a decline in trust and a rise in uncertainty
ndash Lower household wealth reduced Co and higher uncertainty reduced Io
IS
Y
rLM
r1
Y1
CASE STUDY
The US recession of 2001Causes 1) Stock market decline C
300
600
900
1200
1500
1995 1996 1997 1998 1999 2000 2001 2002 2003
Ind
ex
(19
42
= 1
00
) Standard amp Poorrsquos 500
The US Recession of 2001bull Fiscal stimulus moved IS curve
rightndash Major tax cuts were enacted in
2001 and 2003ndash Government spending was
boostedbull to rebuild NYC andbull to bail out the airline industry
bull Fed printed money and moved LM curve rightndash Interest rate on 3-month
Treasury bills fellbull 64 in 1100bull 33 in 801bull 09 in 703
IS1
Y
rLM1
r1
Y1
IS2
LM2
Y3
All three toolsmdashG T and Mmdashwere used
CASE STUDY
The US recession of 2001bull Monetary policy response shifted LM curve right
Three-month T-Bill Rate
Three-month T-Bill Rate
0
1
2
3
4
5
6
7
010
120
0004
02
2000
070
320
0010
03
2000
010
320
0104
05
2001
070
620
0110
06
2001
010
620
0204
08
2002
070
920
0210
09
2002
010
920
0304
11
2003
Skip
bull I am skipping section 11-2
THE GREAT DEPRESSION
The Great Depression
Unemployment (right scale)
Real GNP(left scale)
120
140
160
180
200
220
240
1929 1931 1933 1935 1937 1939
billi
ons
of 1
958
dolla
rs
0
5
10
15
20
25
30
perc
ent o
f lab
or fo
rce
THE SPENDING HYPOTHESIS
Shocks to the IS curvebull asserts that the
Depression was largely due to an exogenous fall in the demand for goods and services ndash a leftward shift of the IS curve
bull evidence output and interest rates both fell in early 1930s which is what a leftward IS shift would cause
IS
Y
rLM
r1
Y1
THE SPENDING HYPOTHESIS
Reasons for the IS shiftbull Stock market crash exogenous C
ndash Oct-Dec 1929 SampP 500 fell 17ndash Oct 1929-Dec 1933 SampP 500 fell 71
bull Drop in investmentndash ldquocorrectionrdquo after overbuilding in the 1920sndash widespread bank failures in early 1930s made it harder
to obtain financing for investmentbull Contractionary fiscal policy
ndash Politicians raised tax rates in 1932 and cut spending to combat increasing deficits
THE MONEY HYPOTHESIS
A shock to the LM curvebull asserts that the Depression was largely due to
huge fall in the money supplybull evidence M1 fell 25 during 1929-33 bull But two problems with this hypothesis
ndash P fell even more so MP actually rose slightly during 1929-31
ndash nominal interest rates fell which is the opposite of what a leftward LM shift would cause
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull asserts that the severity of the Depression
was due to a huge deflation ndash P fell 25 during 1929-33
bull This deflation was probably caused by the fall in M so perhaps money played an important role after all
bull In what ways does a deflation affect the economy
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The stabilizing effects of deflationbull P (MP ) LM shifts right Ybull Pigou effect
P (MP )
consumersrsquo wealth
C
IS shifts right
Y
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects
of expected deflation E
bull LM curve shifts leftr and I (r ) planned expenditure income and output
bull Also the nominal interest rate decreases (idarr) ndash see IS-LM predictions grid
IS
Y
rLM
r1
Y1
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects of unexpected deflation
debt-deflation theoryP (if unexpected)
transfers purchasing power from borrowers to lenders
borrowers spend less lenders spend more if borrowersrsquo propensity to spend is larger than
lendersrsquo then aggregate spending falls the IS curve shifts left and Y falls
The evidence on output and nominal interest rates
bull Note that other than the money hypothesis all the other hypothesesmdashthe spending hypothesis the debt-deflation hypothesis and the deflationary expectations hypothesismdashpredict falling real GDP and falling nominal interest rates
bull This is exactly what happened in the early stages of the Great Depression
bull The spending hypothesis and the debt-deflation hypothesis both predict falling real interest rates whereas the deflationary expectations hypothesis predicts rising real interest rates
bull Therefore evidence on real interest rates is crucial in identifying suitable explanations for the Great Depression
Why another Depression is unlikelybull Policymakers (or their advisors) now know much more
about macroeconomicsndash The Fed knows better than to let M fall so much
especially during a contractionndash Fiscal policymakers know better than to raise
taxes or cut spending during a contractionbull Federal deposit insurance makes widespread bank
failures very unlikely
bull Automatic stabilizers make fiscal policy expansionary during an economic downturn
THE FINANCIAL CRISIS AND ECONOMIC DOWNTURN OF 2008 AND 2009
CASE STUDYThe 2008-09 Financial Crisis amp Recession
bull 2009 Real GDP fell unemployment rate approached 10
bull Important factors in the crisisndash early 2000s Federal Reserve interest rate policy ndash sub-prime mortgage crisisndash bursting of house price bubble rising foreclosure
ratesndash falling stock pricesndash failing financial institutionsndash declining consumer confidence drop in spending on
consumer durables and investment goods
A Too-Brief and Too-Simple Explanation
bull The price of housing had risen to unsustainable levels
bull When home prices inevitably crashed people suddenly felt poor and cut back their spending plans
bull This fall in planned expenditure brought about the Great Recession of 2008-09
The Housing Bubble Inflates then Deflates
bull The SampP Case-Shiller 20-City Home Price Index went from ndash 100 in Jan 2000 tondash 20654 in April 2006 tondash 14095 in May 2009 tondash 14216 in Dec 2010
bull Why did the housing bubble inflate
The Housing Bubble Reasons
bull The Fed kept the interest rates too low for too long
bull Securitization technology got a lot fancier in the mortgage bond market
bull The government regulators were sleepingbull Pretty much everybody believed that home
prices could never fall
The Housing Bubble Low FFR
bull The Fed had reduced the Federal Funds Rate to fight the Recession of 2001
bull After that recession ended the Fed continued to keep interest rates low until 2004ndash The Fed was watching inflation which remained
tame Consequently the Fed saw little reason to raise interest rates
ndash The Fed did not believe that housing prices had formed a bubble hellip until it was blindingly obvious
The Housing Bubble Securitization
bull In the past people with money did not like to lend money to home buyers because such loans were risky and had unreliable returns
bull 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
bull The financial sector was regulated by people who were ideologically opposed to regulation
bull They turned a blind eye to even the worst lending practices
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
The Zero Lower Bound on Nominal Interest Rates
bull The problem is that there is a limit to how low the nominal interest rate can be
bull Nominal interest rates (such as the federal funds rate) cannot be negative
bull To deal with the 2008 economic crisis the Fed reduced the FFR to zero
bull But the recession persistedbull Unfortunately the Fed could
not reduce interest rates below zero monetary policy had reached its limit
IS
Y
rLM
r1
Y1
The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
The Zero Lower Bound on Nominal Interest Rates
bull r = i minus Eπbull iminimum = 0
bull Therefore rminimum = iminimum minus Eπ = 0 minus Eπ
bull Therefore rminimum = minus Eπ
bull For example if Eπ = minus3 then rminimum = minus Eπ = 3
IS
Y
rLM
r1
Y1
21
The Zero Lower Bound on Nominal Interest Rates
bull For example in the diagram the central bank will have to reduce the real interest rate to r = 21 in order to end the recession
bull But suppose expected inflation is Eπ = minus 3
bull Then the nominal interest rate would have to be brought down to i = r + Eπ = 21 ndash 30 = ndash 09
bull Which alas is impossible
IS
Y
rLM
r1
Y1
21
This example also shows how dangerous it can be if we have deflation and people begin to expect the deflation to continue
The Zero Lower Bound on Nominal Interest Rates
bull 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 bendash at the zero lower bound orndash in a liquidity trap
bull See page 350 of the textbook
The Zero Lower Bound on Nominal Interest Rates Solutions
bull When an economy is in a liquidity trap monetary policy cannot be used to reduce interest rates any further
bull But is there nothing else that can be done to bring the economy back to life
bull Yes there isbull Expansionary fiscal policy can be usedbull And therersquos 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
bull In my example ndash the central bank needs to reduce
the real interest rate to r = 21 to end the recession
ndash But expected inflation is Eπ = minus 3 ndash So the nominal interest rate would
have to be brought down to i = ndash 09 which alas is impossible
bull Recall that the LM curve shifts right if either M or Eπ increases
bull If the central bank promises to be irresponsible and to create rapid inflation in the future and if people believe its promise then Eπ will increase say from minus 3 to +1
bull Then the nominal interest rate required for full-employment will be i = r + Eπ = 21 + 10 = 31 which is definitely attainable
IS
Y
rLM
r1
Y1
21
The zero-lower-bound problem can be solved if the central bank can credibly promise to be irresponsible
The Zero Lower Bound on Nominal Interest Rates Solutions
bull Although this chapter assumes a closed economy in reality foreign trade does matter
bull So the central bank can ndash print domestic currency and ndash use it to buy foreign currency ndash thereby making the domestic currency cheaper
relative to the foreign currencyndash thereby stimulating exportsndash thereby ending the recession
The Zero Lower Bound on Nominal Interest Rates Solutions
bull 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
bull This would reduce long-term interest rates directly thereby stimulating spending by the borrowers
bull This strategymdashcalled quantitative easingmdashmay also end a recession
Interaction between monetary and fiscal policy
bull IS-LM Model Monetary and fiscal policy variables (M G and T ) are exogenous
bull Real world Monetary policymakers may adjust M in response to changes in fiscal policy or vice versa
bull Such responses by the central bank may affect the effectiveness of fiscal policy
The Fedrsquos response to G gt 0
bull Suppose the government increases Gbull Possible Fed responses
1 hold M constant2 hold r constant3 hold Y constant
bull In each case the effects of G on Yare differenthellip
When G increases the IS curve shifts right
IS1
Response 1 Hold M constant
Y
rLM
r1
Y1
IS2
Y2
r2
If Fed holds M constant then LM curve does not shift
As a result interest rates rise This has a crowding-out effect Consequently GDP increases but not a lot
If Congress raises G the IS curve shifts right
IS1
Response 2 Hold r constant
Y
rLM1
r1
Y1
IS2
Y2
r2
To keep r constant Fed increases M to shift LM curve right
3 1Y Y Y
0r
LM2
Y3
Results
IS1
Response 3 Hold Y constant
Y
rLM1
r1
IS2
Y2
r2
To keep Y constant Fed reduces M to shift LM curve left
0Y
3 1r r r
LM2
Results
Y1
r3
If Congress raises G the IS curve shifts right
At this point you should be able to do problem 7 on page 353 of the textbook Please try it
Estimates of fiscal policy multipliersfrom the DRI macroeconometric model
Assumption about monetary policy
Estimated value of Y G
Fed holds nominal interest rate constant
Fed holds money supply constant
193
060
Estimated value of Y T
119
026
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 amp services
Examples ndash stock market boom or crash
change in householdsrsquo wealth C
ndash change in business or consumer confidence or expectations I andor C
Shocks in the IS -LM model
LM shocks exogenous changes in the demand for money
Examplesndash a wave of credit card fraud increases demand
for moneyndash 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 of1 a boom in the stock market that makes consumers
wealthier2 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 rb determine what happens to C I and the
unemployment rate
CASE STUDY
THE US RECESSION OF 2001
The US Recession of 2001
bull 39 on 900bull 49 on 801bull 63 on 603bull 50 on 705
The US Recession of 2001
bull Growth of GDP was negative in the 1st and 3rd quarters of 2001
bull Thatrsquos essentially before 911
Recall IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
The US Recession of 2001bull Whybull Demand shocks moved the IS
curve leftndash The ldquotech bubblerdquo ended and
stocks fell 25 between 800 and 801
ndash 911 attacks led to a 12 fall in stock prices in one week and a huge rise in uncertainty
ndash Scandals at Enron WorldCom and other corporations led to stock price declines and a decline in trust and a rise in uncertainty
ndash Lower household wealth reduced Co and higher uncertainty reduced Io
IS
Y
rLM
r1
Y1
CASE STUDY
The US recession of 2001Causes 1) Stock market decline C
300
600
900
1200
1500
1995 1996 1997 1998 1999 2000 2001 2002 2003
Ind
ex
(19
42
= 1
00
) Standard amp Poorrsquos 500
The US Recession of 2001bull Fiscal stimulus moved IS curve
rightndash Major tax cuts were enacted in
2001 and 2003ndash Government spending was
boostedbull to rebuild NYC andbull to bail out the airline industry
bull Fed printed money and moved LM curve rightndash Interest rate on 3-month
Treasury bills fellbull 64 in 1100bull 33 in 801bull 09 in 703
IS1
Y
rLM1
r1
Y1
IS2
LM2
Y3
All three toolsmdashG T and Mmdashwere used
CASE STUDY
The US recession of 2001bull Monetary policy response shifted LM curve right
Three-month T-Bill Rate
Three-month T-Bill Rate
0
1
2
3
4
5
6
7
010
120
0004
02
2000
070
320
0010
03
2000
010
320
0104
05
2001
070
620
0110
06
2001
010
620
0204
08
2002
070
920
0210
09
2002
010
920
0304
11
2003
Skip
bull I am skipping section 11-2
THE GREAT DEPRESSION
The Great Depression
Unemployment (right scale)
Real GNP(left scale)
120
140
160
180
200
220
240
1929 1931 1933 1935 1937 1939
billi
ons
of 1
958
dolla
rs
0
5
10
15
20
25
30
perc
ent o
f lab
or fo
rce
THE SPENDING HYPOTHESIS
Shocks to the IS curvebull asserts that the
Depression was largely due to an exogenous fall in the demand for goods and services ndash a leftward shift of the IS curve
bull evidence output and interest rates both fell in early 1930s which is what a leftward IS shift would cause
IS
Y
rLM
r1
Y1
THE SPENDING HYPOTHESIS
Reasons for the IS shiftbull Stock market crash exogenous C
ndash Oct-Dec 1929 SampP 500 fell 17ndash Oct 1929-Dec 1933 SampP 500 fell 71
bull Drop in investmentndash ldquocorrectionrdquo after overbuilding in the 1920sndash widespread bank failures in early 1930s made it harder
to obtain financing for investmentbull Contractionary fiscal policy
ndash Politicians raised tax rates in 1932 and cut spending to combat increasing deficits
THE MONEY HYPOTHESIS
A shock to the LM curvebull asserts that the Depression was largely due to
huge fall in the money supplybull evidence M1 fell 25 during 1929-33 bull But two problems with this hypothesis
ndash P fell even more so MP actually rose slightly during 1929-31
ndash nominal interest rates fell which is the opposite of what a leftward LM shift would cause
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull asserts that the severity of the Depression
was due to a huge deflation ndash P fell 25 during 1929-33
bull This deflation was probably caused by the fall in M so perhaps money played an important role after all
bull In what ways does a deflation affect the economy
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The stabilizing effects of deflationbull P (MP ) LM shifts right Ybull Pigou effect
P (MP )
consumersrsquo wealth
C
IS shifts right
Y
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects
of expected deflation E
bull LM curve shifts leftr and I (r ) planned expenditure income and output
bull Also the nominal interest rate decreases (idarr) ndash see IS-LM predictions grid
IS
Y
rLM
r1
Y1
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects of unexpected deflation
debt-deflation theoryP (if unexpected)
transfers purchasing power from borrowers to lenders
borrowers spend less lenders spend more if borrowersrsquo propensity to spend is larger than
lendersrsquo then aggregate spending falls the IS curve shifts left and Y falls
The evidence on output and nominal interest rates
bull Note that other than the money hypothesis all the other hypothesesmdashthe spending hypothesis the debt-deflation hypothesis and the deflationary expectations hypothesismdashpredict falling real GDP and falling nominal interest rates
bull This is exactly what happened in the early stages of the Great Depression
bull The spending hypothesis and the debt-deflation hypothesis both predict falling real interest rates whereas the deflationary expectations hypothesis predicts rising real interest rates
bull Therefore evidence on real interest rates is crucial in identifying suitable explanations for the Great Depression
Why another Depression is unlikelybull Policymakers (or their advisors) now know much more
about macroeconomicsndash The Fed knows better than to let M fall so much
especially during a contractionndash Fiscal policymakers know better than to raise
taxes or cut spending during a contractionbull Federal deposit insurance makes widespread bank
failures very unlikely
bull Automatic stabilizers make fiscal policy expansionary during an economic downturn
THE FINANCIAL CRISIS AND ECONOMIC DOWNTURN OF 2008 AND 2009
CASE STUDYThe 2008-09 Financial Crisis amp Recession
bull 2009 Real GDP fell unemployment rate approached 10
bull Important factors in the crisisndash early 2000s Federal Reserve interest rate policy ndash sub-prime mortgage crisisndash bursting of house price bubble rising foreclosure
ratesndash falling stock pricesndash failing financial institutionsndash declining consumer confidence drop in spending on
consumer durables and investment goods
A Too-Brief and Too-Simple Explanation
bull The price of housing had risen to unsustainable levels
bull When home prices inevitably crashed people suddenly felt poor and cut back their spending plans
bull This fall in planned expenditure brought about the Great Recession of 2008-09
The Housing Bubble Inflates then Deflates
bull The SampP Case-Shiller 20-City Home Price Index went from ndash 100 in Jan 2000 tondash 20654 in April 2006 tondash 14095 in May 2009 tondash 14216 in Dec 2010
bull Why did the housing bubble inflate
The Housing Bubble Reasons
bull The Fed kept the interest rates too low for too long
bull Securitization technology got a lot fancier in the mortgage bond market
bull The government regulators were sleepingbull Pretty much everybody believed that home
prices could never fall
The Housing Bubble Low FFR
bull The Fed had reduced the Federal Funds Rate to fight the Recession of 2001
bull After that recession ended the Fed continued to keep interest rates low until 2004ndash The Fed was watching inflation which remained
tame Consequently the Fed saw little reason to raise interest rates
ndash The Fed did not believe that housing prices had formed a bubble hellip until it was blindingly obvious
The Housing Bubble Securitization
bull In the past people with money did not like to lend money to home buyers because such loans were risky and had unreliable returns
bull 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
bull The financial sector was regulated by people who were ideologically opposed to regulation
bull They turned a blind eye to even the worst lending practices
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
The Zero Lower Bound on Nominal Interest Rates
bull r = i minus Eπbull iminimum = 0
bull Therefore rminimum = iminimum minus Eπ = 0 minus Eπ
bull Therefore rminimum = minus Eπ
bull For example if Eπ = minus3 then rminimum = minus Eπ = 3
IS
Y
rLM
r1
Y1
21
The Zero Lower Bound on Nominal Interest Rates
bull For example in the diagram the central bank will have to reduce the real interest rate to r = 21 in order to end the recession
bull But suppose expected inflation is Eπ = minus 3
bull Then the nominal interest rate would have to be brought down to i = r + Eπ = 21 ndash 30 = ndash 09
bull Which alas is impossible
IS
Y
rLM
r1
Y1
21
This example also shows how dangerous it can be if we have deflation and people begin to expect the deflation to continue
The Zero Lower Bound on Nominal Interest Rates
bull 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 bendash at the zero lower bound orndash in a liquidity trap
bull See page 350 of the textbook
The Zero Lower Bound on Nominal Interest Rates Solutions
bull When an economy is in a liquidity trap monetary policy cannot be used to reduce interest rates any further
bull But is there nothing else that can be done to bring the economy back to life
bull Yes there isbull Expansionary fiscal policy can be usedbull And therersquos 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
bull In my example ndash the central bank needs to reduce
the real interest rate to r = 21 to end the recession
ndash But expected inflation is Eπ = minus 3 ndash So the nominal interest rate would
have to be brought down to i = ndash 09 which alas is impossible
bull Recall that the LM curve shifts right if either M or Eπ increases
bull If the central bank promises to be irresponsible and to create rapid inflation in the future and if people believe its promise then Eπ will increase say from minus 3 to +1
bull Then the nominal interest rate required for full-employment will be i = r + Eπ = 21 + 10 = 31 which is definitely attainable
IS
Y
rLM
r1
Y1
21
The zero-lower-bound problem can be solved if the central bank can credibly promise to be irresponsible
The Zero Lower Bound on Nominal Interest Rates Solutions
bull Although this chapter assumes a closed economy in reality foreign trade does matter
bull So the central bank can ndash print domestic currency and ndash use it to buy foreign currency ndash thereby making the domestic currency cheaper
relative to the foreign currencyndash thereby stimulating exportsndash thereby ending the recession
The Zero Lower Bound on Nominal Interest Rates Solutions
bull 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
bull This would reduce long-term interest rates directly thereby stimulating spending by the borrowers
bull This strategymdashcalled quantitative easingmdashmay also end a recession
Interaction between monetary and fiscal policy
bull IS-LM Model Monetary and fiscal policy variables (M G and T ) are exogenous
bull Real world Monetary policymakers may adjust M in response to changes in fiscal policy or vice versa
bull Such responses by the central bank may affect the effectiveness of fiscal policy
The Fedrsquos response to G gt 0
bull Suppose the government increases Gbull Possible Fed responses
1 hold M constant2 hold r constant3 hold Y constant
bull In each case the effects of G on Yare differenthellip
When G increases the IS curve shifts right
IS1
Response 1 Hold M constant
Y
rLM
r1
Y1
IS2
Y2
r2
If Fed holds M constant then LM curve does not shift
As a result interest rates rise This has a crowding-out effect Consequently GDP increases but not a lot
If Congress raises G the IS curve shifts right
IS1
Response 2 Hold r constant
Y
rLM1
r1
Y1
IS2
Y2
r2
To keep r constant Fed increases M to shift LM curve right
3 1Y Y Y
0r
LM2
Y3
Results
IS1
Response 3 Hold Y constant
Y
rLM1
r1
IS2
Y2
r2
To keep Y constant Fed reduces M to shift LM curve left
0Y
3 1r r r
LM2
Results
Y1
r3
If Congress raises G the IS curve shifts right
At this point you should be able to do problem 7 on page 353 of the textbook Please try it
Estimates of fiscal policy multipliersfrom the DRI macroeconometric model
Assumption about monetary policy
Estimated value of Y G
Fed holds nominal interest rate constant
Fed holds money supply constant
193
060
Estimated value of Y T
119
026
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 amp services
Examples ndash stock market boom or crash
change in householdsrsquo wealth C
ndash change in business or consumer confidence or expectations I andor C
Shocks in the IS -LM model
LM shocks exogenous changes in the demand for money
Examplesndash a wave of credit card fraud increases demand
for moneyndash 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 of1 a boom in the stock market that makes consumers
wealthier2 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 rb determine what happens to C I and the
unemployment rate
CASE STUDY
THE US RECESSION OF 2001
The US Recession of 2001
bull 39 on 900bull 49 on 801bull 63 on 603bull 50 on 705
The US Recession of 2001
bull Growth of GDP was negative in the 1st and 3rd quarters of 2001
bull Thatrsquos essentially before 911
Recall IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
The US Recession of 2001bull Whybull Demand shocks moved the IS
curve leftndash The ldquotech bubblerdquo ended and
stocks fell 25 between 800 and 801
ndash 911 attacks led to a 12 fall in stock prices in one week and a huge rise in uncertainty
ndash Scandals at Enron WorldCom and other corporations led to stock price declines and a decline in trust and a rise in uncertainty
ndash Lower household wealth reduced Co and higher uncertainty reduced Io
IS
Y
rLM
r1
Y1
CASE STUDY
The US recession of 2001Causes 1) Stock market decline C
300
600
900
1200
1500
1995 1996 1997 1998 1999 2000 2001 2002 2003
Ind
ex
(19
42
= 1
00
) Standard amp Poorrsquos 500
The US Recession of 2001bull Fiscal stimulus moved IS curve
rightndash Major tax cuts were enacted in
2001 and 2003ndash Government spending was
boostedbull to rebuild NYC andbull to bail out the airline industry
bull Fed printed money and moved LM curve rightndash Interest rate on 3-month
Treasury bills fellbull 64 in 1100bull 33 in 801bull 09 in 703
IS1
Y
rLM1
r1
Y1
IS2
LM2
Y3
All three toolsmdashG T and Mmdashwere used
CASE STUDY
The US recession of 2001bull Monetary policy response shifted LM curve right
Three-month T-Bill Rate
Three-month T-Bill Rate
0
1
2
3
4
5
6
7
010
120
0004
02
2000
070
320
0010
03
2000
010
320
0104
05
2001
070
620
0110
06
2001
010
620
0204
08
2002
070
920
0210
09
2002
010
920
0304
11
2003
Skip
bull I am skipping section 11-2
THE GREAT DEPRESSION
The Great Depression
Unemployment (right scale)
Real GNP(left scale)
120
140
160
180
200
220
240
1929 1931 1933 1935 1937 1939
billi
ons
of 1
958
dolla
rs
0
5
10
15
20
25
30
perc
ent o
f lab
or fo
rce
THE SPENDING HYPOTHESIS
Shocks to the IS curvebull asserts that the
Depression was largely due to an exogenous fall in the demand for goods and services ndash a leftward shift of the IS curve
bull evidence output and interest rates both fell in early 1930s which is what a leftward IS shift would cause
IS
Y
rLM
r1
Y1
THE SPENDING HYPOTHESIS
Reasons for the IS shiftbull Stock market crash exogenous C
ndash Oct-Dec 1929 SampP 500 fell 17ndash Oct 1929-Dec 1933 SampP 500 fell 71
bull Drop in investmentndash ldquocorrectionrdquo after overbuilding in the 1920sndash widespread bank failures in early 1930s made it harder
to obtain financing for investmentbull Contractionary fiscal policy
ndash Politicians raised tax rates in 1932 and cut spending to combat increasing deficits
THE MONEY HYPOTHESIS
A shock to the LM curvebull asserts that the Depression was largely due to
huge fall in the money supplybull evidence M1 fell 25 during 1929-33 bull But two problems with this hypothesis
ndash P fell even more so MP actually rose slightly during 1929-31
ndash nominal interest rates fell which is the opposite of what a leftward LM shift would cause
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull asserts that the severity of the Depression
was due to a huge deflation ndash P fell 25 during 1929-33
bull This deflation was probably caused by the fall in M so perhaps money played an important role after all
bull In what ways does a deflation affect the economy
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The stabilizing effects of deflationbull P (MP ) LM shifts right Ybull Pigou effect
P (MP )
consumersrsquo wealth
C
IS shifts right
Y
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects
of expected deflation E
bull LM curve shifts leftr and I (r ) planned expenditure income and output
bull Also the nominal interest rate decreases (idarr) ndash see IS-LM predictions grid
IS
Y
rLM
r1
Y1
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects of unexpected deflation
debt-deflation theoryP (if unexpected)
transfers purchasing power from borrowers to lenders
borrowers spend less lenders spend more if borrowersrsquo propensity to spend is larger than
lendersrsquo then aggregate spending falls the IS curve shifts left and Y falls
The evidence on output and nominal interest rates
bull Note that other than the money hypothesis all the other hypothesesmdashthe spending hypothesis the debt-deflation hypothesis and the deflationary expectations hypothesismdashpredict falling real GDP and falling nominal interest rates
bull This is exactly what happened in the early stages of the Great Depression
bull The spending hypothesis and the debt-deflation hypothesis both predict falling real interest rates whereas the deflationary expectations hypothesis predicts rising real interest rates
bull Therefore evidence on real interest rates is crucial in identifying suitable explanations for the Great Depression
Why another Depression is unlikelybull Policymakers (or their advisors) now know much more
about macroeconomicsndash The Fed knows better than to let M fall so much
especially during a contractionndash Fiscal policymakers know better than to raise
taxes or cut spending during a contractionbull Federal deposit insurance makes widespread bank
failures very unlikely
bull Automatic stabilizers make fiscal policy expansionary during an economic downturn
THE FINANCIAL CRISIS AND ECONOMIC DOWNTURN OF 2008 AND 2009
CASE STUDYThe 2008-09 Financial Crisis amp Recession
bull 2009 Real GDP fell unemployment rate approached 10
bull Important factors in the crisisndash early 2000s Federal Reserve interest rate policy ndash sub-prime mortgage crisisndash bursting of house price bubble rising foreclosure
ratesndash falling stock pricesndash failing financial institutionsndash declining consumer confidence drop in spending on
consumer durables and investment goods
A Too-Brief and Too-Simple Explanation
bull The price of housing had risen to unsustainable levels
bull When home prices inevitably crashed people suddenly felt poor and cut back their spending plans
bull This fall in planned expenditure brought about the Great Recession of 2008-09
The Housing Bubble Inflates then Deflates
bull The SampP Case-Shiller 20-City Home Price Index went from ndash 100 in Jan 2000 tondash 20654 in April 2006 tondash 14095 in May 2009 tondash 14216 in Dec 2010
bull Why did the housing bubble inflate
The Housing Bubble Reasons
bull The Fed kept the interest rates too low for too long
bull Securitization technology got a lot fancier in the mortgage bond market
bull The government regulators were sleepingbull Pretty much everybody believed that home
prices could never fall
The Housing Bubble Low FFR
bull The Fed had reduced the Federal Funds Rate to fight the Recession of 2001
bull After that recession ended the Fed continued to keep interest rates low until 2004ndash The Fed was watching inflation which remained
tame Consequently the Fed saw little reason to raise interest rates
ndash The Fed did not believe that housing prices had formed a bubble hellip until it was blindingly obvious
The Housing Bubble Securitization
bull In the past people with money did not like to lend money to home buyers because such loans were risky and had unreliable returns
bull 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
bull The financial sector was regulated by people who were ideologically opposed to regulation
bull They turned a blind eye to even the worst lending practices
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
The Zero Lower Bound on Nominal Interest Rates
bull r = i minus Eπbull iminimum = 0
bull Therefore rminimum = iminimum minus Eπ = 0 minus Eπ
bull Therefore rminimum = minus Eπ
bull For example if Eπ = minus3 then rminimum = minus Eπ = 3
IS
Y
rLM
r1
Y1
21
The Zero Lower Bound on Nominal Interest Rates
bull For example in the diagram the central bank will have to reduce the real interest rate to r = 21 in order to end the recession
bull But suppose expected inflation is Eπ = minus 3
bull Then the nominal interest rate would have to be brought down to i = r + Eπ = 21 ndash 30 = ndash 09
bull Which alas is impossible
IS
Y
rLM
r1
Y1
21
This example also shows how dangerous it can be if we have deflation and people begin to expect the deflation to continue
The Zero Lower Bound on Nominal Interest Rates
bull 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 bendash at the zero lower bound orndash in a liquidity trap
bull See page 350 of the textbook
The Zero Lower Bound on Nominal Interest Rates Solutions
bull When an economy is in a liquidity trap monetary policy cannot be used to reduce interest rates any further
bull But is there nothing else that can be done to bring the economy back to life
bull Yes there isbull Expansionary fiscal policy can be usedbull And therersquos 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
bull In my example ndash the central bank needs to reduce
the real interest rate to r = 21 to end the recession
ndash But expected inflation is Eπ = minus 3 ndash So the nominal interest rate would
have to be brought down to i = ndash 09 which alas is impossible
bull Recall that the LM curve shifts right if either M or Eπ increases
bull If the central bank promises to be irresponsible and to create rapid inflation in the future and if people believe its promise then Eπ will increase say from minus 3 to +1
bull Then the nominal interest rate required for full-employment will be i = r + Eπ = 21 + 10 = 31 which is definitely attainable
IS
Y
rLM
r1
Y1
21
The zero-lower-bound problem can be solved if the central bank can credibly promise to be irresponsible
The Zero Lower Bound on Nominal Interest Rates Solutions
bull Although this chapter assumes a closed economy in reality foreign trade does matter
bull So the central bank can ndash print domestic currency and ndash use it to buy foreign currency ndash thereby making the domestic currency cheaper
relative to the foreign currencyndash thereby stimulating exportsndash thereby ending the recession
The Zero Lower Bound on Nominal Interest Rates Solutions
bull 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
bull This would reduce long-term interest rates directly thereby stimulating spending by the borrowers
bull This strategymdashcalled quantitative easingmdashmay also end a recession
Interaction between monetary and fiscal policy
bull IS-LM Model Monetary and fiscal policy variables (M G and T ) are exogenous
bull Real world Monetary policymakers may adjust M in response to changes in fiscal policy or vice versa
bull Such responses by the central bank may affect the effectiveness of fiscal policy
The Fedrsquos response to G gt 0
bull Suppose the government increases Gbull Possible Fed responses
1 hold M constant2 hold r constant3 hold Y constant
bull In each case the effects of G on Yare differenthellip
When G increases the IS curve shifts right
IS1
Response 1 Hold M constant
Y
rLM
r1
Y1
IS2
Y2
r2
If Fed holds M constant then LM curve does not shift
As a result interest rates rise This has a crowding-out effect Consequently GDP increases but not a lot
If Congress raises G the IS curve shifts right
IS1
Response 2 Hold r constant
Y
rLM1
r1
Y1
IS2
Y2
r2
To keep r constant Fed increases M to shift LM curve right
3 1Y Y Y
0r
LM2
Y3
Results
IS1
Response 3 Hold Y constant
Y
rLM1
r1
IS2
Y2
r2
To keep Y constant Fed reduces M to shift LM curve left
0Y
3 1r r r
LM2
Results
Y1
r3
If Congress raises G the IS curve shifts right
At this point you should be able to do problem 7 on page 353 of the textbook Please try it
Estimates of fiscal policy multipliersfrom the DRI macroeconometric model
Assumption about monetary policy
Estimated value of Y G
Fed holds nominal interest rate constant
Fed holds money supply constant
193
060
Estimated value of Y T
119
026
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 amp services
Examples ndash stock market boom or crash
change in householdsrsquo wealth C
ndash change in business or consumer confidence or expectations I andor C
Shocks in the IS -LM model
LM shocks exogenous changes in the demand for money
Examplesndash a wave of credit card fraud increases demand
for moneyndash 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 of1 a boom in the stock market that makes consumers
wealthier2 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 rb determine what happens to C I and the
unemployment rate
CASE STUDY
THE US RECESSION OF 2001
The US Recession of 2001
bull 39 on 900bull 49 on 801bull 63 on 603bull 50 on 705
The US Recession of 2001
bull Growth of GDP was negative in the 1st and 3rd quarters of 2001
bull Thatrsquos essentially before 911
Recall IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
The US Recession of 2001bull Whybull Demand shocks moved the IS
curve leftndash The ldquotech bubblerdquo ended and
stocks fell 25 between 800 and 801
ndash 911 attacks led to a 12 fall in stock prices in one week and a huge rise in uncertainty
ndash Scandals at Enron WorldCom and other corporations led to stock price declines and a decline in trust and a rise in uncertainty
ndash Lower household wealth reduced Co and higher uncertainty reduced Io
IS
Y
rLM
r1
Y1
CASE STUDY
The US recession of 2001Causes 1) Stock market decline C
300
600
900
1200
1500
1995 1996 1997 1998 1999 2000 2001 2002 2003
Ind
ex
(19
42
= 1
00
) Standard amp Poorrsquos 500
The US Recession of 2001bull Fiscal stimulus moved IS curve
rightndash Major tax cuts were enacted in
2001 and 2003ndash Government spending was
boostedbull to rebuild NYC andbull to bail out the airline industry
bull Fed printed money and moved LM curve rightndash Interest rate on 3-month
Treasury bills fellbull 64 in 1100bull 33 in 801bull 09 in 703
IS1
Y
rLM1
r1
Y1
IS2
LM2
Y3
All three toolsmdashG T and Mmdashwere used
CASE STUDY
The US recession of 2001bull Monetary policy response shifted LM curve right
Three-month T-Bill Rate
Three-month T-Bill Rate
0
1
2
3
4
5
6
7
010
120
0004
02
2000
070
320
0010
03
2000
010
320
0104
05
2001
070
620
0110
06
2001
010
620
0204
08
2002
070
920
0210
09
2002
010
920
0304
11
2003
Skip
bull I am skipping section 11-2
THE GREAT DEPRESSION
The Great Depression
Unemployment (right scale)
Real GNP(left scale)
120
140
160
180
200
220
240
1929 1931 1933 1935 1937 1939
billi
ons
of 1
958
dolla
rs
0
5
10
15
20
25
30
perc
ent o
f lab
or fo
rce
THE SPENDING HYPOTHESIS
Shocks to the IS curvebull asserts that the
Depression was largely due to an exogenous fall in the demand for goods and services ndash a leftward shift of the IS curve
bull evidence output and interest rates both fell in early 1930s which is what a leftward IS shift would cause
IS
Y
rLM
r1
Y1
THE SPENDING HYPOTHESIS
Reasons for the IS shiftbull Stock market crash exogenous C
ndash Oct-Dec 1929 SampP 500 fell 17ndash Oct 1929-Dec 1933 SampP 500 fell 71
bull Drop in investmentndash ldquocorrectionrdquo after overbuilding in the 1920sndash widespread bank failures in early 1930s made it harder
to obtain financing for investmentbull Contractionary fiscal policy
ndash Politicians raised tax rates in 1932 and cut spending to combat increasing deficits
THE MONEY HYPOTHESIS
A shock to the LM curvebull asserts that the Depression was largely due to
huge fall in the money supplybull evidence M1 fell 25 during 1929-33 bull But two problems with this hypothesis
ndash P fell even more so MP actually rose slightly during 1929-31
ndash nominal interest rates fell which is the opposite of what a leftward LM shift would cause
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull asserts that the severity of the Depression
was due to a huge deflation ndash P fell 25 during 1929-33
bull This deflation was probably caused by the fall in M so perhaps money played an important role after all
bull In what ways does a deflation affect the economy
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The stabilizing effects of deflationbull P (MP ) LM shifts right Ybull Pigou effect
P (MP )
consumersrsquo wealth
C
IS shifts right
Y
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects
of expected deflation E
bull LM curve shifts leftr and I (r ) planned expenditure income and output
bull Also the nominal interest rate decreases (idarr) ndash see IS-LM predictions grid
IS
Y
rLM
r1
Y1
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects of unexpected deflation
debt-deflation theoryP (if unexpected)
transfers purchasing power from borrowers to lenders
borrowers spend less lenders spend more if borrowersrsquo propensity to spend is larger than
lendersrsquo then aggregate spending falls the IS curve shifts left and Y falls
The evidence on output and nominal interest rates
bull Note that other than the money hypothesis all the other hypothesesmdashthe spending hypothesis the debt-deflation hypothesis and the deflationary expectations hypothesismdashpredict falling real GDP and falling nominal interest rates
bull This is exactly what happened in the early stages of the Great Depression
bull The spending hypothesis and the debt-deflation hypothesis both predict falling real interest rates whereas the deflationary expectations hypothesis predicts rising real interest rates
bull Therefore evidence on real interest rates is crucial in identifying suitable explanations for the Great Depression
Why another Depression is unlikelybull Policymakers (or their advisors) now know much more
about macroeconomicsndash The Fed knows better than to let M fall so much
especially during a contractionndash Fiscal policymakers know better than to raise
taxes or cut spending during a contractionbull Federal deposit insurance makes widespread bank
failures very unlikely
bull Automatic stabilizers make fiscal policy expansionary during an economic downturn
THE FINANCIAL CRISIS AND ECONOMIC DOWNTURN OF 2008 AND 2009
CASE STUDYThe 2008-09 Financial Crisis amp Recession
bull 2009 Real GDP fell unemployment rate approached 10
bull Important factors in the crisisndash early 2000s Federal Reserve interest rate policy ndash sub-prime mortgage crisisndash bursting of house price bubble rising foreclosure
ratesndash falling stock pricesndash failing financial institutionsndash declining consumer confidence drop in spending on
consumer durables and investment goods
A Too-Brief and Too-Simple Explanation
bull The price of housing had risen to unsustainable levels
bull When home prices inevitably crashed people suddenly felt poor and cut back their spending plans
bull This fall in planned expenditure brought about the Great Recession of 2008-09
The Housing Bubble Inflates then Deflates
bull The SampP Case-Shiller 20-City Home Price Index went from ndash 100 in Jan 2000 tondash 20654 in April 2006 tondash 14095 in May 2009 tondash 14216 in Dec 2010
bull Why did the housing bubble inflate
The Housing Bubble Reasons
bull The Fed kept the interest rates too low for too long
bull Securitization technology got a lot fancier in the mortgage bond market
bull The government regulators were sleepingbull Pretty much everybody believed that home
prices could never fall
The Housing Bubble Low FFR
bull The Fed had reduced the Federal Funds Rate to fight the Recession of 2001
bull After that recession ended the Fed continued to keep interest rates low until 2004ndash The Fed was watching inflation which remained
tame Consequently the Fed saw little reason to raise interest rates
ndash The Fed did not believe that housing prices had formed a bubble hellip until it was blindingly obvious
The Housing Bubble Securitization
bull In the past people with money did not like to lend money to home buyers because such loans were risky and had unreliable returns
bull 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
bull The financial sector was regulated by people who were ideologically opposed to regulation
bull They turned a blind eye to even the worst lending practices
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
The Zero Lower Bound on Nominal Interest Rates
bull For example in the diagram the central bank will have to reduce the real interest rate to r = 21 in order to end the recession
bull But suppose expected inflation is Eπ = minus 3
bull Then the nominal interest rate would have to be brought down to i = r + Eπ = 21 ndash 30 = ndash 09
bull Which alas is impossible
IS
Y
rLM
r1
Y1
21
This example also shows how dangerous it can be if we have deflation and people begin to expect the deflation to continue
The Zero Lower Bound on Nominal Interest Rates
bull 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 bendash at the zero lower bound orndash in a liquidity trap
bull See page 350 of the textbook
The Zero Lower Bound on Nominal Interest Rates Solutions
bull When an economy is in a liquidity trap monetary policy cannot be used to reduce interest rates any further
bull But is there nothing else that can be done to bring the economy back to life
bull Yes there isbull Expansionary fiscal policy can be usedbull And therersquos 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
bull In my example ndash the central bank needs to reduce
the real interest rate to r = 21 to end the recession
ndash But expected inflation is Eπ = minus 3 ndash So the nominal interest rate would
have to be brought down to i = ndash 09 which alas is impossible
bull Recall that the LM curve shifts right if either M or Eπ increases
bull If the central bank promises to be irresponsible and to create rapid inflation in the future and if people believe its promise then Eπ will increase say from minus 3 to +1
bull Then the nominal interest rate required for full-employment will be i = r + Eπ = 21 + 10 = 31 which is definitely attainable
IS
Y
rLM
r1
Y1
21
The zero-lower-bound problem can be solved if the central bank can credibly promise to be irresponsible
The Zero Lower Bound on Nominal Interest Rates Solutions
bull Although this chapter assumes a closed economy in reality foreign trade does matter
bull So the central bank can ndash print domestic currency and ndash use it to buy foreign currency ndash thereby making the domestic currency cheaper
relative to the foreign currencyndash thereby stimulating exportsndash thereby ending the recession
The Zero Lower Bound on Nominal Interest Rates Solutions
bull 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
bull This would reduce long-term interest rates directly thereby stimulating spending by the borrowers
bull This strategymdashcalled quantitative easingmdashmay also end a recession
Interaction between monetary and fiscal policy
bull IS-LM Model Monetary and fiscal policy variables (M G and T ) are exogenous
bull Real world Monetary policymakers may adjust M in response to changes in fiscal policy or vice versa
bull Such responses by the central bank may affect the effectiveness of fiscal policy
The Fedrsquos response to G gt 0
bull Suppose the government increases Gbull Possible Fed responses
1 hold M constant2 hold r constant3 hold Y constant
bull In each case the effects of G on Yare differenthellip
When G increases the IS curve shifts right
IS1
Response 1 Hold M constant
Y
rLM
r1
Y1
IS2
Y2
r2
If Fed holds M constant then LM curve does not shift
As a result interest rates rise This has a crowding-out effect Consequently GDP increases but not a lot
If Congress raises G the IS curve shifts right
IS1
Response 2 Hold r constant
Y
rLM1
r1
Y1
IS2
Y2
r2
To keep r constant Fed increases M to shift LM curve right
3 1Y Y Y
0r
LM2
Y3
Results
IS1
Response 3 Hold Y constant
Y
rLM1
r1
IS2
Y2
r2
To keep Y constant Fed reduces M to shift LM curve left
0Y
3 1r r r
LM2
Results
Y1
r3
If Congress raises G the IS curve shifts right
At this point you should be able to do problem 7 on page 353 of the textbook Please try it
Estimates of fiscal policy multipliersfrom the DRI macroeconometric model
Assumption about monetary policy
Estimated value of Y G
Fed holds nominal interest rate constant
Fed holds money supply constant
193
060
Estimated value of Y T
119
026
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 amp services
Examples ndash stock market boom or crash
change in householdsrsquo wealth C
ndash change in business or consumer confidence or expectations I andor C
Shocks in the IS -LM model
LM shocks exogenous changes in the demand for money
Examplesndash a wave of credit card fraud increases demand
for moneyndash 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 of1 a boom in the stock market that makes consumers
wealthier2 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 rb determine what happens to C I and the
unemployment rate
CASE STUDY
THE US RECESSION OF 2001
The US Recession of 2001
bull 39 on 900bull 49 on 801bull 63 on 603bull 50 on 705
The US Recession of 2001
bull Growth of GDP was negative in the 1st and 3rd quarters of 2001
bull Thatrsquos essentially before 911
Recall IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
The US Recession of 2001bull Whybull Demand shocks moved the IS
curve leftndash The ldquotech bubblerdquo ended and
stocks fell 25 between 800 and 801
ndash 911 attacks led to a 12 fall in stock prices in one week and a huge rise in uncertainty
ndash Scandals at Enron WorldCom and other corporations led to stock price declines and a decline in trust and a rise in uncertainty
ndash Lower household wealth reduced Co and higher uncertainty reduced Io
IS
Y
rLM
r1
Y1
CASE STUDY
The US recession of 2001Causes 1) Stock market decline C
300
600
900
1200
1500
1995 1996 1997 1998 1999 2000 2001 2002 2003
Ind
ex
(19
42
= 1
00
) Standard amp Poorrsquos 500
The US Recession of 2001bull Fiscal stimulus moved IS curve
rightndash Major tax cuts were enacted in
2001 and 2003ndash Government spending was
boostedbull to rebuild NYC andbull to bail out the airline industry
bull Fed printed money and moved LM curve rightndash Interest rate on 3-month
Treasury bills fellbull 64 in 1100bull 33 in 801bull 09 in 703
IS1
Y
rLM1
r1
Y1
IS2
LM2
Y3
All three toolsmdashG T and Mmdashwere used
CASE STUDY
The US recession of 2001bull Monetary policy response shifted LM curve right
Three-month T-Bill Rate
Three-month T-Bill Rate
0
1
2
3
4
5
6
7
010
120
0004
02
2000
070
320
0010
03
2000
010
320
0104
05
2001
070
620
0110
06
2001
010
620
0204
08
2002
070
920
0210
09
2002
010
920
0304
11
2003
Skip
bull I am skipping section 11-2
THE GREAT DEPRESSION
The Great Depression
Unemployment (right scale)
Real GNP(left scale)
120
140
160
180
200
220
240
1929 1931 1933 1935 1937 1939
billi
ons
of 1
958
dolla
rs
0
5
10
15
20
25
30
perc
ent o
f lab
or fo
rce
THE SPENDING HYPOTHESIS
Shocks to the IS curvebull asserts that the
Depression was largely due to an exogenous fall in the demand for goods and services ndash a leftward shift of the IS curve
bull evidence output and interest rates both fell in early 1930s which is what a leftward IS shift would cause
IS
Y
rLM
r1
Y1
THE SPENDING HYPOTHESIS
Reasons for the IS shiftbull Stock market crash exogenous C
ndash Oct-Dec 1929 SampP 500 fell 17ndash Oct 1929-Dec 1933 SampP 500 fell 71
bull Drop in investmentndash ldquocorrectionrdquo after overbuilding in the 1920sndash widespread bank failures in early 1930s made it harder
to obtain financing for investmentbull Contractionary fiscal policy
ndash Politicians raised tax rates in 1932 and cut spending to combat increasing deficits
THE MONEY HYPOTHESIS
A shock to the LM curvebull asserts that the Depression was largely due to
huge fall in the money supplybull evidence M1 fell 25 during 1929-33 bull But two problems with this hypothesis
ndash P fell even more so MP actually rose slightly during 1929-31
ndash nominal interest rates fell which is the opposite of what a leftward LM shift would cause
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull asserts that the severity of the Depression
was due to a huge deflation ndash P fell 25 during 1929-33
bull This deflation was probably caused by the fall in M so perhaps money played an important role after all
bull In what ways does a deflation affect the economy
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The stabilizing effects of deflationbull P (MP ) LM shifts right Ybull Pigou effect
P (MP )
consumersrsquo wealth
C
IS shifts right
Y
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects
of expected deflation E
bull LM curve shifts leftr and I (r ) planned expenditure income and output
bull Also the nominal interest rate decreases (idarr) ndash see IS-LM predictions grid
IS
Y
rLM
r1
Y1
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects of unexpected deflation
debt-deflation theoryP (if unexpected)
transfers purchasing power from borrowers to lenders
borrowers spend less lenders spend more if borrowersrsquo propensity to spend is larger than
lendersrsquo then aggregate spending falls the IS curve shifts left and Y falls
The evidence on output and nominal interest rates
bull Note that other than the money hypothesis all the other hypothesesmdashthe spending hypothesis the debt-deflation hypothesis and the deflationary expectations hypothesismdashpredict falling real GDP and falling nominal interest rates
bull This is exactly what happened in the early stages of the Great Depression
bull The spending hypothesis and the debt-deflation hypothesis both predict falling real interest rates whereas the deflationary expectations hypothesis predicts rising real interest rates
bull Therefore evidence on real interest rates is crucial in identifying suitable explanations for the Great Depression
Why another Depression is unlikelybull Policymakers (or their advisors) now know much more
about macroeconomicsndash The Fed knows better than to let M fall so much
especially during a contractionndash Fiscal policymakers know better than to raise
taxes or cut spending during a contractionbull Federal deposit insurance makes widespread bank
failures very unlikely
bull Automatic stabilizers make fiscal policy expansionary during an economic downturn
THE FINANCIAL CRISIS AND ECONOMIC DOWNTURN OF 2008 AND 2009
CASE STUDYThe 2008-09 Financial Crisis amp Recession
bull 2009 Real GDP fell unemployment rate approached 10
bull Important factors in the crisisndash early 2000s Federal Reserve interest rate policy ndash sub-prime mortgage crisisndash bursting of house price bubble rising foreclosure
ratesndash falling stock pricesndash failing financial institutionsndash declining consumer confidence drop in spending on
consumer durables and investment goods
A Too-Brief and Too-Simple Explanation
bull The price of housing had risen to unsustainable levels
bull When home prices inevitably crashed people suddenly felt poor and cut back their spending plans
bull This fall in planned expenditure brought about the Great Recession of 2008-09
The Housing Bubble Inflates then Deflates
bull The SampP Case-Shiller 20-City Home Price Index went from ndash 100 in Jan 2000 tondash 20654 in April 2006 tondash 14095 in May 2009 tondash 14216 in Dec 2010
bull Why did the housing bubble inflate
The Housing Bubble Reasons
bull The Fed kept the interest rates too low for too long
bull Securitization technology got a lot fancier in the mortgage bond market
bull The government regulators were sleepingbull Pretty much everybody believed that home
prices could never fall
The Housing Bubble Low FFR
bull The Fed had reduced the Federal Funds Rate to fight the Recession of 2001
bull After that recession ended the Fed continued to keep interest rates low until 2004ndash The Fed was watching inflation which remained
tame Consequently the Fed saw little reason to raise interest rates
ndash The Fed did not believe that housing prices had formed a bubble hellip until it was blindingly obvious
The Housing Bubble Securitization
bull In the past people with money did not like to lend money to home buyers because such loans were risky and had unreliable returns
bull 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
bull The financial sector was regulated by people who were ideologically opposed to regulation
bull They turned a blind eye to even the worst lending practices
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
The Zero Lower Bound on Nominal Interest Rates
bull 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 bendash at the zero lower bound orndash in a liquidity trap
bull See page 350 of the textbook
The Zero Lower Bound on Nominal Interest Rates Solutions
bull When an economy is in a liquidity trap monetary policy cannot be used to reduce interest rates any further
bull But is there nothing else that can be done to bring the economy back to life
bull Yes there isbull Expansionary fiscal policy can be usedbull And therersquos 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
bull In my example ndash the central bank needs to reduce
the real interest rate to r = 21 to end the recession
ndash But expected inflation is Eπ = minus 3 ndash So the nominal interest rate would
have to be brought down to i = ndash 09 which alas is impossible
bull Recall that the LM curve shifts right if either M or Eπ increases
bull If the central bank promises to be irresponsible and to create rapid inflation in the future and if people believe its promise then Eπ will increase say from minus 3 to +1
bull Then the nominal interest rate required for full-employment will be i = r + Eπ = 21 + 10 = 31 which is definitely attainable
IS
Y
rLM
r1
Y1
21
The zero-lower-bound problem can be solved if the central bank can credibly promise to be irresponsible
The Zero Lower Bound on Nominal Interest Rates Solutions
bull Although this chapter assumes a closed economy in reality foreign trade does matter
bull So the central bank can ndash print domestic currency and ndash use it to buy foreign currency ndash thereby making the domestic currency cheaper
relative to the foreign currencyndash thereby stimulating exportsndash thereby ending the recession
The Zero Lower Bound on Nominal Interest Rates Solutions
bull 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
bull This would reduce long-term interest rates directly thereby stimulating spending by the borrowers
bull This strategymdashcalled quantitative easingmdashmay also end a recession
Interaction between monetary and fiscal policy
bull IS-LM Model Monetary and fiscal policy variables (M G and T ) are exogenous
bull Real world Monetary policymakers may adjust M in response to changes in fiscal policy or vice versa
bull Such responses by the central bank may affect the effectiveness of fiscal policy
The Fedrsquos response to G gt 0
bull Suppose the government increases Gbull Possible Fed responses
1 hold M constant2 hold r constant3 hold Y constant
bull In each case the effects of G on Yare differenthellip
When G increases the IS curve shifts right
IS1
Response 1 Hold M constant
Y
rLM
r1
Y1
IS2
Y2
r2
If Fed holds M constant then LM curve does not shift
As a result interest rates rise This has a crowding-out effect Consequently GDP increases but not a lot
If Congress raises G the IS curve shifts right
IS1
Response 2 Hold r constant
Y
rLM1
r1
Y1
IS2
Y2
r2
To keep r constant Fed increases M to shift LM curve right
3 1Y Y Y
0r
LM2
Y3
Results
IS1
Response 3 Hold Y constant
Y
rLM1
r1
IS2
Y2
r2
To keep Y constant Fed reduces M to shift LM curve left
0Y
3 1r r r
LM2
Results
Y1
r3
If Congress raises G the IS curve shifts right
At this point you should be able to do problem 7 on page 353 of the textbook Please try it
Estimates of fiscal policy multipliersfrom the DRI macroeconometric model
Assumption about monetary policy
Estimated value of Y G
Fed holds nominal interest rate constant
Fed holds money supply constant
193
060
Estimated value of Y T
119
026
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 amp services
Examples ndash stock market boom or crash
change in householdsrsquo wealth C
ndash change in business or consumer confidence or expectations I andor C
Shocks in the IS -LM model
LM shocks exogenous changes in the demand for money
Examplesndash a wave of credit card fraud increases demand
for moneyndash 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 of1 a boom in the stock market that makes consumers
wealthier2 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 rb determine what happens to C I and the
unemployment rate
CASE STUDY
THE US RECESSION OF 2001
The US Recession of 2001
bull 39 on 900bull 49 on 801bull 63 on 603bull 50 on 705
The US Recession of 2001
bull Growth of GDP was negative in the 1st and 3rd quarters of 2001
bull Thatrsquos essentially before 911
Recall IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
The US Recession of 2001bull Whybull Demand shocks moved the IS
curve leftndash The ldquotech bubblerdquo ended and
stocks fell 25 between 800 and 801
ndash 911 attacks led to a 12 fall in stock prices in one week and a huge rise in uncertainty
ndash Scandals at Enron WorldCom and other corporations led to stock price declines and a decline in trust and a rise in uncertainty
ndash Lower household wealth reduced Co and higher uncertainty reduced Io
IS
Y
rLM
r1
Y1
CASE STUDY
The US recession of 2001Causes 1) Stock market decline C
300
600
900
1200
1500
1995 1996 1997 1998 1999 2000 2001 2002 2003
Ind
ex
(19
42
= 1
00
) Standard amp Poorrsquos 500
The US Recession of 2001bull Fiscal stimulus moved IS curve
rightndash Major tax cuts were enacted in
2001 and 2003ndash Government spending was
boostedbull to rebuild NYC andbull to bail out the airline industry
bull Fed printed money and moved LM curve rightndash Interest rate on 3-month
Treasury bills fellbull 64 in 1100bull 33 in 801bull 09 in 703
IS1
Y
rLM1
r1
Y1
IS2
LM2
Y3
All three toolsmdashG T and Mmdashwere used
CASE STUDY
The US recession of 2001bull Monetary policy response shifted LM curve right
Three-month T-Bill Rate
Three-month T-Bill Rate
0
1
2
3
4
5
6
7
010
120
0004
02
2000
070
320
0010
03
2000
010
320
0104
05
2001
070
620
0110
06
2001
010
620
0204
08
2002
070
920
0210
09
2002
010
920
0304
11
2003
Skip
bull I am skipping section 11-2
THE GREAT DEPRESSION
The Great Depression
Unemployment (right scale)
Real GNP(left scale)
120
140
160
180
200
220
240
1929 1931 1933 1935 1937 1939
billi
ons
of 1
958
dolla
rs
0
5
10
15
20
25
30
perc
ent o
f lab
or fo
rce
THE SPENDING HYPOTHESIS
Shocks to the IS curvebull asserts that the
Depression was largely due to an exogenous fall in the demand for goods and services ndash a leftward shift of the IS curve
bull evidence output and interest rates both fell in early 1930s which is what a leftward IS shift would cause
IS
Y
rLM
r1
Y1
THE SPENDING HYPOTHESIS
Reasons for the IS shiftbull Stock market crash exogenous C
ndash Oct-Dec 1929 SampP 500 fell 17ndash Oct 1929-Dec 1933 SampP 500 fell 71
bull Drop in investmentndash ldquocorrectionrdquo after overbuilding in the 1920sndash widespread bank failures in early 1930s made it harder
to obtain financing for investmentbull Contractionary fiscal policy
ndash Politicians raised tax rates in 1932 and cut spending to combat increasing deficits
THE MONEY HYPOTHESIS
A shock to the LM curvebull asserts that the Depression was largely due to
huge fall in the money supplybull evidence M1 fell 25 during 1929-33 bull But two problems with this hypothesis
ndash P fell even more so MP actually rose slightly during 1929-31
ndash nominal interest rates fell which is the opposite of what a leftward LM shift would cause
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull asserts that the severity of the Depression
was due to a huge deflation ndash P fell 25 during 1929-33
bull This deflation was probably caused by the fall in M so perhaps money played an important role after all
bull In what ways does a deflation affect the economy
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The stabilizing effects of deflationbull P (MP ) LM shifts right Ybull Pigou effect
P (MP )
consumersrsquo wealth
C
IS shifts right
Y
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects
of expected deflation E
bull LM curve shifts leftr and I (r ) planned expenditure income and output
bull Also the nominal interest rate decreases (idarr) ndash see IS-LM predictions grid
IS
Y
rLM
r1
Y1
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects of unexpected deflation
debt-deflation theoryP (if unexpected)
transfers purchasing power from borrowers to lenders
borrowers spend less lenders spend more if borrowersrsquo propensity to spend is larger than
lendersrsquo then aggregate spending falls the IS curve shifts left and Y falls
The evidence on output and nominal interest rates
bull Note that other than the money hypothesis all the other hypothesesmdashthe spending hypothesis the debt-deflation hypothesis and the deflationary expectations hypothesismdashpredict falling real GDP and falling nominal interest rates
bull This is exactly what happened in the early stages of the Great Depression
bull The spending hypothesis and the debt-deflation hypothesis both predict falling real interest rates whereas the deflationary expectations hypothesis predicts rising real interest rates
bull Therefore evidence on real interest rates is crucial in identifying suitable explanations for the Great Depression
Why another Depression is unlikelybull Policymakers (or their advisors) now know much more
about macroeconomicsndash The Fed knows better than to let M fall so much
especially during a contractionndash Fiscal policymakers know better than to raise
taxes or cut spending during a contractionbull Federal deposit insurance makes widespread bank
failures very unlikely
bull Automatic stabilizers make fiscal policy expansionary during an economic downturn
THE FINANCIAL CRISIS AND ECONOMIC DOWNTURN OF 2008 AND 2009
CASE STUDYThe 2008-09 Financial Crisis amp Recession
bull 2009 Real GDP fell unemployment rate approached 10
bull Important factors in the crisisndash early 2000s Federal Reserve interest rate policy ndash sub-prime mortgage crisisndash bursting of house price bubble rising foreclosure
ratesndash falling stock pricesndash failing financial institutionsndash declining consumer confidence drop in spending on
consumer durables and investment goods
A Too-Brief and Too-Simple Explanation
bull The price of housing had risen to unsustainable levels
bull When home prices inevitably crashed people suddenly felt poor and cut back their spending plans
bull This fall in planned expenditure brought about the Great Recession of 2008-09
The Housing Bubble Inflates then Deflates
bull The SampP Case-Shiller 20-City Home Price Index went from ndash 100 in Jan 2000 tondash 20654 in April 2006 tondash 14095 in May 2009 tondash 14216 in Dec 2010
bull Why did the housing bubble inflate
The Housing Bubble Reasons
bull The Fed kept the interest rates too low for too long
bull Securitization technology got a lot fancier in the mortgage bond market
bull The government regulators were sleepingbull Pretty much everybody believed that home
prices could never fall
The Housing Bubble Low FFR
bull The Fed had reduced the Federal Funds Rate to fight the Recession of 2001
bull After that recession ended the Fed continued to keep interest rates low until 2004ndash The Fed was watching inflation which remained
tame Consequently the Fed saw little reason to raise interest rates
ndash The Fed did not believe that housing prices had formed a bubble hellip until it was blindingly obvious
The Housing Bubble Securitization
bull In the past people with money did not like to lend money to home buyers because such loans were risky and had unreliable returns
bull 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
bull The financial sector was regulated by people who were ideologically opposed to regulation
bull They turned a blind eye to even the worst lending practices
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
The Zero Lower Bound on Nominal Interest Rates Solutions
bull When an economy is in a liquidity trap monetary policy cannot be used to reduce interest rates any further
bull But is there nothing else that can be done to bring the economy back to life
bull Yes there isbull Expansionary fiscal policy can be usedbull And therersquos 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
bull In my example ndash the central bank needs to reduce
the real interest rate to r = 21 to end the recession
ndash But expected inflation is Eπ = minus 3 ndash So the nominal interest rate would
have to be brought down to i = ndash 09 which alas is impossible
bull Recall that the LM curve shifts right if either M or Eπ increases
bull If the central bank promises to be irresponsible and to create rapid inflation in the future and if people believe its promise then Eπ will increase say from minus 3 to +1
bull Then the nominal interest rate required for full-employment will be i = r + Eπ = 21 + 10 = 31 which is definitely attainable
IS
Y
rLM
r1
Y1
21
The zero-lower-bound problem can be solved if the central bank can credibly promise to be irresponsible
The Zero Lower Bound on Nominal Interest Rates Solutions
bull Although this chapter assumes a closed economy in reality foreign trade does matter
bull So the central bank can ndash print domestic currency and ndash use it to buy foreign currency ndash thereby making the domestic currency cheaper
relative to the foreign currencyndash thereby stimulating exportsndash thereby ending the recession
The Zero Lower Bound on Nominal Interest Rates Solutions
bull 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
bull This would reduce long-term interest rates directly thereby stimulating spending by the borrowers
bull This strategymdashcalled quantitative easingmdashmay also end a recession
Interaction between monetary and fiscal policy
bull IS-LM Model Monetary and fiscal policy variables (M G and T ) are exogenous
bull Real world Monetary policymakers may adjust M in response to changes in fiscal policy or vice versa
bull Such responses by the central bank may affect the effectiveness of fiscal policy
The Fedrsquos response to G gt 0
bull Suppose the government increases Gbull Possible Fed responses
1 hold M constant2 hold r constant3 hold Y constant
bull In each case the effects of G on Yare differenthellip
When G increases the IS curve shifts right
IS1
Response 1 Hold M constant
Y
rLM
r1
Y1
IS2
Y2
r2
If Fed holds M constant then LM curve does not shift
As a result interest rates rise This has a crowding-out effect Consequently GDP increases but not a lot
If Congress raises G the IS curve shifts right
IS1
Response 2 Hold r constant
Y
rLM1
r1
Y1
IS2
Y2
r2
To keep r constant Fed increases M to shift LM curve right
3 1Y Y Y
0r
LM2
Y3
Results
IS1
Response 3 Hold Y constant
Y
rLM1
r1
IS2
Y2
r2
To keep Y constant Fed reduces M to shift LM curve left
0Y
3 1r r r
LM2
Results
Y1
r3
If Congress raises G the IS curve shifts right
At this point you should be able to do problem 7 on page 353 of the textbook Please try it
Estimates of fiscal policy multipliersfrom the DRI macroeconometric model
Assumption about monetary policy
Estimated value of Y G
Fed holds nominal interest rate constant
Fed holds money supply constant
193
060
Estimated value of Y T
119
026
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 amp services
Examples ndash stock market boom or crash
change in householdsrsquo wealth C
ndash change in business or consumer confidence or expectations I andor C
Shocks in the IS -LM model
LM shocks exogenous changes in the demand for money
Examplesndash a wave of credit card fraud increases demand
for moneyndash 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 of1 a boom in the stock market that makes consumers
wealthier2 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 rb determine what happens to C I and the
unemployment rate
CASE STUDY
THE US RECESSION OF 2001
The US Recession of 2001
bull 39 on 900bull 49 on 801bull 63 on 603bull 50 on 705
The US Recession of 2001
bull Growth of GDP was negative in the 1st and 3rd quarters of 2001
bull Thatrsquos essentially before 911
Recall IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
The US Recession of 2001bull Whybull Demand shocks moved the IS
curve leftndash The ldquotech bubblerdquo ended and
stocks fell 25 between 800 and 801
ndash 911 attacks led to a 12 fall in stock prices in one week and a huge rise in uncertainty
ndash Scandals at Enron WorldCom and other corporations led to stock price declines and a decline in trust and a rise in uncertainty
ndash Lower household wealth reduced Co and higher uncertainty reduced Io
IS
Y
rLM
r1
Y1
CASE STUDY
The US recession of 2001Causes 1) Stock market decline C
300
600
900
1200
1500
1995 1996 1997 1998 1999 2000 2001 2002 2003
Ind
ex
(19
42
= 1
00
) Standard amp Poorrsquos 500
The US Recession of 2001bull Fiscal stimulus moved IS curve
rightndash Major tax cuts were enacted in
2001 and 2003ndash Government spending was
boostedbull to rebuild NYC andbull to bail out the airline industry
bull Fed printed money and moved LM curve rightndash Interest rate on 3-month
Treasury bills fellbull 64 in 1100bull 33 in 801bull 09 in 703
IS1
Y
rLM1
r1
Y1
IS2
LM2
Y3
All three toolsmdashG T and Mmdashwere used
CASE STUDY
The US recession of 2001bull Monetary policy response shifted LM curve right
Three-month T-Bill Rate
Three-month T-Bill Rate
0
1
2
3
4
5
6
7
010
120
0004
02
2000
070
320
0010
03
2000
010
320
0104
05
2001
070
620
0110
06
2001
010
620
0204
08
2002
070
920
0210
09
2002
010
920
0304
11
2003
Skip
bull I am skipping section 11-2
THE GREAT DEPRESSION
The Great Depression
Unemployment (right scale)
Real GNP(left scale)
120
140
160
180
200
220
240
1929 1931 1933 1935 1937 1939
billi
ons
of 1
958
dolla
rs
0
5
10
15
20
25
30
perc
ent o
f lab
or fo
rce
THE SPENDING HYPOTHESIS
Shocks to the IS curvebull asserts that the
Depression was largely due to an exogenous fall in the demand for goods and services ndash a leftward shift of the IS curve
bull evidence output and interest rates both fell in early 1930s which is what a leftward IS shift would cause
IS
Y
rLM
r1
Y1
THE SPENDING HYPOTHESIS
Reasons for the IS shiftbull Stock market crash exogenous C
ndash Oct-Dec 1929 SampP 500 fell 17ndash Oct 1929-Dec 1933 SampP 500 fell 71
bull Drop in investmentndash ldquocorrectionrdquo after overbuilding in the 1920sndash widespread bank failures in early 1930s made it harder
to obtain financing for investmentbull Contractionary fiscal policy
ndash Politicians raised tax rates in 1932 and cut spending to combat increasing deficits
THE MONEY HYPOTHESIS
A shock to the LM curvebull asserts that the Depression was largely due to
huge fall in the money supplybull evidence M1 fell 25 during 1929-33 bull But two problems with this hypothesis
ndash P fell even more so MP actually rose slightly during 1929-31
ndash nominal interest rates fell which is the opposite of what a leftward LM shift would cause
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull asserts that the severity of the Depression
was due to a huge deflation ndash P fell 25 during 1929-33
bull This deflation was probably caused by the fall in M so perhaps money played an important role after all
bull In what ways does a deflation affect the economy
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The stabilizing effects of deflationbull P (MP ) LM shifts right Ybull Pigou effect
P (MP )
consumersrsquo wealth
C
IS shifts right
Y
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects
of expected deflation E
bull LM curve shifts leftr and I (r ) planned expenditure income and output
bull Also the nominal interest rate decreases (idarr) ndash see IS-LM predictions grid
IS
Y
rLM
r1
Y1
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects of unexpected deflation
debt-deflation theoryP (if unexpected)
transfers purchasing power from borrowers to lenders
borrowers spend less lenders spend more if borrowersrsquo propensity to spend is larger than
lendersrsquo then aggregate spending falls the IS curve shifts left and Y falls
The evidence on output and nominal interest rates
bull Note that other than the money hypothesis all the other hypothesesmdashthe spending hypothesis the debt-deflation hypothesis and the deflationary expectations hypothesismdashpredict falling real GDP and falling nominal interest rates
bull This is exactly what happened in the early stages of the Great Depression
bull The spending hypothesis and the debt-deflation hypothesis both predict falling real interest rates whereas the deflationary expectations hypothesis predicts rising real interest rates
bull Therefore evidence on real interest rates is crucial in identifying suitable explanations for the Great Depression
Why another Depression is unlikelybull Policymakers (or their advisors) now know much more
about macroeconomicsndash The Fed knows better than to let M fall so much
especially during a contractionndash Fiscal policymakers know better than to raise
taxes or cut spending during a contractionbull Federal deposit insurance makes widespread bank
failures very unlikely
bull Automatic stabilizers make fiscal policy expansionary during an economic downturn
THE FINANCIAL CRISIS AND ECONOMIC DOWNTURN OF 2008 AND 2009
CASE STUDYThe 2008-09 Financial Crisis amp Recession
bull 2009 Real GDP fell unemployment rate approached 10
bull Important factors in the crisisndash early 2000s Federal Reserve interest rate policy ndash sub-prime mortgage crisisndash bursting of house price bubble rising foreclosure
ratesndash falling stock pricesndash failing financial institutionsndash declining consumer confidence drop in spending on
consumer durables and investment goods
A Too-Brief and Too-Simple Explanation
bull The price of housing had risen to unsustainable levels
bull When home prices inevitably crashed people suddenly felt poor and cut back their spending plans
bull This fall in planned expenditure brought about the Great Recession of 2008-09
The Housing Bubble Inflates then Deflates
bull The SampP Case-Shiller 20-City Home Price Index went from ndash 100 in Jan 2000 tondash 20654 in April 2006 tondash 14095 in May 2009 tondash 14216 in Dec 2010
bull Why did the housing bubble inflate
The Housing Bubble Reasons
bull The Fed kept the interest rates too low for too long
bull Securitization technology got a lot fancier in the mortgage bond market
bull The government regulators were sleepingbull Pretty much everybody believed that home
prices could never fall
The Housing Bubble Low FFR
bull The Fed had reduced the Federal Funds Rate to fight the Recession of 2001
bull After that recession ended the Fed continued to keep interest rates low until 2004ndash The Fed was watching inflation which remained
tame Consequently the Fed saw little reason to raise interest rates
ndash The Fed did not believe that housing prices had formed a bubble hellip until it was blindingly obvious
The Housing Bubble Securitization
bull In the past people with money did not like to lend money to home buyers because such loans were risky and had unreliable returns
bull 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
bull The financial sector was regulated by people who were ideologically opposed to regulation
bull They turned a blind eye to even the worst lending practices
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
The Zero Lower Bound on Nominal Interest Rates Solutions
bull In my example ndash the central bank needs to reduce
the real interest rate to r = 21 to end the recession
ndash But expected inflation is Eπ = minus 3 ndash So the nominal interest rate would
have to be brought down to i = ndash 09 which alas is impossible
bull Recall that the LM curve shifts right if either M or Eπ increases
bull If the central bank promises to be irresponsible and to create rapid inflation in the future and if people believe its promise then Eπ will increase say from minus 3 to +1
bull Then the nominal interest rate required for full-employment will be i = r + Eπ = 21 + 10 = 31 which is definitely attainable
IS
Y
rLM
r1
Y1
21
The zero-lower-bound problem can be solved if the central bank can credibly promise to be irresponsible
The Zero Lower Bound on Nominal Interest Rates Solutions
bull Although this chapter assumes a closed economy in reality foreign trade does matter
bull So the central bank can ndash print domestic currency and ndash use it to buy foreign currency ndash thereby making the domestic currency cheaper
relative to the foreign currencyndash thereby stimulating exportsndash thereby ending the recession
The Zero Lower Bound on Nominal Interest Rates Solutions
bull 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
bull This would reduce long-term interest rates directly thereby stimulating spending by the borrowers
bull This strategymdashcalled quantitative easingmdashmay also end a recession
Interaction between monetary and fiscal policy
bull IS-LM Model Monetary and fiscal policy variables (M G and T ) are exogenous
bull Real world Monetary policymakers may adjust M in response to changes in fiscal policy or vice versa
bull Such responses by the central bank may affect the effectiveness of fiscal policy
The Fedrsquos response to G gt 0
bull Suppose the government increases Gbull Possible Fed responses
1 hold M constant2 hold r constant3 hold Y constant
bull In each case the effects of G on Yare differenthellip
When G increases the IS curve shifts right
IS1
Response 1 Hold M constant
Y
rLM
r1
Y1
IS2
Y2
r2
If Fed holds M constant then LM curve does not shift
As a result interest rates rise This has a crowding-out effect Consequently GDP increases but not a lot
If Congress raises G the IS curve shifts right
IS1
Response 2 Hold r constant
Y
rLM1
r1
Y1
IS2
Y2
r2
To keep r constant Fed increases M to shift LM curve right
3 1Y Y Y
0r
LM2
Y3
Results
IS1
Response 3 Hold Y constant
Y
rLM1
r1
IS2
Y2
r2
To keep Y constant Fed reduces M to shift LM curve left
0Y
3 1r r r
LM2
Results
Y1
r3
If Congress raises G the IS curve shifts right
At this point you should be able to do problem 7 on page 353 of the textbook Please try it
Estimates of fiscal policy multipliersfrom the DRI macroeconometric model
Assumption about monetary policy
Estimated value of Y G
Fed holds nominal interest rate constant
Fed holds money supply constant
193
060
Estimated value of Y T
119
026
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 amp services
Examples ndash stock market boom or crash
change in householdsrsquo wealth C
ndash change in business or consumer confidence or expectations I andor C
Shocks in the IS -LM model
LM shocks exogenous changes in the demand for money
Examplesndash a wave of credit card fraud increases demand
for moneyndash 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 of1 a boom in the stock market that makes consumers
wealthier2 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 rb determine what happens to C I and the
unemployment rate
CASE STUDY
THE US RECESSION OF 2001
The US Recession of 2001
bull 39 on 900bull 49 on 801bull 63 on 603bull 50 on 705
The US Recession of 2001
bull Growth of GDP was negative in the 1st and 3rd quarters of 2001
bull Thatrsquos essentially before 911
Recall IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
The US Recession of 2001bull Whybull Demand shocks moved the IS
curve leftndash The ldquotech bubblerdquo ended and
stocks fell 25 between 800 and 801
ndash 911 attacks led to a 12 fall in stock prices in one week and a huge rise in uncertainty
ndash Scandals at Enron WorldCom and other corporations led to stock price declines and a decline in trust and a rise in uncertainty
ndash Lower household wealth reduced Co and higher uncertainty reduced Io
IS
Y
rLM
r1
Y1
CASE STUDY
The US recession of 2001Causes 1) Stock market decline C
300
600
900
1200
1500
1995 1996 1997 1998 1999 2000 2001 2002 2003
Ind
ex
(19
42
= 1
00
) Standard amp Poorrsquos 500
The US Recession of 2001bull Fiscal stimulus moved IS curve
rightndash Major tax cuts were enacted in
2001 and 2003ndash Government spending was
boostedbull to rebuild NYC andbull to bail out the airline industry
bull Fed printed money and moved LM curve rightndash Interest rate on 3-month
Treasury bills fellbull 64 in 1100bull 33 in 801bull 09 in 703
IS1
Y
rLM1
r1
Y1
IS2
LM2
Y3
All three toolsmdashG T and Mmdashwere used
CASE STUDY
The US recession of 2001bull Monetary policy response shifted LM curve right
Three-month T-Bill Rate
Three-month T-Bill Rate
0
1
2
3
4
5
6
7
010
120
0004
02
2000
070
320
0010
03
2000
010
320
0104
05
2001
070
620
0110
06
2001
010
620
0204
08
2002
070
920
0210
09
2002
010
920
0304
11
2003
Skip
bull I am skipping section 11-2
THE GREAT DEPRESSION
The Great Depression
Unemployment (right scale)
Real GNP(left scale)
120
140
160
180
200
220
240
1929 1931 1933 1935 1937 1939
billi
ons
of 1
958
dolla
rs
0
5
10
15
20
25
30
perc
ent o
f lab
or fo
rce
THE SPENDING HYPOTHESIS
Shocks to the IS curvebull asserts that the
Depression was largely due to an exogenous fall in the demand for goods and services ndash a leftward shift of the IS curve
bull evidence output and interest rates both fell in early 1930s which is what a leftward IS shift would cause
IS
Y
rLM
r1
Y1
THE SPENDING HYPOTHESIS
Reasons for the IS shiftbull Stock market crash exogenous C
ndash Oct-Dec 1929 SampP 500 fell 17ndash Oct 1929-Dec 1933 SampP 500 fell 71
bull Drop in investmentndash ldquocorrectionrdquo after overbuilding in the 1920sndash widespread bank failures in early 1930s made it harder
to obtain financing for investmentbull Contractionary fiscal policy
ndash Politicians raised tax rates in 1932 and cut spending to combat increasing deficits
THE MONEY HYPOTHESIS
A shock to the LM curvebull asserts that the Depression was largely due to
huge fall in the money supplybull evidence M1 fell 25 during 1929-33 bull But two problems with this hypothesis
ndash P fell even more so MP actually rose slightly during 1929-31
ndash nominal interest rates fell which is the opposite of what a leftward LM shift would cause
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull asserts that the severity of the Depression
was due to a huge deflation ndash P fell 25 during 1929-33
bull This deflation was probably caused by the fall in M so perhaps money played an important role after all
bull In what ways does a deflation affect the economy
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The stabilizing effects of deflationbull P (MP ) LM shifts right Ybull Pigou effect
P (MP )
consumersrsquo wealth
C
IS shifts right
Y
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects
of expected deflation E
bull LM curve shifts leftr and I (r ) planned expenditure income and output
bull Also the nominal interest rate decreases (idarr) ndash see IS-LM predictions grid
IS
Y
rLM
r1
Y1
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects of unexpected deflation
debt-deflation theoryP (if unexpected)
transfers purchasing power from borrowers to lenders
borrowers spend less lenders spend more if borrowersrsquo propensity to spend is larger than
lendersrsquo then aggregate spending falls the IS curve shifts left and Y falls
The evidence on output and nominal interest rates
bull Note that other than the money hypothesis all the other hypothesesmdashthe spending hypothesis the debt-deflation hypothesis and the deflationary expectations hypothesismdashpredict falling real GDP and falling nominal interest rates
bull This is exactly what happened in the early stages of the Great Depression
bull The spending hypothesis and the debt-deflation hypothesis both predict falling real interest rates whereas the deflationary expectations hypothesis predicts rising real interest rates
bull Therefore evidence on real interest rates is crucial in identifying suitable explanations for the Great Depression
Why another Depression is unlikelybull Policymakers (or their advisors) now know much more
about macroeconomicsndash The Fed knows better than to let M fall so much
especially during a contractionndash Fiscal policymakers know better than to raise
taxes or cut spending during a contractionbull Federal deposit insurance makes widespread bank
failures very unlikely
bull Automatic stabilizers make fiscal policy expansionary during an economic downturn
THE FINANCIAL CRISIS AND ECONOMIC DOWNTURN OF 2008 AND 2009
CASE STUDYThe 2008-09 Financial Crisis amp Recession
bull 2009 Real GDP fell unemployment rate approached 10
bull Important factors in the crisisndash early 2000s Federal Reserve interest rate policy ndash sub-prime mortgage crisisndash bursting of house price bubble rising foreclosure
ratesndash falling stock pricesndash failing financial institutionsndash declining consumer confidence drop in spending on
consumer durables and investment goods
A Too-Brief and Too-Simple Explanation
bull The price of housing had risen to unsustainable levels
bull When home prices inevitably crashed people suddenly felt poor and cut back their spending plans
bull This fall in planned expenditure brought about the Great Recession of 2008-09
The Housing Bubble Inflates then Deflates
bull The SampP Case-Shiller 20-City Home Price Index went from ndash 100 in Jan 2000 tondash 20654 in April 2006 tondash 14095 in May 2009 tondash 14216 in Dec 2010
bull Why did the housing bubble inflate
The Housing Bubble Reasons
bull The Fed kept the interest rates too low for too long
bull Securitization technology got a lot fancier in the mortgage bond market
bull The government regulators were sleepingbull Pretty much everybody believed that home
prices could never fall
The Housing Bubble Low FFR
bull The Fed had reduced the Federal Funds Rate to fight the Recession of 2001
bull After that recession ended the Fed continued to keep interest rates low until 2004ndash The Fed was watching inflation which remained
tame Consequently the Fed saw little reason to raise interest rates
ndash The Fed did not believe that housing prices had formed a bubble hellip until it was blindingly obvious
The Housing Bubble Securitization
bull In the past people with money did not like to lend money to home buyers because such loans were risky and had unreliable returns
bull 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
bull The financial sector was regulated by people who were ideologically opposed to regulation
bull They turned a blind eye to even the worst lending practices
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
The Zero Lower Bound on Nominal Interest Rates Solutions
bull Although this chapter assumes a closed economy in reality foreign trade does matter
bull So the central bank can ndash print domestic currency and ndash use it to buy foreign currency ndash thereby making the domestic currency cheaper
relative to the foreign currencyndash thereby stimulating exportsndash thereby ending the recession
The Zero Lower Bound on Nominal Interest Rates Solutions
bull 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
bull This would reduce long-term interest rates directly thereby stimulating spending by the borrowers
bull This strategymdashcalled quantitative easingmdashmay also end a recession
Interaction between monetary and fiscal policy
bull IS-LM Model Monetary and fiscal policy variables (M G and T ) are exogenous
bull Real world Monetary policymakers may adjust M in response to changes in fiscal policy or vice versa
bull Such responses by the central bank may affect the effectiveness of fiscal policy
The Fedrsquos response to G gt 0
bull Suppose the government increases Gbull Possible Fed responses
1 hold M constant2 hold r constant3 hold Y constant
bull In each case the effects of G on Yare differenthellip
When G increases the IS curve shifts right
IS1
Response 1 Hold M constant
Y
rLM
r1
Y1
IS2
Y2
r2
If Fed holds M constant then LM curve does not shift
As a result interest rates rise This has a crowding-out effect Consequently GDP increases but not a lot
If Congress raises G the IS curve shifts right
IS1
Response 2 Hold r constant
Y
rLM1
r1
Y1
IS2
Y2
r2
To keep r constant Fed increases M to shift LM curve right
3 1Y Y Y
0r
LM2
Y3
Results
IS1
Response 3 Hold Y constant
Y
rLM1
r1
IS2
Y2
r2
To keep Y constant Fed reduces M to shift LM curve left
0Y
3 1r r r
LM2
Results
Y1
r3
If Congress raises G the IS curve shifts right
At this point you should be able to do problem 7 on page 353 of the textbook Please try it
Estimates of fiscal policy multipliersfrom the DRI macroeconometric model
Assumption about monetary policy
Estimated value of Y G
Fed holds nominal interest rate constant
Fed holds money supply constant
193
060
Estimated value of Y T
119
026
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 amp services
Examples ndash stock market boom or crash
change in householdsrsquo wealth C
ndash change in business or consumer confidence or expectations I andor C
Shocks in the IS -LM model
LM shocks exogenous changes in the demand for money
Examplesndash a wave of credit card fraud increases demand
for moneyndash 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 of1 a boom in the stock market that makes consumers
wealthier2 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 rb determine what happens to C I and the
unemployment rate
CASE STUDY
THE US RECESSION OF 2001
The US Recession of 2001
bull 39 on 900bull 49 on 801bull 63 on 603bull 50 on 705
The US Recession of 2001
bull Growth of GDP was negative in the 1st and 3rd quarters of 2001
bull Thatrsquos essentially before 911
Recall IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
The US Recession of 2001bull Whybull Demand shocks moved the IS
curve leftndash The ldquotech bubblerdquo ended and
stocks fell 25 between 800 and 801
ndash 911 attacks led to a 12 fall in stock prices in one week and a huge rise in uncertainty
ndash Scandals at Enron WorldCom and other corporations led to stock price declines and a decline in trust and a rise in uncertainty
ndash Lower household wealth reduced Co and higher uncertainty reduced Io
IS
Y
rLM
r1
Y1
CASE STUDY
The US recession of 2001Causes 1) Stock market decline C
300
600
900
1200
1500
1995 1996 1997 1998 1999 2000 2001 2002 2003
Ind
ex
(19
42
= 1
00
) Standard amp Poorrsquos 500
The US Recession of 2001bull Fiscal stimulus moved IS curve
rightndash Major tax cuts were enacted in
2001 and 2003ndash Government spending was
boostedbull to rebuild NYC andbull to bail out the airline industry
bull Fed printed money and moved LM curve rightndash Interest rate on 3-month
Treasury bills fellbull 64 in 1100bull 33 in 801bull 09 in 703
IS1
Y
rLM1
r1
Y1
IS2
LM2
Y3
All three toolsmdashG T and Mmdashwere used
CASE STUDY
The US recession of 2001bull Monetary policy response shifted LM curve right
Three-month T-Bill Rate
Three-month T-Bill Rate
0
1
2
3
4
5
6
7
010
120
0004
02
2000
070
320
0010
03
2000
010
320
0104
05
2001
070
620
0110
06
2001
010
620
0204
08
2002
070
920
0210
09
2002
010
920
0304
11
2003
Skip
bull I am skipping section 11-2
THE GREAT DEPRESSION
The Great Depression
Unemployment (right scale)
Real GNP(left scale)
120
140
160
180
200
220
240
1929 1931 1933 1935 1937 1939
billi
ons
of 1
958
dolla
rs
0
5
10
15
20
25
30
perc
ent o
f lab
or fo
rce
THE SPENDING HYPOTHESIS
Shocks to the IS curvebull asserts that the
Depression was largely due to an exogenous fall in the demand for goods and services ndash a leftward shift of the IS curve
bull evidence output and interest rates both fell in early 1930s which is what a leftward IS shift would cause
IS
Y
rLM
r1
Y1
THE SPENDING HYPOTHESIS
Reasons for the IS shiftbull Stock market crash exogenous C
ndash Oct-Dec 1929 SampP 500 fell 17ndash Oct 1929-Dec 1933 SampP 500 fell 71
bull Drop in investmentndash ldquocorrectionrdquo after overbuilding in the 1920sndash widespread bank failures in early 1930s made it harder
to obtain financing for investmentbull Contractionary fiscal policy
ndash Politicians raised tax rates in 1932 and cut spending to combat increasing deficits
THE MONEY HYPOTHESIS
A shock to the LM curvebull asserts that the Depression was largely due to
huge fall in the money supplybull evidence M1 fell 25 during 1929-33 bull But two problems with this hypothesis
ndash P fell even more so MP actually rose slightly during 1929-31
ndash nominal interest rates fell which is the opposite of what a leftward LM shift would cause
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull asserts that the severity of the Depression
was due to a huge deflation ndash P fell 25 during 1929-33
bull This deflation was probably caused by the fall in M so perhaps money played an important role after all
bull In what ways does a deflation affect the economy
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The stabilizing effects of deflationbull P (MP ) LM shifts right Ybull Pigou effect
P (MP )
consumersrsquo wealth
C
IS shifts right
Y
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects
of expected deflation E
bull LM curve shifts leftr and I (r ) planned expenditure income and output
bull Also the nominal interest rate decreases (idarr) ndash see IS-LM predictions grid
IS
Y
rLM
r1
Y1
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects of unexpected deflation
debt-deflation theoryP (if unexpected)
transfers purchasing power from borrowers to lenders
borrowers spend less lenders spend more if borrowersrsquo propensity to spend is larger than
lendersrsquo then aggregate spending falls the IS curve shifts left and Y falls
The evidence on output and nominal interest rates
bull Note that other than the money hypothesis all the other hypothesesmdashthe spending hypothesis the debt-deflation hypothesis and the deflationary expectations hypothesismdashpredict falling real GDP and falling nominal interest rates
bull This is exactly what happened in the early stages of the Great Depression
bull The spending hypothesis and the debt-deflation hypothesis both predict falling real interest rates whereas the deflationary expectations hypothesis predicts rising real interest rates
bull Therefore evidence on real interest rates is crucial in identifying suitable explanations for the Great Depression
Why another Depression is unlikelybull Policymakers (or their advisors) now know much more
about macroeconomicsndash The Fed knows better than to let M fall so much
especially during a contractionndash Fiscal policymakers know better than to raise
taxes or cut spending during a contractionbull Federal deposit insurance makes widespread bank
failures very unlikely
bull Automatic stabilizers make fiscal policy expansionary during an economic downturn
THE FINANCIAL CRISIS AND ECONOMIC DOWNTURN OF 2008 AND 2009
CASE STUDYThe 2008-09 Financial Crisis amp Recession
bull 2009 Real GDP fell unemployment rate approached 10
bull Important factors in the crisisndash early 2000s Federal Reserve interest rate policy ndash sub-prime mortgage crisisndash bursting of house price bubble rising foreclosure
ratesndash falling stock pricesndash failing financial institutionsndash declining consumer confidence drop in spending on
consumer durables and investment goods
A Too-Brief and Too-Simple Explanation
bull The price of housing had risen to unsustainable levels
bull When home prices inevitably crashed people suddenly felt poor and cut back their spending plans
bull This fall in planned expenditure brought about the Great Recession of 2008-09
The Housing Bubble Inflates then Deflates
bull The SampP Case-Shiller 20-City Home Price Index went from ndash 100 in Jan 2000 tondash 20654 in April 2006 tondash 14095 in May 2009 tondash 14216 in Dec 2010
bull Why did the housing bubble inflate
The Housing Bubble Reasons
bull The Fed kept the interest rates too low for too long
bull Securitization technology got a lot fancier in the mortgage bond market
bull The government regulators were sleepingbull Pretty much everybody believed that home
prices could never fall
The Housing Bubble Low FFR
bull The Fed had reduced the Federal Funds Rate to fight the Recession of 2001
bull After that recession ended the Fed continued to keep interest rates low until 2004ndash The Fed was watching inflation which remained
tame Consequently the Fed saw little reason to raise interest rates
ndash The Fed did not believe that housing prices had formed a bubble hellip until it was blindingly obvious
The Housing Bubble Securitization
bull In the past people with money did not like to lend money to home buyers because such loans were risky and had unreliable returns
bull 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
bull The financial sector was regulated by people who were ideologically opposed to regulation
bull They turned a blind eye to even the worst lending practices
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
The Zero Lower Bound on Nominal Interest Rates Solutions
bull 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
bull This would reduce long-term interest rates directly thereby stimulating spending by the borrowers
bull This strategymdashcalled quantitative easingmdashmay also end a recession
Interaction between monetary and fiscal policy
bull IS-LM Model Monetary and fiscal policy variables (M G and T ) are exogenous
bull Real world Monetary policymakers may adjust M in response to changes in fiscal policy or vice versa
bull Such responses by the central bank may affect the effectiveness of fiscal policy
The Fedrsquos response to G gt 0
bull Suppose the government increases Gbull Possible Fed responses
1 hold M constant2 hold r constant3 hold Y constant
bull In each case the effects of G on Yare differenthellip
When G increases the IS curve shifts right
IS1
Response 1 Hold M constant
Y
rLM
r1
Y1
IS2
Y2
r2
If Fed holds M constant then LM curve does not shift
As a result interest rates rise This has a crowding-out effect Consequently GDP increases but not a lot
If Congress raises G the IS curve shifts right
IS1
Response 2 Hold r constant
Y
rLM1
r1
Y1
IS2
Y2
r2
To keep r constant Fed increases M to shift LM curve right
3 1Y Y Y
0r
LM2
Y3
Results
IS1
Response 3 Hold Y constant
Y
rLM1
r1
IS2
Y2
r2
To keep Y constant Fed reduces M to shift LM curve left
0Y
3 1r r r
LM2
Results
Y1
r3
If Congress raises G the IS curve shifts right
At this point you should be able to do problem 7 on page 353 of the textbook Please try it
Estimates of fiscal policy multipliersfrom the DRI macroeconometric model
Assumption about monetary policy
Estimated value of Y G
Fed holds nominal interest rate constant
Fed holds money supply constant
193
060
Estimated value of Y T
119
026
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 amp services
Examples ndash stock market boom or crash
change in householdsrsquo wealth C
ndash change in business or consumer confidence or expectations I andor C
Shocks in the IS -LM model
LM shocks exogenous changes in the demand for money
Examplesndash a wave of credit card fraud increases demand
for moneyndash 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 of1 a boom in the stock market that makes consumers
wealthier2 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 rb determine what happens to C I and the
unemployment rate
CASE STUDY
THE US RECESSION OF 2001
The US Recession of 2001
bull 39 on 900bull 49 on 801bull 63 on 603bull 50 on 705
The US Recession of 2001
bull Growth of GDP was negative in the 1st and 3rd quarters of 2001
bull Thatrsquos essentially before 911
Recall IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
The US Recession of 2001bull Whybull Demand shocks moved the IS
curve leftndash The ldquotech bubblerdquo ended and
stocks fell 25 between 800 and 801
ndash 911 attacks led to a 12 fall in stock prices in one week and a huge rise in uncertainty
ndash Scandals at Enron WorldCom and other corporations led to stock price declines and a decline in trust and a rise in uncertainty
ndash Lower household wealth reduced Co and higher uncertainty reduced Io
IS
Y
rLM
r1
Y1
CASE STUDY
The US recession of 2001Causes 1) Stock market decline C
300
600
900
1200
1500
1995 1996 1997 1998 1999 2000 2001 2002 2003
Ind
ex
(19
42
= 1
00
) Standard amp Poorrsquos 500
The US Recession of 2001bull Fiscal stimulus moved IS curve
rightndash Major tax cuts were enacted in
2001 and 2003ndash Government spending was
boostedbull to rebuild NYC andbull to bail out the airline industry
bull Fed printed money and moved LM curve rightndash Interest rate on 3-month
Treasury bills fellbull 64 in 1100bull 33 in 801bull 09 in 703
IS1
Y
rLM1
r1
Y1
IS2
LM2
Y3
All three toolsmdashG T and Mmdashwere used
CASE STUDY
The US recession of 2001bull Monetary policy response shifted LM curve right
Three-month T-Bill Rate
Three-month T-Bill Rate
0
1
2
3
4
5
6
7
010
120
0004
02
2000
070
320
0010
03
2000
010
320
0104
05
2001
070
620
0110
06
2001
010
620
0204
08
2002
070
920
0210
09
2002
010
920
0304
11
2003
Skip
bull I am skipping section 11-2
THE GREAT DEPRESSION
The Great Depression
Unemployment (right scale)
Real GNP(left scale)
120
140
160
180
200
220
240
1929 1931 1933 1935 1937 1939
billi
ons
of 1
958
dolla
rs
0
5
10
15
20
25
30
perc
ent o
f lab
or fo
rce
THE SPENDING HYPOTHESIS
Shocks to the IS curvebull asserts that the
Depression was largely due to an exogenous fall in the demand for goods and services ndash a leftward shift of the IS curve
bull evidence output and interest rates both fell in early 1930s which is what a leftward IS shift would cause
IS
Y
rLM
r1
Y1
THE SPENDING HYPOTHESIS
Reasons for the IS shiftbull Stock market crash exogenous C
ndash Oct-Dec 1929 SampP 500 fell 17ndash Oct 1929-Dec 1933 SampP 500 fell 71
bull Drop in investmentndash ldquocorrectionrdquo after overbuilding in the 1920sndash widespread bank failures in early 1930s made it harder
to obtain financing for investmentbull Contractionary fiscal policy
ndash Politicians raised tax rates in 1932 and cut spending to combat increasing deficits
THE MONEY HYPOTHESIS
A shock to the LM curvebull asserts that the Depression was largely due to
huge fall in the money supplybull evidence M1 fell 25 during 1929-33 bull But two problems with this hypothesis
ndash P fell even more so MP actually rose slightly during 1929-31
ndash nominal interest rates fell which is the opposite of what a leftward LM shift would cause
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull asserts that the severity of the Depression
was due to a huge deflation ndash P fell 25 during 1929-33
bull This deflation was probably caused by the fall in M so perhaps money played an important role after all
bull In what ways does a deflation affect the economy
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The stabilizing effects of deflationbull P (MP ) LM shifts right Ybull Pigou effect
P (MP )
consumersrsquo wealth
C
IS shifts right
Y
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects
of expected deflation E
bull LM curve shifts leftr and I (r ) planned expenditure income and output
bull Also the nominal interest rate decreases (idarr) ndash see IS-LM predictions grid
IS
Y
rLM
r1
Y1
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects of unexpected deflation
debt-deflation theoryP (if unexpected)
transfers purchasing power from borrowers to lenders
borrowers spend less lenders spend more if borrowersrsquo propensity to spend is larger than
lendersrsquo then aggregate spending falls the IS curve shifts left and Y falls
The evidence on output and nominal interest rates
bull Note that other than the money hypothesis all the other hypothesesmdashthe spending hypothesis the debt-deflation hypothesis and the deflationary expectations hypothesismdashpredict falling real GDP and falling nominal interest rates
bull This is exactly what happened in the early stages of the Great Depression
bull The spending hypothesis and the debt-deflation hypothesis both predict falling real interest rates whereas the deflationary expectations hypothesis predicts rising real interest rates
bull Therefore evidence on real interest rates is crucial in identifying suitable explanations for the Great Depression
Why another Depression is unlikelybull Policymakers (or their advisors) now know much more
about macroeconomicsndash The Fed knows better than to let M fall so much
especially during a contractionndash Fiscal policymakers know better than to raise
taxes or cut spending during a contractionbull Federal deposit insurance makes widespread bank
failures very unlikely
bull Automatic stabilizers make fiscal policy expansionary during an economic downturn
THE FINANCIAL CRISIS AND ECONOMIC DOWNTURN OF 2008 AND 2009
CASE STUDYThe 2008-09 Financial Crisis amp Recession
bull 2009 Real GDP fell unemployment rate approached 10
bull Important factors in the crisisndash early 2000s Federal Reserve interest rate policy ndash sub-prime mortgage crisisndash bursting of house price bubble rising foreclosure
ratesndash falling stock pricesndash failing financial institutionsndash declining consumer confidence drop in spending on
consumer durables and investment goods
A Too-Brief and Too-Simple Explanation
bull The price of housing had risen to unsustainable levels
bull When home prices inevitably crashed people suddenly felt poor and cut back their spending plans
bull This fall in planned expenditure brought about the Great Recession of 2008-09
The Housing Bubble Inflates then Deflates
bull The SampP Case-Shiller 20-City Home Price Index went from ndash 100 in Jan 2000 tondash 20654 in April 2006 tondash 14095 in May 2009 tondash 14216 in Dec 2010
bull Why did the housing bubble inflate
The Housing Bubble Reasons
bull The Fed kept the interest rates too low for too long
bull Securitization technology got a lot fancier in the mortgage bond market
bull The government regulators were sleepingbull Pretty much everybody believed that home
prices could never fall
The Housing Bubble Low FFR
bull The Fed had reduced the Federal Funds Rate to fight the Recession of 2001
bull After that recession ended the Fed continued to keep interest rates low until 2004ndash The Fed was watching inflation which remained
tame Consequently the Fed saw little reason to raise interest rates
ndash The Fed did not believe that housing prices had formed a bubble hellip until it was blindingly obvious
The Housing Bubble Securitization
bull In the past people with money did not like to lend money to home buyers because such loans were risky and had unreliable returns
bull 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
bull The financial sector was regulated by people who were ideologically opposed to regulation
bull They turned a blind eye to even the worst lending practices
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
Interaction between monetary and fiscal policy
bull IS-LM Model Monetary and fiscal policy variables (M G and T ) are exogenous
bull Real world Monetary policymakers may adjust M in response to changes in fiscal policy or vice versa
bull Such responses by the central bank may affect the effectiveness of fiscal policy
The Fedrsquos response to G gt 0
bull Suppose the government increases Gbull Possible Fed responses
1 hold M constant2 hold r constant3 hold Y constant
bull In each case the effects of G on Yare differenthellip
When G increases the IS curve shifts right
IS1
Response 1 Hold M constant
Y
rLM
r1
Y1
IS2
Y2
r2
If Fed holds M constant then LM curve does not shift
As a result interest rates rise This has a crowding-out effect Consequently GDP increases but not a lot
If Congress raises G the IS curve shifts right
IS1
Response 2 Hold r constant
Y
rLM1
r1
Y1
IS2
Y2
r2
To keep r constant Fed increases M to shift LM curve right
3 1Y Y Y
0r
LM2
Y3
Results
IS1
Response 3 Hold Y constant
Y
rLM1
r1
IS2
Y2
r2
To keep Y constant Fed reduces M to shift LM curve left
0Y
3 1r r r
LM2
Results
Y1
r3
If Congress raises G the IS curve shifts right
At this point you should be able to do problem 7 on page 353 of the textbook Please try it
Estimates of fiscal policy multipliersfrom the DRI macroeconometric model
Assumption about monetary policy
Estimated value of Y G
Fed holds nominal interest rate constant
Fed holds money supply constant
193
060
Estimated value of Y T
119
026
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 amp services
Examples ndash stock market boom or crash
change in householdsrsquo wealth C
ndash change in business or consumer confidence or expectations I andor C
Shocks in the IS -LM model
LM shocks exogenous changes in the demand for money
Examplesndash a wave of credit card fraud increases demand
for moneyndash 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 of1 a boom in the stock market that makes consumers
wealthier2 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 rb determine what happens to C I and the
unemployment rate
CASE STUDY
THE US RECESSION OF 2001
The US Recession of 2001
bull 39 on 900bull 49 on 801bull 63 on 603bull 50 on 705
The US Recession of 2001
bull Growth of GDP was negative in the 1st and 3rd quarters of 2001
bull Thatrsquos essentially before 911
Recall IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
The US Recession of 2001bull Whybull Demand shocks moved the IS
curve leftndash The ldquotech bubblerdquo ended and
stocks fell 25 between 800 and 801
ndash 911 attacks led to a 12 fall in stock prices in one week and a huge rise in uncertainty
ndash Scandals at Enron WorldCom and other corporations led to stock price declines and a decline in trust and a rise in uncertainty
ndash Lower household wealth reduced Co and higher uncertainty reduced Io
IS
Y
rLM
r1
Y1
CASE STUDY
The US recession of 2001Causes 1) Stock market decline C
300
600
900
1200
1500
1995 1996 1997 1998 1999 2000 2001 2002 2003
Ind
ex
(19
42
= 1
00
) Standard amp Poorrsquos 500
The US Recession of 2001bull Fiscal stimulus moved IS curve
rightndash Major tax cuts were enacted in
2001 and 2003ndash Government spending was
boostedbull to rebuild NYC andbull to bail out the airline industry
bull Fed printed money and moved LM curve rightndash Interest rate on 3-month
Treasury bills fellbull 64 in 1100bull 33 in 801bull 09 in 703
IS1
Y
rLM1
r1
Y1
IS2
LM2
Y3
All three toolsmdashG T and Mmdashwere used
CASE STUDY
The US recession of 2001bull Monetary policy response shifted LM curve right
Three-month T-Bill Rate
Three-month T-Bill Rate
0
1
2
3
4
5
6
7
010
120
0004
02
2000
070
320
0010
03
2000
010
320
0104
05
2001
070
620
0110
06
2001
010
620
0204
08
2002
070
920
0210
09
2002
010
920
0304
11
2003
Skip
bull I am skipping section 11-2
THE GREAT DEPRESSION
The Great Depression
Unemployment (right scale)
Real GNP(left scale)
120
140
160
180
200
220
240
1929 1931 1933 1935 1937 1939
billi
ons
of 1
958
dolla
rs
0
5
10
15
20
25
30
perc
ent o
f lab
or fo
rce
THE SPENDING HYPOTHESIS
Shocks to the IS curvebull asserts that the
Depression was largely due to an exogenous fall in the demand for goods and services ndash a leftward shift of the IS curve
bull evidence output and interest rates both fell in early 1930s which is what a leftward IS shift would cause
IS
Y
rLM
r1
Y1
THE SPENDING HYPOTHESIS
Reasons for the IS shiftbull Stock market crash exogenous C
ndash Oct-Dec 1929 SampP 500 fell 17ndash Oct 1929-Dec 1933 SampP 500 fell 71
bull Drop in investmentndash ldquocorrectionrdquo after overbuilding in the 1920sndash widespread bank failures in early 1930s made it harder
to obtain financing for investmentbull Contractionary fiscal policy
ndash Politicians raised tax rates in 1932 and cut spending to combat increasing deficits
THE MONEY HYPOTHESIS
A shock to the LM curvebull asserts that the Depression was largely due to
huge fall in the money supplybull evidence M1 fell 25 during 1929-33 bull But two problems with this hypothesis
ndash P fell even more so MP actually rose slightly during 1929-31
ndash nominal interest rates fell which is the opposite of what a leftward LM shift would cause
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull asserts that the severity of the Depression
was due to a huge deflation ndash P fell 25 during 1929-33
bull This deflation was probably caused by the fall in M so perhaps money played an important role after all
bull In what ways does a deflation affect the economy
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The stabilizing effects of deflationbull P (MP ) LM shifts right Ybull Pigou effect
P (MP )
consumersrsquo wealth
C
IS shifts right
Y
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects
of expected deflation E
bull LM curve shifts leftr and I (r ) planned expenditure income and output
bull Also the nominal interest rate decreases (idarr) ndash see IS-LM predictions grid
IS
Y
rLM
r1
Y1
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects of unexpected deflation
debt-deflation theoryP (if unexpected)
transfers purchasing power from borrowers to lenders
borrowers spend less lenders spend more if borrowersrsquo propensity to spend is larger than
lendersrsquo then aggregate spending falls the IS curve shifts left and Y falls
The evidence on output and nominal interest rates
bull Note that other than the money hypothesis all the other hypothesesmdashthe spending hypothesis the debt-deflation hypothesis and the deflationary expectations hypothesismdashpredict falling real GDP and falling nominal interest rates
bull This is exactly what happened in the early stages of the Great Depression
bull The spending hypothesis and the debt-deflation hypothesis both predict falling real interest rates whereas the deflationary expectations hypothesis predicts rising real interest rates
bull Therefore evidence on real interest rates is crucial in identifying suitable explanations for the Great Depression
Why another Depression is unlikelybull Policymakers (or their advisors) now know much more
about macroeconomicsndash The Fed knows better than to let M fall so much
especially during a contractionndash Fiscal policymakers know better than to raise
taxes or cut spending during a contractionbull Federal deposit insurance makes widespread bank
failures very unlikely
bull Automatic stabilizers make fiscal policy expansionary during an economic downturn
THE FINANCIAL CRISIS AND ECONOMIC DOWNTURN OF 2008 AND 2009
CASE STUDYThe 2008-09 Financial Crisis amp Recession
bull 2009 Real GDP fell unemployment rate approached 10
bull Important factors in the crisisndash early 2000s Federal Reserve interest rate policy ndash sub-prime mortgage crisisndash bursting of house price bubble rising foreclosure
ratesndash falling stock pricesndash failing financial institutionsndash declining consumer confidence drop in spending on
consumer durables and investment goods
A Too-Brief and Too-Simple Explanation
bull The price of housing had risen to unsustainable levels
bull When home prices inevitably crashed people suddenly felt poor and cut back their spending plans
bull This fall in planned expenditure brought about the Great Recession of 2008-09
The Housing Bubble Inflates then Deflates
bull The SampP Case-Shiller 20-City Home Price Index went from ndash 100 in Jan 2000 tondash 20654 in April 2006 tondash 14095 in May 2009 tondash 14216 in Dec 2010
bull Why did the housing bubble inflate
The Housing Bubble Reasons
bull The Fed kept the interest rates too low for too long
bull Securitization technology got a lot fancier in the mortgage bond market
bull The government regulators were sleepingbull Pretty much everybody believed that home
prices could never fall
The Housing Bubble Low FFR
bull The Fed had reduced the Federal Funds Rate to fight the Recession of 2001
bull After that recession ended the Fed continued to keep interest rates low until 2004ndash The Fed was watching inflation which remained
tame Consequently the Fed saw little reason to raise interest rates
ndash The Fed did not believe that housing prices had formed a bubble hellip until it was blindingly obvious
The Housing Bubble Securitization
bull In the past people with money did not like to lend money to home buyers because such loans were risky and had unreliable returns
bull 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
bull The financial sector was regulated by people who were ideologically opposed to regulation
bull They turned a blind eye to even the worst lending practices
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
The Fedrsquos response to G gt 0
bull Suppose the government increases Gbull Possible Fed responses
1 hold M constant2 hold r constant3 hold Y constant
bull In each case the effects of G on Yare differenthellip
When G increases the IS curve shifts right
IS1
Response 1 Hold M constant
Y
rLM
r1
Y1
IS2
Y2
r2
If Fed holds M constant then LM curve does not shift
As a result interest rates rise This has a crowding-out effect Consequently GDP increases but not a lot
If Congress raises G the IS curve shifts right
IS1
Response 2 Hold r constant
Y
rLM1
r1
Y1
IS2
Y2
r2
To keep r constant Fed increases M to shift LM curve right
3 1Y Y Y
0r
LM2
Y3
Results
IS1
Response 3 Hold Y constant
Y
rLM1
r1
IS2
Y2
r2
To keep Y constant Fed reduces M to shift LM curve left
0Y
3 1r r r
LM2
Results
Y1
r3
If Congress raises G the IS curve shifts right
At this point you should be able to do problem 7 on page 353 of the textbook Please try it
Estimates of fiscal policy multipliersfrom the DRI macroeconometric model
Assumption about monetary policy
Estimated value of Y G
Fed holds nominal interest rate constant
Fed holds money supply constant
193
060
Estimated value of Y T
119
026
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 amp services
Examples ndash stock market boom or crash
change in householdsrsquo wealth C
ndash change in business or consumer confidence or expectations I andor C
Shocks in the IS -LM model
LM shocks exogenous changes in the demand for money
Examplesndash a wave of credit card fraud increases demand
for moneyndash 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 of1 a boom in the stock market that makes consumers
wealthier2 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 rb determine what happens to C I and the
unemployment rate
CASE STUDY
THE US RECESSION OF 2001
The US Recession of 2001
bull 39 on 900bull 49 on 801bull 63 on 603bull 50 on 705
The US Recession of 2001
bull Growth of GDP was negative in the 1st and 3rd quarters of 2001
bull Thatrsquos essentially before 911
Recall IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
The US Recession of 2001bull Whybull Demand shocks moved the IS
curve leftndash The ldquotech bubblerdquo ended and
stocks fell 25 between 800 and 801
ndash 911 attacks led to a 12 fall in stock prices in one week and a huge rise in uncertainty
ndash Scandals at Enron WorldCom and other corporations led to stock price declines and a decline in trust and a rise in uncertainty
ndash Lower household wealth reduced Co and higher uncertainty reduced Io
IS
Y
rLM
r1
Y1
CASE STUDY
The US recession of 2001Causes 1) Stock market decline C
300
600
900
1200
1500
1995 1996 1997 1998 1999 2000 2001 2002 2003
Ind
ex
(19
42
= 1
00
) Standard amp Poorrsquos 500
The US Recession of 2001bull Fiscal stimulus moved IS curve
rightndash Major tax cuts were enacted in
2001 and 2003ndash Government spending was
boostedbull to rebuild NYC andbull to bail out the airline industry
bull Fed printed money and moved LM curve rightndash Interest rate on 3-month
Treasury bills fellbull 64 in 1100bull 33 in 801bull 09 in 703
IS1
Y
rLM1
r1
Y1
IS2
LM2
Y3
All three toolsmdashG T and Mmdashwere used
CASE STUDY
The US recession of 2001bull Monetary policy response shifted LM curve right
Three-month T-Bill Rate
Three-month T-Bill Rate
0
1
2
3
4
5
6
7
010
120
0004
02
2000
070
320
0010
03
2000
010
320
0104
05
2001
070
620
0110
06
2001
010
620
0204
08
2002
070
920
0210
09
2002
010
920
0304
11
2003
Skip
bull I am skipping section 11-2
THE GREAT DEPRESSION
The Great Depression
Unemployment (right scale)
Real GNP(left scale)
120
140
160
180
200
220
240
1929 1931 1933 1935 1937 1939
billi
ons
of 1
958
dolla
rs
0
5
10
15
20
25
30
perc
ent o
f lab
or fo
rce
THE SPENDING HYPOTHESIS
Shocks to the IS curvebull asserts that the
Depression was largely due to an exogenous fall in the demand for goods and services ndash a leftward shift of the IS curve
bull evidence output and interest rates both fell in early 1930s which is what a leftward IS shift would cause
IS
Y
rLM
r1
Y1
THE SPENDING HYPOTHESIS
Reasons for the IS shiftbull Stock market crash exogenous C
ndash Oct-Dec 1929 SampP 500 fell 17ndash Oct 1929-Dec 1933 SampP 500 fell 71
bull Drop in investmentndash ldquocorrectionrdquo after overbuilding in the 1920sndash widespread bank failures in early 1930s made it harder
to obtain financing for investmentbull Contractionary fiscal policy
ndash Politicians raised tax rates in 1932 and cut spending to combat increasing deficits
THE MONEY HYPOTHESIS
A shock to the LM curvebull asserts that the Depression was largely due to
huge fall in the money supplybull evidence M1 fell 25 during 1929-33 bull But two problems with this hypothesis
ndash P fell even more so MP actually rose slightly during 1929-31
ndash nominal interest rates fell which is the opposite of what a leftward LM shift would cause
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull asserts that the severity of the Depression
was due to a huge deflation ndash P fell 25 during 1929-33
bull This deflation was probably caused by the fall in M so perhaps money played an important role after all
bull In what ways does a deflation affect the economy
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The stabilizing effects of deflationbull P (MP ) LM shifts right Ybull Pigou effect
P (MP )
consumersrsquo wealth
C
IS shifts right
Y
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects
of expected deflation E
bull LM curve shifts leftr and I (r ) planned expenditure income and output
bull Also the nominal interest rate decreases (idarr) ndash see IS-LM predictions grid
IS
Y
rLM
r1
Y1
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects of unexpected deflation
debt-deflation theoryP (if unexpected)
transfers purchasing power from borrowers to lenders
borrowers spend less lenders spend more if borrowersrsquo propensity to spend is larger than
lendersrsquo then aggregate spending falls the IS curve shifts left and Y falls
The evidence on output and nominal interest rates
bull Note that other than the money hypothesis all the other hypothesesmdashthe spending hypothesis the debt-deflation hypothesis and the deflationary expectations hypothesismdashpredict falling real GDP and falling nominal interest rates
bull This is exactly what happened in the early stages of the Great Depression
bull The spending hypothesis and the debt-deflation hypothesis both predict falling real interest rates whereas the deflationary expectations hypothesis predicts rising real interest rates
bull Therefore evidence on real interest rates is crucial in identifying suitable explanations for the Great Depression
Why another Depression is unlikelybull Policymakers (or their advisors) now know much more
about macroeconomicsndash The Fed knows better than to let M fall so much
especially during a contractionndash Fiscal policymakers know better than to raise
taxes or cut spending during a contractionbull Federal deposit insurance makes widespread bank
failures very unlikely
bull Automatic stabilizers make fiscal policy expansionary during an economic downturn
THE FINANCIAL CRISIS AND ECONOMIC DOWNTURN OF 2008 AND 2009
CASE STUDYThe 2008-09 Financial Crisis amp Recession
bull 2009 Real GDP fell unemployment rate approached 10
bull Important factors in the crisisndash early 2000s Federal Reserve interest rate policy ndash sub-prime mortgage crisisndash bursting of house price bubble rising foreclosure
ratesndash falling stock pricesndash failing financial institutionsndash declining consumer confidence drop in spending on
consumer durables and investment goods
A Too-Brief and Too-Simple Explanation
bull The price of housing had risen to unsustainable levels
bull When home prices inevitably crashed people suddenly felt poor and cut back their spending plans
bull This fall in planned expenditure brought about the Great Recession of 2008-09
The Housing Bubble Inflates then Deflates
bull The SampP Case-Shiller 20-City Home Price Index went from ndash 100 in Jan 2000 tondash 20654 in April 2006 tondash 14095 in May 2009 tondash 14216 in Dec 2010
bull Why did the housing bubble inflate
The Housing Bubble Reasons
bull The Fed kept the interest rates too low for too long
bull Securitization technology got a lot fancier in the mortgage bond market
bull The government regulators were sleepingbull Pretty much everybody believed that home
prices could never fall
The Housing Bubble Low FFR
bull The Fed had reduced the Federal Funds Rate to fight the Recession of 2001
bull After that recession ended the Fed continued to keep interest rates low until 2004ndash The Fed was watching inflation which remained
tame Consequently the Fed saw little reason to raise interest rates
ndash The Fed did not believe that housing prices had formed a bubble hellip until it was blindingly obvious
The Housing Bubble Securitization
bull In the past people with money did not like to lend money to home buyers because such loans were risky and had unreliable returns
bull 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
bull The financial sector was regulated by people who were ideologically opposed to regulation
bull They turned a blind eye to even the worst lending practices
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
When G increases the IS curve shifts right
IS1
Response 1 Hold M constant
Y
rLM
r1
Y1
IS2
Y2
r2
If Fed holds M constant then LM curve does not shift
As a result interest rates rise This has a crowding-out effect Consequently GDP increases but not a lot
If Congress raises G the IS curve shifts right
IS1
Response 2 Hold r constant
Y
rLM1
r1
Y1
IS2
Y2
r2
To keep r constant Fed increases M to shift LM curve right
3 1Y Y Y
0r
LM2
Y3
Results
IS1
Response 3 Hold Y constant
Y
rLM1
r1
IS2
Y2
r2
To keep Y constant Fed reduces M to shift LM curve left
0Y
3 1r r r
LM2
Results
Y1
r3
If Congress raises G the IS curve shifts right
At this point you should be able to do problem 7 on page 353 of the textbook Please try it
Estimates of fiscal policy multipliersfrom the DRI macroeconometric model
Assumption about monetary policy
Estimated value of Y G
Fed holds nominal interest rate constant
Fed holds money supply constant
193
060
Estimated value of Y T
119
026
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 amp services
Examples ndash stock market boom or crash
change in householdsrsquo wealth C
ndash change in business or consumer confidence or expectations I andor C
Shocks in the IS -LM model
LM shocks exogenous changes in the demand for money
Examplesndash a wave of credit card fraud increases demand
for moneyndash 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 of1 a boom in the stock market that makes consumers
wealthier2 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 rb determine what happens to C I and the
unemployment rate
CASE STUDY
THE US RECESSION OF 2001
The US Recession of 2001
bull 39 on 900bull 49 on 801bull 63 on 603bull 50 on 705
The US Recession of 2001
bull Growth of GDP was negative in the 1st and 3rd quarters of 2001
bull Thatrsquos essentially before 911
Recall IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
The US Recession of 2001bull Whybull Demand shocks moved the IS
curve leftndash The ldquotech bubblerdquo ended and
stocks fell 25 between 800 and 801
ndash 911 attacks led to a 12 fall in stock prices in one week and a huge rise in uncertainty
ndash Scandals at Enron WorldCom and other corporations led to stock price declines and a decline in trust and a rise in uncertainty
ndash Lower household wealth reduced Co and higher uncertainty reduced Io
IS
Y
rLM
r1
Y1
CASE STUDY
The US recession of 2001Causes 1) Stock market decline C
300
600
900
1200
1500
1995 1996 1997 1998 1999 2000 2001 2002 2003
Ind
ex
(19
42
= 1
00
) Standard amp Poorrsquos 500
The US Recession of 2001bull Fiscal stimulus moved IS curve
rightndash Major tax cuts were enacted in
2001 and 2003ndash Government spending was
boostedbull to rebuild NYC andbull to bail out the airline industry
bull Fed printed money and moved LM curve rightndash Interest rate on 3-month
Treasury bills fellbull 64 in 1100bull 33 in 801bull 09 in 703
IS1
Y
rLM1
r1
Y1
IS2
LM2
Y3
All three toolsmdashG T and Mmdashwere used
CASE STUDY
The US recession of 2001bull Monetary policy response shifted LM curve right
Three-month T-Bill Rate
Three-month T-Bill Rate
0
1
2
3
4
5
6
7
010
120
0004
02
2000
070
320
0010
03
2000
010
320
0104
05
2001
070
620
0110
06
2001
010
620
0204
08
2002
070
920
0210
09
2002
010
920
0304
11
2003
Skip
bull I am skipping section 11-2
THE GREAT DEPRESSION
The Great Depression
Unemployment (right scale)
Real GNP(left scale)
120
140
160
180
200
220
240
1929 1931 1933 1935 1937 1939
billi
ons
of 1
958
dolla
rs
0
5
10
15
20
25
30
perc
ent o
f lab
or fo
rce
THE SPENDING HYPOTHESIS
Shocks to the IS curvebull asserts that the
Depression was largely due to an exogenous fall in the demand for goods and services ndash a leftward shift of the IS curve
bull evidence output and interest rates both fell in early 1930s which is what a leftward IS shift would cause
IS
Y
rLM
r1
Y1
THE SPENDING HYPOTHESIS
Reasons for the IS shiftbull Stock market crash exogenous C
ndash Oct-Dec 1929 SampP 500 fell 17ndash Oct 1929-Dec 1933 SampP 500 fell 71
bull Drop in investmentndash ldquocorrectionrdquo after overbuilding in the 1920sndash widespread bank failures in early 1930s made it harder
to obtain financing for investmentbull Contractionary fiscal policy
ndash Politicians raised tax rates in 1932 and cut spending to combat increasing deficits
THE MONEY HYPOTHESIS
A shock to the LM curvebull asserts that the Depression was largely due to
huge fall in the money supplybull evidence M1 fell 25 during 1929-33 bull But two problems with this hypothesis
ndash P fell even more so MP actually rose slightly during 1929-31
ndash nominal interest rates fell which is the opposite of what a leftward LM shift would cause
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull asserts that the severity of the Depression
was due to a huge deflation ndash P fell 25 during 1929-33
bull This deflation was probably caused by the fall in M so perhaps money played an important role after all
bull In what ways does a deflation affect the economy
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The stabilizing effects of deflationbull P (MP ) LM shifts right Ybull Pigou effect
P (MP )
consumersrsquo wealth
C
IS shifts right
Y
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects
of expected deflation E
bull LM curve shifts leftr and I (r ) planned expenditure income and output
bull Also the nominal interest rate decreases (idarr) ndash see IS-LM predictions grid
IS
Y
rLM
r1
Y1
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects of unexpected deflation
debt-deflation theoryP (if unexpected)
transfers purchasing power from borrowers to lenders
borrowers spend less lenders spend more if borrowersrsquo propensity to spend is larger than
lendersrsquo then aggregate spending falls the IS curve shifts left and Y falls
The evidence on output and nominal interest rates
bull Note that other than the money hypothesis all the other hypothesesmdashthe spending hypothesis the debt-deflation hypothesis and the deflationary expectations hypothesismdashpredict falling real GDP and falling nominal interest rates
bull This is exactly what happened in the early stages of the Great Depression
bull The spending hypothesis and the debt-deflation hypothesis both predict falling real interest rates whereas the deflationary expectations hypothesis predicts rising real interest rates
bull Therefore evidence on real interest rates is crucial in identifying suitable explanations for the Great Depression
Why another Depression is unlikelybull Policymakers (or their advisors) now know much more
about macroeconomicsndash The Fed knows better than to let M fall so much
especially during a contractionndash Fiscal policymakers know better than to raise
taxes or cut spending during a contractionbull Federal deposit insurance makes widespread bank
failures very unlikely
bull Automatic stabilizers make fiscal policy expansionary during an economic downturn
THE FINANCIAL CRISIS AND ECONOMIC DOWNTURN OF 2008 AND 2009
CASE STUDYThe 2008-09 Financial Crisis amp Recession
bull 2009 Real GDP fell unemployment rate approached 10
bull Important factors in the crisisndash early 2000s Federal Reserve interest rate policy ndash sub-prime mortgage crisisndash bursting of house price bubble rising foreclosure
ratesndash falling stock pricesndash failing financial institutionsndash declining consumer confidence drop in spending on
consumer durables and investment goods
A Too-Brief and Too-Simple Explanation
bull The price of housing had risen to unsustainable levels
bull When home prices inevitably crashed people suddenly felt poor and cut back their spending plans
bull This fall in planned expenditure brought about the Great Recession of 2008-09
The Housing Bubble Inflates then Deflates
bull The SampP Case-Shiller 20-City Home Price Index went from ndash 100 in Jan 2000 tondash 20654 in April 2006 tondash 14095 in May 2009 tondash 14216 in Dec 2010
bull Why did the housing bubble inflate
The Housing Bubble Reasons
bull The Fed kept the interest rates too low for too long
bull Securitization technology got a lot fancier in the mortgage bond market
bull The government regulators were sleepingbull Pretty much everybody believed that home
prices could never fall
The Housing Bubble Low FFR
bull The Fed had reduced the Federal Funds Rate to fight the Recession of 2001
bull After that recession ended the Fed continued to keep interest rates low until 2004ndash The Fed was watching inflation which remained
tame Consequently the Fed saw little reason to raise interest rates
ndash The Fed did not believe that housing prices had formed a bubble hellip until it was blindingly obvious
The Housing Bubble Securitization
bull In the past people with money did not like to lend money to home buyers because such loans were risky and had unreliable returns
bull 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
bull The financial sector was regulated by people who were ideologically opposed to regulation
bull They turned a blind eye to even the worst lending practices
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
If Congress raises G the IS curve shifts right
IS1
Response 2 Hold r constant
Y
rLM1
r1
Y1
IS2
Y2
r2
To keep r constant Fed increases M to shift LM curve right
3 1Y Y Y
0r
LM2
Y3
Results
IS1
Response 3 Hold Y constant
Y
rLM1
r1
IS2
Y2
r2
To keep Y constant Fed reduces M to shift LM curve left
0Y
3 1r r r
LM2
Results
Y1
r3
If Congress raises G the IS curve shifts right
At this point you should be able to do problem 7 on page 353 of the textbook Please try it
Estimates of fiscal policy multipliersfrom the DRI macroeconometric model
Assumption about monetary policy
Estimated value of Y G
Fed holds nominal interest rate constant
Fed holds money supply constant
193
060
Estimated value of Y T
119
026
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 amp services
Examples ndash stock market boom or crash
change in householdsrsquo wealth C
ndash change in business or consumer confidence or expectations I andor C
Shocks in the IS -LM model
LM shocks exogenous changes in the demand for money
Examplesndash a wave of credit card fraud increases demand
for moneyndash 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 of1 a boom in the stock market that makes consumers
wealthier2 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 rb determine what happens to C I and the
unemployment rate
CASE STUDY
THE US RECESSION OF 2001
The US Recession of 2001
bull 39 on 900bull 49 on 801bull 63 on 603bull 50 on 705
The US Recession of 2001
bull Growth of GDP was negative in the 1st and 3rd quarters of 2001
bull Thatrsquos essentially before 911
Recall IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
The US Recession of 2001bull Whybull Demand shocks moved the IS
curve leftndash The ldquotech bubblerdquo ended and
stocks fell 25 between 800 and 801
ndash 911 attacks led to a 12 fall in stock prices in one week and a huge rise in uncertainty
ndash Scandals at Enron WorldCom and other corporations led to stock price declines and a decline in trust and a rise in uncertainty
ndash Lower household wealth reduced Co and higher uncertainty reduced Io
IS
Y
rLM
r1
Y1
CASE STUDY
The US recession of 2001Causes 1) Stock market decline C
300
600
900
1200
1500
1995 1996 1997 1998 1999 2000 2001 2002 2003
Ind
ex
(19
42
= 1
00
) Standard amp Poorrsquos 500
The US Recession of 2001bull Fiscal stimulus moved IS curve
rightndash Major tax cuts were enacted in
2001 and 2003ndash Government spending was
boostedbull to rebuild NYC andbull to bail out the airline industry
bull Fed printed money and moved LM curve rightndash Interest rate on 3-month
Treasury bills fellbull 64 in 1100bull 33 in 801bull 09 in 703
IS1
Y
rLM1
r1
Y1
IS2
LM2
Y3
All three toolsmdashG T and Mmdashwere used
CASE STUDY
The US recession of 2001bull Monetary policy response shifted LM curve right
Three-month T-Bill Rate
Three-month T-Bill Rate
0
1
2
3
4
5
6
7
010
120
0004
02
2000
070
320
0010
03
2000
010
320
0104
05
2001
070
620
0110
06
2001
010
620
0204
08
2002
070
920
0210
09
2002
010
920
0304
11
2003
Skip
bull I am skipping section 11-2
THE GREAT DEPRESSION
The Great Depression
Unemployment (right scale)
Real GNP(left scale)
120
140
160
180
200
220
240
1929 1931 1933 1935 1937 1939
billi
ons
of 1
958
dolla
rs
0
5
10
15
20
25
30
perc
ent o
f lab
or fo
rce
THE SPENDING HYPOTHESIS
Shocks to the IS curvebull asserts that the
Depression was largely due to an exogenous fall in the demand for goods and services ndash a leftward shift of the IS curve
bull evidence output and interest rates both fell in early 1930s which is what a leftward IS shift would cause
IS
Y
rLM
r1
Y1
THE SPENDING HYPOTHESIS
Reasons for the IS shiftbull Stock market crash exogenous C
ndash Oct-Dec 1929 SampP 500 fell 17ndash Oct 1929-Dec 1933 SampP 500 fell 71
bull Drop in investmentndash ldquocorrectionrdquo after overbuilding in the 1920sndash widespread bank failures in early 1930s made it harder
to obtain financing for investmentbull Contractionary fiscal policy
ndash Politicians raised tax rates in 1932 and cut spending to combat increasing deficits
THE MONEY HYPOTHESIS
A shock to the LM curvebull asserts that the Depression was largely due to
huge fall in the money supplybull evidence M1 fell 25 during 1929-33 bull But two problems with this hypothesis
ndash P fell even more so MP actually rose slightly during 1929-31
ndash nominal interest rates fell which is the opposite of what a leftward LM shift would cause
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull asserts that the severity of the Depression
was due to a huge deflation ndash P fell 25 during 1929-33
bull This deflation was probably caused by the fall in M so perhaps money played an important role after all
bull In what ways does a deflation affect the economy
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The stabilizing effects of deflationbull P (MP ) LM shifts right Ybull Pigou effect
P (MP )
consumersrsquo wealth
C
IS shifts right
Y
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects
of expected deflation E
bull LM curve shifts leftr and I (r ) planned expenditure income and output
bull Also the nominal interest rate decreases (idarr) ndash see IS-LM predictions grid
IS
Y
rLM
r1
Y1
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects of unexpected deflation
debt-deflation theoryP (if unexpected)
transfers purchasing power from borrowers to lenders
borrowers spend less lenders spend more if borrowersrsquo propensity to spend is larger than
lendersrsquo then aggregate spending falls the IS curve shifts left and Y falls
The evidence on output and nominal interest rates
bull Note that other than the money hypothesis all the other hypothesesmdashthe spending hypothesis the debt-deflation hypothesis and the deflationary expectations hypothesismdashpredict falling real GDP and falling nominal interest rates
bull This is exactly what happened in the early stages of the Great Depression
bull The spending hypothesis and the debt-deflation hypothesis both predict falling real interest rates whereas the deflationary expectations hypothesis predicts rising real interest rates
bull Therefore evidence on real interest rates is crucial in identifying suitable explanations for the Great Depression
Why another Depression is unlikelybull Policymakers (or their advisors) now know much more
about macroeconomicsndash The Fed knows better than to let M fall so much
especially during a contractionndash Fiscal policymakers know better than to raise
taxes or cut spending during a contractionbull Federal deposit insurance makes widespread bank
failures very unlikely
bull Automatic stabilizers make fiscal policy expansionary during an economic downturn
THE FINANCIAL CRISIS AND ECONOMIC DOWNTURN OF 2008 AND 2009
CASE STUDYThe 2008-09 Financial Crisis amp Recession
bull 2009 Real GDP fell unemployment rate approached 10
bull Important factors in the crisisndash early 2000s Federal Reserve interest rate policy ndash sub-prime mortgage crisisndash bursting of house price bubble rising foreclosure
ratesndash falling stock pricesndash failing financial institutionsndash declining consumer confidence drop in spending on
consumer durables and investment goods
A Too-Brief and Too-Simple Explanation
bull The price of housing had risen to unsustainable levels
bull When home prices inevitably crashed people suddenly felt poor and cut back their spending plans
bull This fall in planned expenditure brought about the Great Recession of 2008-09
The Housing Bubble Inflates then Deflates
bull The SampP Case-Shiller 20-City Home Price Index went from ndash 100 in Jan 2000 tondash 20654 in April 2006 tondash 14095 in May 2009 tondash 14216 in Dec 2010
bull Why did the housing bubble inflate
The Housing Bubble Reasons
bull The Fed kept the interest rates too low for too long
bull Securitization technology got a lot fancier in the mortgage bond market
bull The government regulators were sleepingbull Pretty much everybody believed that home
prices could never fall
The Housing Bubble Low FFR
bull The Fed had reduced the Federal Funds Rate to fight the Recession of 2001
bull After that recession ended the Fed continued to keep interest rates low until 2004ndash The Fed was watching inflation which remained
tame Consequently the Fed saw little reason to raise interest rates
ndash The Fed did not believe that housing prices had formed a bubble hellip until it was blindingly obvious
The Housing Bubble Securitization
bull In the past people with money did not like to lend money to home buyers because such loans were risky and had unreliable returns
bull 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
bull The financial sector was regulated by people who were ideologically opposed to regulation
bull They turned a blind eye to even the worst lending practices
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
IS1
Response 3 Hold Y constant
Y
rLM1
r1
IS2
Y2
r2
To keep Y constant Fed reduces M to shift LM curve left
0Y
3 1r r r
LM2
Results
Y1
r3
If Congress raises G the IS curve shifts right
At this point you should be able to do problem 7 on page 353 of the textbook Please try it
Estimates of fiscal policy multipliersfrom the DRI macroeconometric model
Assumption about monetary policy
Estimated value of Y G
Fed holds nominal interest rate constant
Fed holds money supply constant
193
060
Estimated value of Y T
119
026
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 amp services
Examples ndash stock market boom or crash
change in householdsrsquo wealth C
ndash change in business or consumer confidence or expectations I andor C
Shocks in the IS -LM model
LM shocks exogenous changes in the demand for money
Examplesndash a wave of credit card fraud increases demand
for moneyndash 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 of1 a boom in the stock market that makes consumers
wealthier2 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 rb determine what happens to C I and the
unemployment rate
CASE STUDY
THE US RECESSION OF 2001
The US Recession of 2001
bull 39 on 900bull 49 on 801bull 63 on 603bull 50 on 705
The US Recession of 2001
bull Growth of GDP was negative in the 1st and 3rd quarters of 2001
bull Thatrsquos essentially before 911
Recall IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
The US Recession of 2001bull Whybull Demand shocks moved the IS
curve leftndash The ldquotech bubblerdquo ended and
stocks fell 25 between 800 and 801
ndash 911 attacks led to a 12 fall in stock prices in one week and a huge rise in uncertainty
ndash Scandals at Enron WorldCom and other corporations led to stock price declines and a decline in trust and a rise in uncertainty
ndash Lower household wealth reduced Co and higher uncertainty reduced Io
IS
Y
rLM
r1
Y1
CASE STUDY
The US recession of 2001Causes 1) Stock market decline C
300
600
900
1200
1500
1995 1996 1997 1998 1999 2000 2001 2002 2003
Ind
ex
(19
42
= 1
00
) Standard amp Poorrsquos 500
The US Recession of 2001bull Fiscal stimulus moved IS curve
rightndash Major tax cuts were enacted in
2001 and 2003ndash Government spending was
boostedbull to rebuild NYC andbull to bail out the airline industry
bull Fed printed money and moved LM curve rightndash Interest rate on 3-month
Treasury bills fellbull 64 in 1100bull 33 in 801bull 09 in 703
IS1
Y
rLM1
r1
Y1
IS2
LM2
Y3
All three toolsmdashG T and Mmdashwere used
CASE STUDY
The US recession of 2001bull Monetary policy response shifted LM curve right
Three-month T-Bill Rate
Three-month T-Bill Rate
0
1
2
3
4
5
6
7
010
120
0004
02
2000
070
320
0010
03
2000
010
320
0104
05
2001
070
620
0110
06
2001
010
620
0204
08
2002
070
920
0210
09
2002
010
920
0304
11
2003
Skip
bull I am skipping section 11-2
THE GREAT DEPRESSION
The Great Depression
Unemployment (right scale)
Real GNP(left scale)
120
140
160
180
200
220
240
1929 1931 1933 1935 1937 1939
billi
ons
of 1
958
dolla
rs
0
5
10
15
20
25
30
perc
ent o
f lab
or fo
rce
THE SPENDING HYPOTHESIS
Shocks to the IS curvebull asserts that the
Depression was largely due to an exogenous fall in the demand for goods and services ndash a leftward shift of the IS curve
bull evidence output and interest rates both fell in early 1930s which is what a leftward IS shift would cause
IS
Y
rLM
r1
Y1
THE SPENDING HYPOTHESIS
Reasons for the IS shiftbull Stock market crash exogenous C
ndash Oct-Dec 1929 SampP 500 fell 17ndash Oct 1929-Dec 1933 SampP 500 fell 71
bull Drop in investmentndash ldquocorrectionrdquo after overbuilding in the 1920sndash widespread bank failures in early 1930s made it harder
to obtain financing for investmentbull Contractionary fiscal policy
ndash Politicians raised tax rates in 1932 and cut spending to combat increasing deficits
THE MONEY HYPOTHESIS
A shock to the LM curvebull asserts that the Depression was largely due to
huge fall in the money supplybull evidence M1 fell 25 during 1929-33 bull But two problems with this hypothesis
ndash P fell even more so MP actually rose slightly during 1929-31
ndash nominal interest rates fell which is the opposite of what a leftward LM shift would cause
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull asserts that the severity of the Depression
was due to a huge deflation ndash P fell 25 during 1929-33
bull This deflation was probably caused by the fall in M so perhaps money played an important role after all
bull In what ways does a deflation affect the economy
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The stabilizing effects of deflationbull P (MP ) LM shifts right Ybull Pigou effect
P (MP )
consumersrsquo wealth
C
IS shifts right
Y
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects
of expected deflation E
bull LM curve shifts leftr and I (r ) planned expenditure income and output
bull Also the nominal interest rate decreases (idarr) ndash see IS-LM predictions grid
IS
Y
rLM
r1
Y1
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects of unexpected deflation
debt-deflation theoryP (if unexpected)
transfers purchasing power from borrowers to lenders
borrowers spend less lenders spend more if borrowersrsquo propensity to spend is larger than
lendersrsquo then aggregate spending falls the IS curve shifts left and Y falls
The evidence on output and nominal interest rates
bull Note that other than the money hypothesis all the other hypothesesmdashthe spending hypothesis the debt-deflation hypothesis and the deflationary expectations hypothesismdashpredict falling real GDP and falling nominal interest rates
bull This is exactly what happened in the early stages of the Great Depression
bull The spending hypothesis and the debt-deflation hypothesis both predict falling real interest rates whereas the deflationary expectations hypothesis predicts rising real interest rates
bull Therefore evidence on real interest rates is crucial in identifying suitable explanations for the Great Depression
Why another Depression is unlikelybull Policymakers (or their advisors) now know much more
about macroeconomicsndash The Fed knows better than to let M fall so much
especially during a contractionndash Fiscal policymakers know better than to raise
taxes or cut spending during a contractionbull Federal deposit insurance makes widespread bank
failures very unlikely
bull Automatic stabilizers make fiscal policy expansionary during an economic downturn
THE FINANCIAL CRISIS AND ECONOMIC DOWNTURN OF 2008 AND 2009
CASE STUDYThe 2008-09 Financial Crisis amp Recession
bull 2009 Real GDP fell unemployment rate approached 10
bull Important factors in the crisisndash early 2000s Federal Reserve interest rate policy ndash sub-prime mortgage crisisndash bursting of house price bubble rising foreclosure
ratesndash falling stock pricesndash failing financial institutionsndash declining consumer confidence drop in spending on
consumer durables and investment goods
A Too-Brief and Too-Simple Explanation
bull The price of housing had risen to unsustainable levels
bull When home prices inevitably crashed people suddenly felt poor and cut back their spending plans
bull This fall in planned expenditure brought about the Great Recession of 2008-09
The Housing Bubble Inflates then Deflates
bull The SampP Case-Shiller 20-City Home Price Index went from ndash 100 in Jan 2000 tondash 20654 in April 2006 tondash 14095 in May 2009 tondash 14216 in Dec 2010
bull Why did the housing bubble inflate
The Housing Bubble Reasons
bull The Fed kept the interest rates too low for too long
bull Securitization technology got a lot fancier in the mortgage bond market
bull The government regulators were sleepingbull Pretty much everybody believed that home
prices could never fall
The Housing Bubble Low FFR
bull The Fed had reduced the Federal Funds Rate to fight the Recession of 2001
bull After that recession ended the Fed continued to keep interest rates low until 2004ndash The Fed was watching inflation which remained
tame Consequently the Fed saw little reason to raise interest rates
ndash The Fed did not believe that housing prices had formed a bubble hellip until it was blindingly obvious
The Housing Bubble Securitization
bull In the past people with money did not like to lend money to home buyers because such loans were risky and had unreliable returns
bull 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
bull The financial sector was regulated by people who were ideologically opposed to regulation
bull They turned a blind eye to even the worst lending practices
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
Estimates of fiscal policy multipliersfrom the DRI macroeconometric model
Assumption about monetary policy
Estimated value of Y G
Fed holds nominal interest rate constant
Fed holds money supply constant
193
060
Estimated value of Y T
119
026
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 amp services
Examples ndash stock market boom or crash
change in householdsrsquo wealth C
ndash change in business or consumer confidence or expectations I andor C
Shocks in the IS -LM model
LM shocks exogenous changes in the demand for money
Examplesndash a wave of credit card fraud increases demand
for moneyndash 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 of1 a boom in the stock market that makes consumers
wealthier2 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 rb determine what happens to C I and the
unemployment rate
CASE STUDY
THE US RECESSION OF 2001
The US Recession of 2001
bull 39 on 900bull 49 on 801bull 63 on 603bull 50 on 705
The US Recession of 2001
bull Growth of GDP was negative in the 1st and 3rd quarters of 2001
bull Thatrsquos essentially before 911
Recall IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
The US Recession of 2001bull Whybull Demand shocks moved the IS
curve leftndash The ldquotech bubblerdquo ended and
stocks fell 25 between 800 and 801
ndash 911 attacks led to a 12 fall in stock prices in one week and a huge rise in uncertainty
ndash Scandals at Enron WorldCom and other corporations led to stock price declines and a decline in trust and a rise in uncertainty
ndash Lower household wealth reduced Co and higher uncertainty reduced Io
IS
Y
rLM
r1
Y1
CASE STUDY
The US recession of 2001Causes 1) Stock market decline C
300
600
900
1200
1500
1995 1996 1997 1998 1999 2000 2001 2002 2003
Ind
ex
(19
42
= 1
00
) Standard amp Poorrsquos 500
The US Recession of 2001bull Fiscal stimulus moved IS curve
rightndash Major tax cuts were enacted in
2001 and 2003ndash Government spending was
boostedbull to rebuild NYC andbull to bail out the airline industry
bull Fed printed money and moved LM curve rightndash Interest rate on 3-month
Treasury bills fellbull 64 in 1100bull 33 in 801bull 09 in 703
IS1
Y
rLM1
r1
Y1
IS2
LM2
Y3
All three toolsmdashG T and Mmdashwere used
CASE STUDY
The US recession of 2001bull Monetary policy response shifted LM curve right
Three-month T-Bill Rate
Three-month T-Bill Rate
0
1
2
3
4
5
6
7
010
120
0004
02
2000
070
320
0010
03
2000
010
320
0104
05
2001
070
620
0110
06
2001
010
620
0204
08
2002
070
920
0210
09
2002
010
920
0304
11
2003
Skip
bull I am skipping section 11-2
THE GREAT DEPRESSION
The Great Depression
Unemployment (right scale)
Real GNP(left scale)
120
140
160
180
200
220
240
1929 1931 1933 1935 1937 1939
billi
ons
of 1
958
dolla
rs
0
5
10
15
20
25
30
perc
ent o
f lab
or fo
rce
THE SPENDING HYPOTHESIS
Shocks to the IS curvebull asserts that the
Depression was largely due to an exogenous fall in the demand for goods and services ndash a leftward shift of the IS curve
bull evidence output and interest rates both fell in early 1930s which is what a leftward IS shift would cause
IS
Y
rLM
r1
Y1
THE SPENDING HYPOTHESIS
Reasons for the IS shiftbull Stock market crash exogenous C
ndash Oct-Dec 1929 SampP 500 fell 17ndash Oct 1929-Dec 1933 SampP 500 fell 71
bull Drop in investmentndash ldquocorrectionrdquo after overbuilding in the 1920sndash widespread bank failures in early 1930s made it harder
to obtain financing for investmentbull Contractionary fiscal policy
ndash Politicians raised tax rates in 1932 and cut spending to combat increasing deficits
THE MONEY HYPOTHESIS
A shock to the LM curvebull asserts that the Depression was largely due to
huge fall in the money supplybull evidence M1 fell 25 during 1929-33 bull But two problems with this hypothesis
ndash P fell even more so MP actually rose slightly during 1929-31
ndash nominal interest rates fell which is the opposite of what a leftward LM shift would cause
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull asserts that the severity of the Depression
was due to a huge deflation ndash P fell 25 during 1929-33
bull This deflation was probably caused by the fall in M so perhaps money played an important role after all
bull In what ways does a deflation affect the economy
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The stabilizing effects of deflationbull P (MP ) LM shifts right Ybull Pigou effect
P (MP )
consumersrsquo wealth
C
IS shifts right
Y
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects
of expected deflation E
bull LM curve shifts leftr and I (r ) planned expenditure income and output
bull Also the nominal interest rate decreases (idarr) ndash see IS-LM predictions grid
IS
Y
rLM
r1
Y1
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects of unexpected deflation
debt-deflation theoryP (if unexpected)
transfers purchasing power from borrowers to lenders
borrowers spend less lenders spend more if borrowersrsquo propensity to spend is larger than
lendersrsquo then aggregate spending falls the IS curve shifts left and Y falls
The evidence on output and nominal interest rates
bull Note that other than the money hypothesis all the other hypothesesmdashthe spending hypothesis the debt-deflation hypothesis and the deflationary expectations hypothesismdashpredict falling real GDP and falling nominal interest rates
bull This is exactly what happened in the early stages of the Great Depression
bull The spending hypothesis and the debt-deflation hypothesis both predict falling real interest rates whereas the deflationary expectations hypothesis predicts rising real interest rates
bull Therefore evidence on real interest rates is crucial in identifying suitable explanations for the Great Depression
Why another Depression is unlikelybull Policymakers (or their advisors) now know much more
about macroeconomicsndash The Fed knows better than to let M fall so much
especially during a contractionndash Fiscal policymakers know better than to raise
taxes or cut spending during a contractionbull Federal deposit insurance makes widespread bank
failures very unlikely
bull Automatic stabilizers make fiscal policy expansionary during an economic downturn
THE FINANCIAL CRISIS AND ECONOMIC DOWNTURN OF 2008 AND 2009
CASE STUDYThe 2008-09 Financial Crisis amp Recession
bull 2009 Real GDP fell unemployment rate approached 10
bull Important factors in the crisisndash early 2000s Federal Reserve interest rate policy ndash sub-prime mortgage crisisndash bursting of house price bubble rising foreclosure
ratesndash falling stock pricesndash failing financial institutionsndash declining consumer confidence drop in spending on
consumer durables and investment goods
A Too-Brief and Too-Simple Explanation
bull The price of housing had risen to unsustainable levels
bull When home prices inevitably crashed people suddenly felt poor and cut back their spending plans
bull This fall in planned expenditure brought about the Great Recession of 2008-09
The Housing Bubble Inflates then Deflates
bull The SampP Case-Shiller 20-City Home Price Index went from ndash 100 in Jan 2000 tondash 20654 in April 2006 tondash 14095 in May 2009 tondash 14216 in Dec 2010
bull Why did the housing bubble inflate
The Housing Bubble Reasons
bull The Fed kept the interest rates too low for too long
bull Securitization technology got a lot fancier in the mortgage bond market
bull The government regulators were sleepingbull Pretty much everybody believed that home
prices could never fall
The Housing Bubble Low FFR
bull The Fed had reduced the Federal Funds Rate to fight the Recession of 2001
bull After that recession ended the Fed continued to keep interest rates low until 2004ndash The Fed was watching inflation which remained
tame Consequently the Fed saw little reason to raise interest rates
ndash The Fed did not believe that housing prices had formed a bubble hellip until it was blindingly obvious
The Housing Bubble Securitization
bull In the past people with money did not like to lend money to home buyers because such loans were risky and had unreliable returns
bull 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
bull The financial sector was regulated by people who were ideologically opposed to regulation
bull They turned a blind eye to even the worst lending practices
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
Shocks in the IS -LM model
IS shocks exogenous changes in the demand for goods amp services
Examples ndash stock market boom or crash
change in householdsrsquo wealth C
ndash change in business or consumer confidence or expectations I andor C
Shocks in the IS -LM model
LM shocks exogenous changes in the demand for money
Examplesndash a wave of credit card fraud increases demand
for moneyndash 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 of1 a boom in the stock market that makes consumers
wealthier2 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 rb determine what happens to C I and the
unemployment rate
CASE STUDY
THE US RECESSION OF 2001
The US Recession of 2001
bull 39 on 900bull 49 on 801bull 63 on 603bull 50 on 705
The US Recession of 2001
bull Growth of GDP was negative in the 1st and 3rd quarters of 2001
bull Thatrsquos essentially before 911
Recall IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
The US Recession of 2001bull Whybull Demand shocks moved the IS
curve leftndash The ldquotech bubblerdquo ended and
stocks fell 25 between 800 and 801
ndash 911 attacks led to a 12 fall in stock prices in one week and a huge rise in uncertainty
ndash Scandals at Enron WorldCom and other corporations led to stock price declines and a decline in trust and a rise in uncertainty
ndash Lower household wealth reduced Co and higher uncertainty reduced Io
IS
Y
rLM
r1
Y1
CASE STUDY
The US recession of 2001Causes 1) Stock market decline C
300
600
900
1200
1500
1995 1996 1997 1998 1999 2000 2001 2002 2003
Ind
ex
(19
42
= 1
00
) Standard amp Poorrsquos 500
The US Recession of 2001bull Fiscal stimulus moved IS curve
rightndash Major tax cuts were enacted in
2001 and 2003ndash Government spending was
boostedbull to rebuild NYC andbull to bail out the airline industry
bull Fed printed money and moved LM curve rightndash Interest rate on 3-month
Treasury bills fellbull 64 in 1100bull 33 in 801bull 09 in 703
IS1
Y
rLM1
r1
Y1
IS2
LM2
Y3
All three toolsmdashG T and Mmdashwere used
CASE STUDY
The US recession of 2001bull Monetary policy response shifted LM curve right
Three-month T-Bill Rate
Three-month T-Bill Rate
0
1
2
3
4
5
6
7
010
120
0004
02
2000
070
320
0010
03
2000
010
320
0104
05
2001
070
620
0110
06
2001
010
620
0204
08
2002
070
920
0210
09
2002
010
920
0304
11
2003
Skip
bull I am skipping section 11-2
THE GREAT DEPRESSION
The Great Depression
Unemployment (right scale)
Real GNP(left scale)
120
140
160
180
200
220
240
1929 1931 1933 1935 1937 1939
billi
ons
of 1
958
dolla
rs
0
5
10
15
20
25
30
perc
ent o
f lab
or fo
rce
THE SPENDING HYPOTHESIS
Shocks to the IS curvebull asserts that the
Depression was largely due to an exogenous fall in the demand for goods and services ndash a leftward shift of the IS curve
bull evidence output and interest rates both fell in early 1930s which is what a leftward IS shift would cause
IS
Y
rLM
r1
Y1
THE SPENDING HYPOTHESIS
Reasons for the IS shiftbull Stock market crash exogenous C
ndash Oct-Dec 1929 SampP 500 fell 17ndash Oct 1929-Dec 1933 SampP 500 fell 71
bull Drop in investmentndash ldquocorrectionrdquo after overbuilding in the 1920sndash widespread bank failures in early 1930s made it harder
to obtain financing for investmentbull Contractionary fiscal policy
ndash Politicians raised tax rates in 1932 and cut spending to combat increasing deficits
THE MONEY HYPOTHESIS
A shock to the LM curvebull asserts that the Depression was largely due to
huge fall in the money supplybull evidence M1 fell 25 during 1929-33 bull But two problems with this hypothesis
ndash P fell even more so MP actually rose slightly during 1929-31
ndash nominal interest rates fell which is the opposite of what a leftward LM shift would cause
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull asserts that the severity of the Depression
was due to a huge deflation ndash P fell 25 during 1929-33
bull This deflation was probably caused by the fall in M so perhaps money played an important role after all
bull In what ways does a deflation affect the economy
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The stabilizing effects of deflationbull P (MP ) LM shifts right Ybull Pigou effect
P (MP )
consumersrsquo wealth
C
IS shifts right
Y
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects
of expected deflation E
bull LM curve shifts leftr and I (r ) planned expenditure income and output
bull Also the nominal interest rate decreases (idarr) ndash see IS-LM predictions grid
IS
Y
rLM
r1
Y1
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects of unexpected deflation
debt-deflation theoryP (if unexpected)
transfers purchasing power from borrowers to lenders
borrowers spend less lenders spend more if borrowersrsquo propensity to spend is larger than
lendersrsquo then aggregate spending falls the IS curve shifts left and Y falls
The evidence on output and nominal interest rates
bull Note that other than the money hypothesis all the other hypothesesmdashthe spending hypothesis the debt-deflation hypothesis and the deflationary expectations hypothesismdashpredict falling real GDP and falling nominal interest rates
bull This is exactly what happened in the early stages of the Great Depression
bull The spending hypothesis and the debt-deflation hypothesis both predict falling real interest rates whereas the deflationary expectations hypothesis predicts rising real interest rates
bull Therefore evidence on real interest rates is crucial in identifying suitable explanations for the Great Depression
Why another Depression is unlikelybull Policymakers (or their advisors) now know much more
about macroeconomicsndash The Fed knows better than to let M fall so much
especially during a contractionndash Fiscal policymakers know better than to raise
taxes or cut spending during a contractionbull Federal deposit insurance makes widespread bank
failures very unlikely
bull Automatic stabilizers make fiscal policy expansionary during an economic downturn
THE FINANCIAL CRISIS AND ECONOMIC DOWNTURN OF 2008 AND 2009
CASE STUDYThe 2008-09 Financial Crisis amp Recession
bull 2009 Real GDP fell unemployment rate approached 10
bull Important factors in the crisisndash early 2000s Federal Reserve interest rate policy ndash sub-prime mortgage crisisndash bursting of house price bubble rising foreclosure
ratesndash falling stock pricesndash failing financial institutionsndash declining consumer confidence drop in spending on
consumer durables and investment goods
A Too-Brief and Too-Simple Explanation
bull The price of housing had risen to unsustainable levels
bull When home prices inevitably crashed people suddenly felt poor and cut back their spending plans
bull This fall in planned expenditure brought about the Great Recession of 2008-09
The Housing Bubble Inflates then Deflates
bull The SampP Case-Shiller 20-City Home Price Index went from ndash 100 in Jan 2000 tondash 20654 in April 2006 tondash 14095 in May 2009 tondash 14216 in Dec 2010
bull Why did the housing bubble inflate
The Housing Bubble Reasons
bull The Fed kept the interest rates too low for too long
bull Securitization technology got a lot fancier in the mortgage bond market
bull The government regulators were sleepingbull Pretty much everybody believed that home
prices could never fall
The Housing Bubble Low FFR
bull The Fed had reduced the Federal Funds Rate to fight the Recession of 2001
bull After that recession ended the Fed continued to keep interest rates low until 2004ndash The Fed was watching inflation which remained
tame Consequently the Fed saw little reason to raise interest rates
ndash The Fed did not believe that housing prices had formed a bubble hellip until it was blindingly obvious
The Housing Bubble Securitization
bull In the past people with money did not like to lend money to home buyers because such loans were risky and had unreliable returns
bull 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
bull The financial sector was regulated by people who were ideologically opposed to regulation
bull They turned a blind eye to even the worst lending practices
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
Shocks in the IS -LM model
LM shocks exogenous changes in the demand for money
Examplesndash a wave of credit card fraud increases demand
for moneyndash 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 of1 a boom in the stock market that makes consumers
wealthier2 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 rb determine what happens to C I and the
unemployment rate
CASE STUDY
THE US RECESSION OF 2001
The US Recession of 2001
bull 39 on 900bull 49 on 801bull 63 on 603bull 50 on 705
The US Recession of 2001
bull Growth of GDP was negative in the 1st and 3rd quarters of 2001
bull Thatrsquos essentially before 911
Recall IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
The US Recession of 2001bull Whybull Demand shocks moved the IS
curve leftndash The ldquotech bubblerdquo ended and
stocks fell 25 between 800 and 801
ndash 911 attacks led to a 12 fall in stock prices in one week and a huge rise in uncertainty
ndash Scandals at Enron WorldCom and other corporations led to stock price declines and a decline in trust and a rise in uncertainty
ndash Lower household wealth reduced Co and higher uncertainty reduced Io
IS
Y
rLM
r1
Y1
CASE STUDY
The US recession of 2001Causes 1) Stock market decline C
300
600
900
1200
1500
1995 1996 1997 1998 1999 2000 2001 2002 2003
Ind
ex
(19
42
= 1
00
) Standard amp Poorrsquos 500
The US Recession of 2001bull Fiscal stimulus moved IS curve
rightndash Major tax cuts were enacted in
2001 and 2003ndash Government spending was
boostedbull to rebuild NYC andbull to bail out the airline industry
bull Fed printed money and moved LM curve rightndash Interest rate on 3-month
Treasury bills fellbull 64 in 1100bull 33 in 801bull 09 in 703
IS1
Y
rLM1
r1
Y1
IS2
LM2
Y3
All three toolsmdashG T and Mmdashwere used
CASE STUDY
The US recession of 2001bull Monetary policy response shifted LM curve right
Three-month T-Bill Rate
Three-month T-Bill Rate
0
1
2
3
4
5
6
7
010
120
0004
02
2000
070
320
0010
03
2000
010
320
0104
05
2001
070
620
0110
06
2001
010
620
0204
08
2002
070
920
0210
09
2002
010
920
0304
11
2003
Skip
bull I am skipping section 11-2
THE GREAT DEPRESSION
The Great Depression
Unemployment (right scale)
Real GNP(left scale)
120
140
160
180
200
220
240
1929 1931 1933 1935 1937 1939
billi
ons
of 1
958
dolla
rs
0
5
10
15
20
25
30
perc
ent o
f lab
or fo
rce
THE SPENDING HYPOTHESIS
Shocks to the IS curvebull asserts that the
Depression was largely due to an exogenous fall in the demand for goods and services ndash a leftward shift of the IS curve
bull evidence output and interest rates both fell in early 1930s which is what a leftward IS shift would cause
IS
Y
rLM
r1
Y1
THE SPENDING HYPOTHESIS
Reasons for the IS shiftbull Stock market crash exogenous C
ndash Oct-Dec 1929 SampP 500 fell 17ndash Oct 1929-Dec 1933 SampP 500 fell 71
bull Drop in investmentndash ldquocorrectionrdquo after overbuilding in the 1920sndash widespread bank failures in early 1930s made it harder
to obtain financing for investmentbull Contractionary fiscal policy
ndash Politicians raised tax rates in 1932 and cut spending to combat increasing deficits
THE MONEY HYPOTHESIS
A shock to the LM curvebull asserts that the Depression was largely due to
huge fall in the money supplybull evidence M1 fell 25 during 1929-33 bull But two problems with this hypothesis
ndash P fell even more so MP actually rose slightly during 1929-31
ndash nominal interest rates fell which is the opposite of what a leftward LM shift would cause
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull asserts that the severity of the Depression
was due to a huge deflation ndash P fell 25 during 1929-33
bull This deflation was probably caused by the fall in M so perhaps money played an important role after all
bull In what ways does a deflation affect the economy
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The stabilizing effects of deflationbull P (MP ) LM shifts right Ybull Pigou effect
P (MP )
consumersrsquo wealth
C
IS shifts right
Y
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects
of expected deflation E
bull LM curve shifts leftr and I (r ) planned expenditure income and output
bull Also the nominal interest rate decreases (idarr) ndash see IS-LM predictions grid
IS
Y
rLM
r1
Y1
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects of unexpected deflation
debt-deflation theoryP (if unexpected)
transfers purchasing power from borrowers to lenders
borrowers spend less lenders spend more if borrowersrsquo propensity to spend is larger than
lendersrsquo then aggregate spending falls the IS curve shifts left and Y falls
The evidence on output and nominal interest rates
bull Note that other than the money hypothesis all the other hypothesesmdashthe spending hypothesis the debt-deflation hypothesis and the deflationary expectations hypothesismdashpredict falling real GDP and falling nominal interest rates
bull This is exactly what happened in the early stages of the Great Depression
bull The spending hypothesis and the debt-deflation hypothesis both predict falling real interest rates whereas the deflationary expectations hypothesis predicts rising real interest rates
bull Therefore evidence on real interest rates is crucial in identifying suitable explanations for the Great Depression
Why another Depression is unlikelybull Policymakers (or their advisors) now know much more
about macroeconomicsndash The Fed knows better than to let M fall so much
especially during a contractionndash Fiscal policymakers know better than to raise
taxes or cut spending during a contractionbull Federal deposit insurance makes widespread bank
failures very unlikely
bull Automatic stabilizers make fiscal policy expansionary during an economic downturn
THE FINANCIAL CRISIS AND ECONOMIC DOWNTURN OF 2008 AND 2009
CASE STUDYThe 2008-09 Financial Crisis amp Recession
bull 2009 Real GDP fell unemployment rate approached 10
bull Important factors in the crisisndash early 2000s Federal Reserve interest rate policy ndash sub-prime mortgage crisisndash bursting of house price bubble rising foreclosure
ratesndash falling stock pricesndash failing financial institutionsndash declining consumer confidence drop in spending on
consumer durables and investment goods
A Too-Brief and Too-Simple Explanation
bull The price of housing had risen to unsustainable levels
bull When home prices inevitably crashed people suddenly felt poor and cut back their spending plans
bull This fall in planned expenditure brought about the Great Recession of 2008-09
The Housing Bubble Inflates then Deflates
bull The SampP Case-Shiller 20-City Home Price Index went from ndash 100 in Jan 2000 tondash 20654 in April 2006 tondash 14095 in May 2009 tondash 14216 in Dec 2010
bull Why did the housing bubble inflate
The Housing Bubble Reasons
bull The Fed kept the interest rates too low for too long
bull Securitization technology got a lot fancier in the mortgage bond market
bull The government regulators were sleepingbull Pretty much everybody believed that home
prices could never fall
The Housing Bubble Low FFR
bull The Fed had reduced the Federal Funds Rate to fight the Recession of 2001
bull After that recession ended the Fed continued to keep interest rates low until 2004ndash The Fed was watching inflation which remained
tame Consequently the Fed saw little reason to raise interest rates
ndash The Fed did not believe that housing prices had formed a bubble hellip until it was blindingly obvious
The Housing Bubble Securitization
bull In the past people with money did not like to lend money to home buyers because such loans were risky and had unreliable returns
bull 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
bull The financial sector was regulated by people who were ideologically opposed to regulation
bull They turned a blind eye to even the worst lending practices
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
NOW YOU TRY
Analyze shocks with the IS-LM Model
Use the IS-LM model to analyze the effects of1 a boom in the stock market that makes consumers
wealthier2 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 rb determine what happens to C I and the
unemployment rate
CASE STUDY
THE US RECESSION OF 2001
The US Recession of 2001
bull 39 on 900bull 49 on 801bull 63 on 603bull 50 on 705
The US Recession of 2001
bull Growth of GDP was negative in the 1st and 3rd quarters of 2001
bull Thatrsquos essentially before 911
Recall IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
The US Recession of 2001bull Whybull Demand shocks moved the IS
curve leftndash The ldquotech bubblerdquo ended and
stocks fell 25 between 800 and 801
ndash 911 attacks led to a 12 fall in stock prices in one week and a huge rise in uncertainty
ndash Scandals at Enron WorldCom and other corporations led to stock price declines and a decline in trust and a rise in uncertainty
ndash Lower household wealth reduced Co and higher uncertainty reduced Io
IS
Y
rLM
r1
Y1
CASE STUDY
The US recession of 2001Causes 1) Stock market decline C
300
600
900
1200
1500
1995 1996 1997 1998 1999 2000 2001 2002 2003
Ind
ex
(19
42
= 1
00
) Standard amp Poorrsquos 500
The US Recession of 2001bull Fiscal stimulus moved IS curve
rightndash Major tax cuts were enacted in
2001 and 2003ndash Government spending was
boostedbull to rebuild NYC andbull to bail out the airline industry
bull Fed printed money and moved LM curve rightndash Interest rate on 3-month
Treasury bills fellbull 64 in 1100bull 33 in 801bull 09 in 703
IS1
Y
rLM1
r1
Y1
IS2
LM2
Y3
All three toolsmdashG T and Mmdashwere used
CASE STUDY
The US recession of 2001bull Monetary policy response shifted LM curve right
Three-month T-Bill Rate
Three-month T-Bill Rate
0
1
2
3
4
5
6
7
010
120
0004
02
2000
070
320
0010
03
2000
010
320
0104
05
2001
070
620
0110
06
2001
010
620
0204
08
2002
070
920
0210
09
2002
010
920
0304
11
2003
Skip
bull I am skipping section 11-2
THE GREAT DEPRESSION
The Great Depression
Unemployment (right scale)
Real GNP(left scale)
120
140
160
180
200
220
240
1929 1931 1933 1935 1937 1939
billi
ons
of 1
958
dolla
rs
0
5
10
15
20
25
30
perc
ent o
f lab
or fo
rce
THE SPENDING HYPOTHESIS
Shocks to the IS curvebull asserts that the
Depression was largely due to an exogenous fall in the demand for goods and services ndash a leftward shift of the IS curve
bull evidence output and interest rates both fell in early 1930s which is what a leftward IS shift would cause
IS
Y
rLM
r1
Y1
THE SPENDING HYPOTHESIS
Reasons for the IS shiftbull Stock market crash exogenous C
ndash Oct-Dec 1929 SampP 500 fell 17ndash Oct 1929-Dec 1933 SampP 500 fell 71
bull Drop in investmentndash ldquocorrectionrdquo after overbuilding in the 1920sndash widespread bank failures in early 1930s made it harder
to obtain financing for investmentbull Contractionary fiscal policy
ndash Politicians raised tax rates in 1932 and cut spending to combat increasing deficits
THE MONEY HYPOTHESIS
A shock to the LM curvebull asserts that the Depression was largely due to
huge fall in the money supplybull evidence M1 fell 25 during 1929-33 bull But two problems with this hypothesis
ndash P fell even more so MP actually rose slightly during 1929-31
ndash nominal interest rates fell which is the opposite of what a leftward LM shift would cause
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull asserts that the severity of the Depression
was due to a huge deflation ndash P fell 25 during 1929-33
bull This deflation was probably caused by the fall in M so perhaps money played an important role after all
bull In what ways does a deflation affect the economy
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The stabilizing effects of deflationbull P (MP ) LM shifts right Ybull Pigou effect
P (MP )
consumersrsquo wealth
C
IS shifts right
Y
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects
of expected deflation E
bull LM curve shifts leftr and I (r ) planned expenditure income and output
bull Also the nominal interest rate decreases (idarr) ndash see IS-LM predictions grid
IS
Y
rLM
r1
Y1
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects of unexpected deflation
debt-deflation theoryP (if unexpected)
transfers purchasing power from borrowers to lenders
borrowers spend less lenders spend more if borrowersrsquo propensity to spend is larger than
lendersrsquo then aggregate spending falls the IS curve shifts left and Y falls
The evidence on output and nominal interest rates
bull Note that other than the money hypothesis all the other hypothesesmdashthe spending hypothesis the debt-deflation hypothesis and the deflationary expectations hypothesismdashpredict falling real GDP and falling nominal interest rates
bull This is exactly what happened in the early stages of the Great Depression
bull The spending hypothesis and the debt-deflation hypothesis both predict falling real interest rates whereas the deflationary expectations hypothesis predicts rising real interest rates
bull Therefore evidence on real interest rates is crucial in identifying suitable explanations for the Great Depression
Why another Depression is unlikelybull Policymakers (or their advisors) now know much more
about macroeconomicsndash The Fed knows better than to let M fall so much
especially during a contractionndash Fiscal policymakers know better than to raise
taxes or cut spending during a contractionbull Federal deposit insurance makes widespread bank
failures very unlikely
bull Automatic stabilizers make fiscal policy expansionary during an economic downturn
THE FINANCIAL CRISIS AND ECONOMIC DOWNTURN OF 2008 AND 2009
CASE STUDYThe 2008-09 Financial Crisis amp Recession
bull 2009 Real GDP fell unemployment rate approached 10
bull Important factors in the crisisndash early 2000s Federal Reserve interest rate policy ndash sub-prime mortgage crisisndash bursting of house price bubble rising foreclosure
ratesndash falling stock pricesndash failing financial institutionsndash declining consumer confidence drop in spending on
consumer durables and investment goods
A Too-Brief and Too-Simple Explanation
bull The price of housing had risen to unsustainable levels
bull When home prices inevitably crashed people suddenly felt poor and cut back their spending plans
bull This fall in planned expenditure brought about the Great Recession of 2008-09
The Housing Bubble Inflates then Deflates
bull The SampP Case-Shiller 20-City Home Price Index went from ndash 100 in Jan 2000 tondash 20654 in April 2006 tondash 14095 in May 2009 tondash 14216 in Dec 2010
bull Why did the housing bubble inflate
The Housing Bubble Reasons
bull The Fed kept the interest rates too low for too long
bull Securitization technology got a lot fancier in the mortgage bond market
bull The government regulators were sleepingbull Pretty much everybody believed that home
prices could never fall
The Housing Bubble Low FFR
bull The Fed had reduced the Federal Funds Rate to fight the Recession of 2001
bull After that recession ended the Fed continued to keep interest rates low until 2004ndash The Fed was watching inflation which remained
tame Consequently the Fed saw little reason to raise interest rates
ndash The Fed did not believe that housing prices had formed a bubble hellip until it was blindingly obvious
The Housing Bubble Securitization
bull In the past people with money did not like to lend money to home buyers because such loans were risky and had unreliable returns
bull 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
bull The financial sector was regulated by people who were ideologically opposed to regulation
bull They turned a blind eye to even the worst lending practices
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
CASE STUDY
THE US RECESSION OF 2001
The US Recession of 2001
bull 39 on 900bull 49 on 801bull 63 on 603bull 50 on 705
The US Recession of 2001
bull Growth of GDP was negative in the 1st and 3rd quarters of 2001
bull Thatrsquos essentially before 911
Recall IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
The US Recession of 2001bull Whybull Demand shocks moved the IS
curve leftndash The ldquotech bubblerdquo ended and
stocks fell 25 between 800 and 801
ndash 911 attacks led to a 12 fall in stock prices in one week and a huge rise in uncertainty
ndash Scandals at Enron WorldCom and other corporations led to stock price declines and a decline in trust and a rise in uncertainty
ndash Lower household wealth reduced Co and higher uncertainty reduced Io
IS
Y
rLM
r1
Y1
CASE STUDY
The US recession of 2001Causes 1) Stock market decline C
300
600
900
1200
1500
1995 1996 1997 1998 1999 2000 2001 2002 2003
Ind
ex
(19
42
= 1
00
) Standard amp Poorrsquos 500
The US Recession of 2001bull Fiscal stimulus moved IS curve
rightndash Major tax cuts were enacted in
2001 and 2003ndash Government spending was
boostedbull to rebuild NYC andbull to bail out the airline industry
bull Fed printed money and moved LM curve rightndash Interest rate on 3-month
Treasury bills fellbull 64 in 1100bull 33 in 801bull 09 in 703
IS1
Y
rLM1
r1
Y1
IS2
LM2
Y3
All three toolsmdashG T and Mmdashwere used
CASE STUDY
The US recession of 2001bull Monetary policy response shifted LM curve right
Three-month T-Bill Rate
Three-month T-Bill Rate
0
1
2
3
4
5
6
7
010
120
0004
02
2000
070
320
0010
03
2000
010
320
0104
05
2001
070
620
0110
06
2001
010
620
0204
08
2002
070
920
0210
09
2002
010
920
0304
11
2003
Skip
bull I am skipping section 11-2
THE GREAT DEPRESSION
The Great Depression
Unemployment (right scale)
Real GNP(left scale)
120
140
160
180
200
220
240
1929 1931 1933 1935 1937 1939
billi
ons
of 1
958
dolla
rs
0
5
10
15
20
25
30
perc
ent o
f lab
or fo
rce
THE SPENDING HYPOTHESIS
Shocks to the IS curvebull asserts that the
Depression was largely due to an exogenous fall in the demand for goods and services ndash a leftward shift of the IS curve
bull evidence output and interest rates both fell in early 1930s which is what a leftward IS shift would cause
IS
Y
rLM
r1
Y1
THE SPENDING HYPOTHESIS
Reasons for the IS shiftbull Stock market crash exogenous C
ndash Oct-Dec 1929 SampP 500 fell 17ndash Oct 1929-Dec 1933 SampP 500 fell 71
bull Drop in investmentndash ldquocorrectionrdquo after overbuilding in the 1920sndash widespread bank failures in early 1930s made it harder
to obtain financing for investmentbull Contractionary fiscal policy
ndash Politicians raised tax rates in 1932 and cut spending to combat increasing deficits
THE MONEY HYPOTHESIS
A shock to the LM curvebull asserts that the Depression was largely due to
huge fall in the money supplybull evidence M1 fell 25 during 1929-33 bull But two problems with this hypothesis
ndash P fell even more so MP actually rose slightly during 1929-31
ndash nominal interest rates fell which is the opposite of what a leftward LM shift would cause
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull asserts that the severity of the Depression
was due to a huge deflation ndash P fell 25 during 1929-33
bull This deflation was probably caused by the fall in M so perhaps money played an important role after all
bull In what ways does a deflation affect the economy
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The stabilizing effects of deflationbull P (MP ) LM shifts right Ybull Pigou effect
P (MP )
consumersrsquo wealth
C
IS shifts right
Y
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects
of expected deflation E
bull LM curve shifts leftr and I (r ) planned expenditure income and output
bull Also the nominal interest rate decreases (idarr) ndash see IS-LM predictions grid
IS
Y
rLM
r1
Y1
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects of unexpected deflation
debt-deflation theoryP (if unexpected)
transfers purchasing power from borrowers to lenders
borrowers spend less lenders spend more if borrowersrsquo propensity to spend is larger than
lendersrsquo then aggregate spending falls the IS curve shifts left and Y falls
The evidence on output and nominal interest rates
bull Note that other than the money hypothesis all the other hypothesesmdashthe spending hypothesis the debt-deflation hypothesis and the deflationary expectations hypothesismdashpredict falling real GDP and falling nominal interest rates
bull This is exactly what happened in the early stages of the Great Depression
bull The spending hypothesis and the debt-deflation hypothesis both predict falling real interest rates whereas the deflationary expectations hypothesis predicts rising real interest rates
bull Therefore evidence on real interest rates is crucial in identifying suitable explanations for the Great Depression
Why another Depression is unlikelybull Policymakers (or their advisors) now know much more
about macroeconomicsndash The Fed knows better than to let M fall so much
especially during a contractionndash Fiscal policymakers know better than to raise
taxes or cut spending during a contractionbull Federal deposit insurance makes widespread bank
failures very unlikely
bull Automatic stabilizers make fiscal policy expansionary during an economic downturn
THE FINANCIAL CRISIS AND ECONOMIC DOWNTURN OF 2008 AND 2009
CASE STUDYThe 2008-09 Financial Crisis amp Recession
bull 2009 Real GDP fell unemployment rate approached 10
bull Important factors in the crisisndash early 2000s Federal Reserve interest rate policy ndash sub-prime mortgage crisisndash bursting of house price bubble rising foreclosure
ratesndash falling stock pricesndash failing financial institutionsndash declining consumer confidence drop in spending on
consumer durables and investment goods
A Too-Brief and Too-Simple Explanation
bull The price of housing had risen to unsustainable levels
bull When home prices inevitably crashed people suddenly felt poor and cut back their spending plans
bull This fall in planned expenditure brought about the Great Recession of 2008-09
The Housing Bubble Inflates then Deflates
bull The SampP Case-Shiller 20-City Home Price Index went from ndash 100 in Jan 2000 tondash 20654 in April 2006 tondash 14095 in May 2009 tondash 14216 in Dec 2010
bull Why did the housing bubble inflate
The Housing Bubble Reasons
bull The Fed kept the interest rates too low for too long
bull Securitization technology got a lot fancier in the mortgage bond market
bull The government regulators were sleepingbull Pretty much everybody believed that home
prices could never fall
The Housing Bubble Low FFR
bull The Fed had reduced the Federal Funds Rate to fight the Recession of 2001
bull After that recession ended the Fed continued to keep interest rates low until 2004ndash The Fed was watching inflation which remained
tame Consequently the Fed saw little reason to raise interest rates
ndash The Fed did not believe that housing prices had formed a bubble hellip until it was blindingly obvious
The Housing Bubble Securitization
bull In the past people with money did not like to lend money to home buyers because such loans were risky and had unreliable returns
bull 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
bull The financial sector was regulated by people who were ideologically opposed to regulation
bull They turned a blind eye to even the worst lending practices
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
The US Recession of 2001
bull 39 on 900bull 49 on 801bull 63 on 603bull 50 on 705
The US Recession of 2001
bull Growth of GDP was negative in the 1st and 3rd quarters of 2001
bull Thatrsquos essentially before 911
Recall IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
The US Recession of 2001bull Whybull Demand shocks moved the IS
curve leftndash The ldquotech bubblerdquo ended and
stocks fell 25 between 800 and 801
ndash 911 attacks led to a 12 fall in stock prices in one week and a huge rise in uncertainty
ndash Scandals at Enron WorldCom and other corporations led to stock price declines and a decline in trust and a rise in uncertainty
ndash Lower household wealth reduced Co and higher uncertainty reduced Io
IS
Y
rLM
r1
Y1
CASE STUDY
The US recession of 2001Causes 1) Stock market decline C
300
600
900
1200
1500
1995 1996 1997 1998 1999 2000 2001 2002 2003
Ind
ex
(19
42
= 1
00
) Standard amp Poorrsquos 500
The US Recession of 2001bull Fiscal stimulus moved IS curve
rightndash Major tax cuts were enacted in
2001 and 2003ndash Government spending was
boostedbull to rebuild NYC andbull to bail out the airline industry
bull Fed printed money and moved LM curve rightndash Interest rate on 3-month
Treasury bills fellbull 64 in 1100bull 33 in 801bull 09 in 703
IS1
Y
rLM1
r1
Y1
IS2
LM2
Y3
All three toolsmdashG T and Mmdashwere used
CASE STUDY
The US recession of 2001bull Monetary policy response shifted LM curve right
Three-month T-Bill Rate
Three-month T-Bill Rate
0
1
2
3
4
5
6
7
010
120
0004
02
2000
070
320
0010
03
2000
010
320
0104
05
2001
070
620
0110
06
2001
010
620
0204
08
2002
070
920
0210
09
2002
010
920
0304
11
2003
Skip
bull I am skipping section 11-2
THE GREAT DEPRESSION
The Great Depression
Unemployment (right scale)
Real GNP(left scale)
120
140
160
180
200
220
240
1929 1931 1933 1935 1937 1939
billi
ons
of 1
958
dolla
rs
0
5
10
15
20
25
30
perc
ent o
f lab
or fo
rce
THE SPENDING HYPOTHESIS
Shocks to the IS curvebull asserts that the
Depression was largely due to an exogenous fall in the demand for goods and services ndash a leftward shift of the IS curve
bull evidence output and interest rates both fell in early 1930s which is what a leftward IS shift would cause
IS
Y
rLM
r1
Y1
THE SPENDING HYPOTHESIS
Reasons for the IS shiftbull Stock market crash exogenous C
ndash Oct-Dec 1929 SampP 500 fell 17ndash Oct 1929-Dec 1933 SampP 500 fell 71
bull Drop in investmentndash ldquocorrectionrdquo after overbuilding in the 1920sndash widespread bank failures in early 1930s made it harder
to obtain financing for investmentbull Contractionary fiscal policy
ndash Politicians raised tax rates in 1932 and cut spending to combat increasing deficits
THE MONEY HYPOTHESIS
A shock to the LM curvebull asserts that the Depression was largely due to
huge fall in the money supplybull evidence M1 fell 25 during 1929-33 bull But two problems with this hypothesis
ndash P fell even more so MP actually rose slightly during 1929-31
ndash nominal interest rates fell which is the opposite of what a leftward LM shift would cause
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull asserts that the severity of the Depression
was due to a huge deflation ndash P fell 25 during 1929-33
bull This deflation was probably caused by the fall in M so perhaps money played an important role after all
bull In what ways does a deflation affect the economy
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The stabilizing effects of deflationbull P (MP ) LM shifts right Ybull Pigou effect
P (MP )
consumersrsquo wealth
C
IS shifts right
Y
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects
of expected deflation E
bull LM curve shifts leftr and I (r ) planned expenditure income and output
bull Also the nominal interest rate decreases (idarr) ndash see IS-LM predictions grid
IS
Y
rLM
r1
Y1
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects of unexpected deflation
debt-deflation theoryP (if unexpected)
transfers purchasing power from borrowers to lenders
borrowers spend less lenders spend more if borrowersrsquo propensity to spend is larger than
lendersrsquo then aggregate spending falls the IS curve shifts left and Y falls
The evidence on output and nominal interest rates
bull Note that other than the money hypothesis all the other hypothesesmdashthe spending hypothesis the debt-deflation hypothesis and the deflationary expectations hypothesismdashpredict falling real GDP and falling nominal interest rates
bull This is exactly what happened in the early stages of the Great Depression
bull The spending hypothesis and the debt-deflation hypothesis both predict falling real interest rates whereas the deflationary expectations hypothesis predicts rising real interest rates
bull Therefore evidence on real interest rates is crucial in identifying suitable explanations for the Great Depression
Why another Depression is unlikelybull Policymakers (or their advisors) now know much more
about macroeconomicsndash The Fed knows better than to let M fall so much
especially during a contractionndash Fiscal policymakers know better than to raise
taxes or cut spending during a contractionbull Federal deposit insurance makes widespread bank
failures very unlikely
bull Automatic stabilizers make fiscal policy expansionary during an economic downturn
THE FINANCIAL CRISIS AND ECONOMIC DOWNTURN OF 2008 AND 2009
CASE STUDYThe 2008-09 Financial Crisis amp Recession
bull 2009 Real GDP fell unemployment rate approached 10
bull Important factors in the crisisndash early 2000s Federal Reserve interest rate policy ndash sub-prime mortgage crisisndash bursting of house price bubble rising foreclosure
ratesndash falling stock pricesndash failing financial institutionsndash declining consumer confidence drop in spending on
consumer durables and investment goods
A Too-Brief and Too-Simple Explanation
bull The price of housing had risen to unsustainable levels
bull When home prices inevitably crashed people suddenly felt poor and cut back their spending plans
bull This fall in planned expenditure brought about the Great Recession of 2008-09
The Housing Bubble Inflates then Deflates
bull The SampP Case-Shiller 20-City Home Price Index went from ndash 100 in Jan 2000 tondash 20654 in April 2006 tondash 14095 in May 2009 tondash 14216 in Dec 2010
bull Why did the housing bubble inflate
The Housing Bubble Reasons
bull The Fed kept the interest rates too low for too long
bull Securitization technology got a lot fancier in the mortgage bond market
bull The government regulators were sleepingbull Pretty much everybody believed that home
prices could never fall
The Housing Bubble Low FFR
bull The Fed had reduced the Federal Funds Rate to fight the Recession of 2001
bull After that recession ended the Fed continued to keep interest rates low until 2004ndash The Fed was watching inflation which remained
tame Consequently the Fed saw little reason to raise interest rates
ndash The Fed did not believe that housing prices had formed a bubble hellip until it was blindingly obvious
The Housing Bubble Securitization
bull In the past people with money did not like to lend money to home buyers because such loans were risky and had unreliable returns
bull 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
bull The financial sector was regulated by people who were ideologically opposed to regulation
bull They turned a blind eye to even the worst lending practices
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
The US Recession of 2001
bull Growth of GDP was negative in the 1st and 3rd quarters of 2001
bull Thatrsquos essentially before 911
Recall IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
The US Recession of 2001bull Whybull Demand shocks moved the IS
curve leftndash The ldquotech bubblerdquo ended and
stocks fell 25 between 800 and 801
ndash 911 attacks led to a 12 fall in stock prices in one week and a huge rise in uncertainty
ndash Scandals at Enron WorldCom and other corporations led to stock price declines and a decline in trust and a rise in uncertainty
ndash Lower household wealth reduced Co and higher uncertainty reduced Io
IS
Y
rLM
r1
Y1
CASE STUDY
The US recession of 2001Causes 1) Stock market decline C
300
600
900
1200
1500
1995 1996 1997 1998 1999 2000 2001 2002 2003
Ind
ex
(19
42
= 1
00
) Standard amp Poorrsquos 500
The US Recession of 2001bull Fiscal stimulus moved IS curve
rightndash Major tax cuts were enacted in
2001 and 2003ndash Government spending was
boostedbull to rebuild NYC andbull to bail out the airline industry
bull Fed printed money and moved LM curve rightndash Interest rate on 3-month
Treasury bills fellbull 64 in 1100bull 33 in 801bull 09 in 703
IS1
Y
rLM1
r1
Y1
IS2
LM2
Y3
All three toolsmdashG T and Mmdashwere used
CASE STUDY
The US recession of 2001bull Monetary policy response shifted LM curve right
Three-month T-Bill Rate
Three-month T-Bill Rate
0
1
2
3
4
5
6
7
010
120
0004
02
2000
070
320
0010
03
2000
010
320
0104
05
2001
070
620
0110
06
2001
010
620
0204
08
2002
070
920
0210
09
2002
010
920
0304
11
2003
Skip
bull I am skipping section 11-2
THE GREAT DEPRESSION
The Great Depression
Unemployment (right scale)
Real GNP(left scale)
120
140
160
180
200
220
240
1929 1931 1933 1935 1937 1939
billi
ons
of 1
958
dolla
rs
0
5
10
15
20
25
30
perc
ent o
f lab
or fo
rce
THE SPENDING HYPOTHESIS
Shocks to the IS curvebull asserts that the
Depression was largely due to an exogenous fall in the demand for goods and services ndash a leftward shift of the IS curve
bull evidence output and interest rates both fell in early 1930s which is what a leftward IS shift would cause
IS
Y
rLM
r1
Y1
THE SPENDING HYPOTHESIS
Reasons for the IS shiftbull Stock market crash exogenous C
ndash Oct-Dec 1929 SampP 500 fell 17ndash Oct 1929-Dec 1933 SampP 500 fell 71
bull Drop in investmentndash ldquocorrectionrdquo after overbuilding in the 1920sndash widespread bank failures in early 1930s made it harder
to obtain financing for investmentbull Contractionary fiscal policy
ndash Politicians raised tax rates in 1932 and cut spending to combat increasing deficits
THE MONEY HYPOTHESIS
A shock to the LM curvebull asserts that the Depression was largely due to
huge fall in the money supplybull evidence M1 fell 25 during 1929-33 bull But two problems with this hypothesis
ndash P fell even more so MP actually rose slightly during 1929-31
ndash nominal interest rates fell which is the opposite of what a leftward LM shift would cause
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull asserts that the severity of the Depression
was due to a huge deflation ndash P fell 25 during 1929-33
bull This deflation was probably caused by the fall in M so perhaps money played an important role after all
bull In what ways does a deflation affect the economy
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The stabilizing effects of deflationbull P (MP ) LM shifts right Ybull Pigou effect
P (MP )
consumersrsquo wealth
C
IS shifts right
Y
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects
of expected deflation E
bull LM curve shifts leftr and I (r ) planned expenditure income and output
bull Also the nominal interest rate decreases (idarr) ndash see IS-LM predictions grid
IS
Y
rLM
r1
Y1
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects of unexpected deflation
debt-deflation theoryP (if unexpected)
transfers purchasing power from borrowers to lenders
borrowers spend less lenders spend more if borrowersrsquo propensity to spend is larger than
lendersrsquo then aggregate spending falls the IS curve shifts left and Y falls
The evidence on output and nominal interest rates
bull Note that other than the money hypothesis all the other hypothesesmdashthe spending hypothesis the debt-deflation hypothesis and the deflationary expectations hypothesismdashpredict falling real GDP and falling nominal interest rates
bull This is exactly what happened in the early stages of the Great Depression
bull The spending hypothesis and the debt-deflation hypothesis both predict falling real interest rates whereas the deflationary expectations hypothesis predicts rising real interest rates
bull Therefore evidence on real interest rates is crucial in identifying suitable explanations for the Great Depression
Why another Depression is unlikelybull Policymakers (or their advisors) now know much more
about macroeconomicsndash The Fed knows better than to let M fall so much
especially during a contractionndash Fiscal policymakers know better than to raise
taxes or cut spending during a contractionbull Federal deposit insurance makes widespread bank
failures very unlikely
bull Automatic stabilizers make fiscal policy expansionary during an economic downturn
THE FINANCIAL CRISIS AND ECONOMIC DOWNTURN OF 2008 AND 2009
CASE STUDYThe 2008-09 Financial Crisis amp Recession
bull 2009 Real GDP fell unemployment rate approached 10
bull Important factors in the crisisndash early 2000s Federal Reserve interest rate policy ndash sub-prime mortgage crisisndash bursting of house price bubble rising foreclosure
ratesndash falling stock pricesndash failing financial institutionsndash declining consumer confidence drop in spending on
consumer durables and investment goods
A Too-Brief and Too-Simple Explanation
bull The price of housing had risen to unsustainable levels
bull When home prices inevitably crashed people suddenly felt poor and cut back their spending plans
bull This fall in planned expenditure brought about the Great Recession of 2008-09
The Housing Bubble Inflates then Deflates
bull The SampP Case-Shiller 20-City Home Price Index went from ndash 100 in Jan 2000 tondash 20654 in April 2006 tondash 14095 in May 2009 tondash 14216 in Dec 2010
bull Why did the housing bubble inflate
The Housing Bubble Reasons
bull The Fed kept the interest rates too low for too long
bull Securitization technology got a lot fancier in the mortgage bond market
bull The government regulators were sleepingbull Pretty much everybody believed that home
prices could never fall
The Housing Bubble Low FFR
bull The Fed had reduced the Federal Funds Rate to fight the Recession of 2001
bull After that recession ended the Fed continued to keep interest rates low until 2004ndash The Fed was watching inflation which remained
tame Consequently the Fed saw little reason to raise interest rates
ndash The Fed did not believe that housing prices had formed a bubble hellip until it was blindingly obvious
The Housing Bubble Securitization
bull In the past people with money did not like to lend money to home buyers because such loans were risky and had unreliable returns
bull 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
bull The financial sector was regulated by people who were ideologically opposed to regulation
bull They turned a blind eye to even the worst lending practices
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
Recall IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
The US Recession of 2001bull Whybull Demand shocks moved the IS
curve leftndash The ldquotech bubblerdquo ended and
stocks fell 25 between 800 and 801
ndash 911 attacks led to a 12 fall in stock prices in one week and a huge rise in uncertainty
ndash Scandals at Enron WorldCom and other corporations led to stock price declines and a decline in trust and a rise in uncertainty
ndash Lower household wealth reduced Co and higher uncertainty reduced Io
IS
Y
rLM
r1
Y1
CASE STUDY
The US recession of 2001Causes 1) Stock market decline C
300
600
900
1200
1500
1995 1996 1997 1998 1999 2000 2001 2002 2003
Ind
ex
(19
42
= 1
00
) Standard amp Poorrsquos 500
The US Recession of 2001bull Fiscal stimulus moved IS curve
rightndash Major tax cuts were enacted in
2001 and 2003ndash Government spending was
boostedbull to rebuild NYC andbull to bail out the airline industry
bull Fed printed money and moved LM curve rightndash Interest rate on 3-month
Treasury bills fellbull 64 in 1100bull 33 in 801bull 09 in 703
IS1
Y
rLM1
r1
Y1
IS2
LM2
Y3
All three toolsmdashG T and Mmdashwere used
CASE STUDY
The US recession of 2001bull Monetary policy response shifted LM curve right
Three-month T-Bill Rate
Three-month T-Bill Rate
0
1
2
3
4
5
6
7
010
120
0004
02
2000
070
320
0010
03
2000
010
320
0104
05
2001
070
620
0110
06
2001
010
620
0204
08
2002
070
920
0210
09
2002
010
920
0304
11
2003
Skip
bull I am skipping section 11-2
THE GREAT DEPRESSION
The Great Depression
Unemployment (right scale)
Real GNP(left scale)
120
140
160
180
200
220
240
1929 1931 1933 1935 1937 1939
billi
ons
of 1
958
dolla
rs
0
5
10
15
20
25
30
perc
ent o
f lab
or fo
rce
THE SPENDING HYPOTHESIS
Shocks to the IS curvebull asserts that the
Depression was largely due to an exogenous fall in the demand for goods and services ndash a leftward shift of the IS curve
bull evidence output and interest rates both fell in early 1930s which is what a leftward IS shift would cause
IS
Y
rLM
r1
Y1
THE SPENDING HYPOTHESIS
Reasons for the IS shiftbull Stock market crash exogenous C
ndash Oct-Dec 1929 SampP 500 fell 17ndash Oct 1929-Dec 1933 SampP 500 fell 71
bull Drop in investmentndash ldquocorrectionrdquo after overbuilding in the 1920sndash widespread bank failures in early 1930s made it harder
to obtain financing for investmentbull Contractionary fiscal policy
ndash Politicians raised tax rates in 1932 and cut spending to combat increasing deficits
THE MONEY HYPOTHESIS
A shock to the LM curvebull asserts that the Depression was largely due to
huge fall in the money supplybull evidence M1 fell 25 during 1929-33 bull But two problems with this hypothesis
ndash P fell even more so MP actually rose slightly during 1929-31
ndash nominal interest rates fell which is the opposite of what a leftward LM shift would cause
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull asserts that the severity of the Depression
was due to a huge deflation ndash P fell 25 during 1929-33
bull This deflation was probably caused by the fall in M so perhaps money played an important role after all
bull In what ways does a deflation affect the economy
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The stabilizing effects of deflationbull P (MP ) LM shifts right Ybull Pigou effect
P (MP )
consumersrsquo wealth
C
IS shifts right
Y
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects
of expected deflation E
bull LM curve shifts leftr and I (r ) planned expenditure income and output
bull Also the nominal interest rate decreases (idarr) ndash see IS-LM predictions grid
IS
Y
rLM
r1
Y1
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects of unexpected deflation
debt-deflation theoryP (if unexpected)
transfers purchasing power from borrowers to lenders
borrowers spend less lenders spend more if borrowersrsquo propensity to spend is larger than
lendersrsquo then aggregate spending falls the IS curve shifts left and Y falls
The evidence on output and nominal interest rates
bull Note that other than the money hypothesis all the other hypothesesmdashthe spending hypothesis the debt-deflation hypothesis and the deflationary expectations hypothesismdashpredict falling real GDP and falling nominal interest rates
bull This is exactly what happened in the early stages of the Great Depression
bull The spending hypothesis and the debt-deflation hypothesis both predict falling real interest rates whereas the deflationary expectations hypothesis predicts rising real interest rates
bull Therefore evidence on real interest rates is crucial in identifying suitable explanations for the Great Depression
Why another Depression is unlikelybull Policymakers (or their advisors) now know much more
about macroeconomicsndash The Fed knows better than to let M fall so much
especially during a contractionndash Fiscal policymakers know better than to raise
taxes or cut spending during a contractionbull Federal deposit insurance makes widespread bank
failures very unlikely
bull Automatic stabilizers make fiscal policy expansionary during an economic downturn
THE FINANCIAL CRISIS AND ECONOMIC DOWNTURN OF 2008 AND 2009
CASE STUDYThe 2008-09 Financial Crisis amp Recession
bull 2009 Real GDP fell unemployment rate approached 10
bull Important factors in the crisisndash early 2000s Federal Reserve interest rate policy ndash sub-prime mortgage crisisndash bursting of house price bubble rising foreclosure
ratesndash falling stock pricesndash failing financial institutionsndash declining consumer confidence drop in spending on
consumer durables and investment goods
A Too-Brief and Too-Simple Explanation
bull The price of housing had risen to unsustainable levels
bull When home prices inevitably crashed people suddenly felt poor and cut back their spending plans
bull This fall in planned expenditure brought about the Great Recession of 2008-09
The Housing Bubble Inflates then Deflates
bull The SampP Case-Shiller 20-City Home Price Index went from ndash 100 in Jan 2000 tondash 20654 in April 2006 tondash 14095 in May 2009 tondash 14216 in Dec 2010
bull Why did the housing bubble inflate
The Housing Bubble Reasons
bull The Fed kept the interest rates too low for too long
bull Securitization technology got a lot fancier in the mortgage bond market
bull The government regulators were sleepingbull Pretty much everybody believed that home
prices could never fall
The Housing Bubble Low FFR
bull The Fed had reduced the Federal Funds Rate to fight the Recession of 2001
bull After that recession ended the Fed continued to keep interest rates low until 2004ndash The Fed was watching inflation which remained
tame Consequently the Fed saw little reason to raise interest rates
ndash The Fed did not believe that housing prices had formed a bubble hellip until it was blindingly obvious
The Housing Bubble Securitization
bull In the past people with money did not like to lend money to home buyers because such loans were risky and had unreliable returns
bull 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
bull The financial sector was regulated by people who were ideologically opposed to regulation
bull They turned a blind eye to even the worst lending practices
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
The US Recession of 2001bull Whybull Demand shocks moved the IS
curve leftndash The ldquotech bubblerdquo ended and
stocks fell 25 between 800 and 801
ndash 911 attacks led to a 12 fall in stock prices in one week and a huge rise in uncertainty
ndash Scandals at Enron WorldCom and other corporations led to stock price declines and a decline in trust and a rise in uncertainty
ndash Lower household wealth reduced Co and higher uncertainty reduced Io
IS
Y
rLM
r1
Y1
CASE STUDY
The US recession of 2001Causes 1) Stock market decline C
300
600
900
1200
1500
1995 1996 1997 1998 1999 2000 2001 2002 2003
Ind
ex
(19
42
= 1
00
) Standard amp Poorrsquos 500
The US Recession of 2001bull Fiscal stimulus moved IS curve
rightndash Major tax cuts were enacted in
2001 and 2003ndash Government spending was
boostedbull to rebuild NYC andbull to bail out the airline industry
bull Fed printed money and moved LM curve rightndash Interest rate on 3-month
Treasury bills fellbull 64 in 1100bull 33 in 801bull 09 in 703
IS1
Y
rLM1
r1
Y1
IS2
LM2
Y3
All three toolsmdashG T and Mmdashwere used
CASE STUDY
The US recession of 2001bull Monetary policy response shifted LM curve right
Three-month T-Bill Rate
Three-month T-Bill Rate
0
1
2
3
4
5
6
7
010
120
0004
02
2000
070
320
0010
03
2000
010
320
0104
05
2001
070
620
0110
06
2001
010
620
0204
08
2002
070
920
0210
09
2002
010
920
0304
11
2003
Skip
bull I am skipping section 11-2
THE GREAT DEPRESSION
The Great Depression
Unemployment (right scale)
Real GNP(left scale)
120
140
160
180
200
220
240
1929 1931 1933 1935 1937 1939
billi
ons
of 1
958
dolla
rs
0
5
10
15
20
25
30
perc
ent o
f lab
or fo
rce
THE SPENDING HYPOTHESIS
Shocks to the IS curvebull asserts that the
Depression was largely due to an exogenous fall in the demand for goods and services ndash a leftward shift of the IS curve
bull evidence output and interest rates both fell in early 1930s which is what a leftward IS shift would cause
IS
Y
rLM
r1
Y1
THE SPENDING HYPOTHESIS
Reasons for the IS shiftbull Stock market crash exogenous C
ndash Oct-Dec 1929 SampP 500 fell 17ndash Oct 1929-Dec 1933 SampP 500 fell 71
bull Drop in investmentndash ldquocorrectionrdquo after overbuilding in the 1920sndash widespread bank failures in early 1930s made it harder
to obtain financing for investmentbull Contractionary fiscal policy
ndash Politicians raised tax rates in 1932 and cut spending to combat increasing deficits
THE MONEY HYPOTHESIS
A shock to the LM curvebull asserts that the Depression was largely due to
huge fall in the money supplybull evidence M1 fell 25 during 1929-33 bull But two problems with this hypothesis
ndash P fell even more so MP actually rose slightly during 1929-31
ndash nominal interest rates fell which is the opposite of what a leftward LM shift would cause
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull asserts that the severity of the Depression
was due to a huge deflation ndash P fell 25 during 1929-33
bull This deflation was probably caused by the fall in M so perhaps money played an important role after all
bull In what ways does a deflation affect the economy
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The stabilizing effects of deflationbull P (MP ) LM shifts right Ybull Pigou effect
P (MP )
consumersrsquo wealth
C
IS shifts right
Y
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects
of expected deflation E
bull LM curve shifts leftr and I (r ) planned expenditure income and output
bull Also the nominal interest rate decreases (idarr) ndash see IS-LM predictions grid
IS
Y
rLM
r1
Y1
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects of unexpected deflation
debt-deflation theoryP (if unexpected)
transfers purchasing power from borrowers to lenders
borrowers spend less lenders spend more if borrowersrsquo propensity to spend is larger than
lendersrsquo then aggregate spending falls the IS curve shifts left and Y falls
The evidence on output and nominal interest rates
bull Note that other than the money hypothesis all the other hypothesesmdashthe spending hypothesis the debt-deflation hypothesis and the deflationary expectations hypothesismdashpredict falling real GDP and falling nominal interest rates
bull This is exactly what happened in the early stages of the Great Depression
bull The spending hypothesis and the debt-deflation hypothesis both predict falling real interest rates whereas the deflationary expectations hypothesis predicts rising real interest rates
bull Therefore evidence on real interest rates is crucial in identifying suitable explanations for the Great Depression
Why another Depression is unlikelybull Policymakers (or their advisors) now know much more
about macroeconomicsndash The Fed knows better than to let M fall so much
especially during a contractionndash Fiscal policymakers know better than to raise
taxes or cut spending during a contractionbull Federal deposit insurance makes widespread bank
failures very unlikely
bull Automatic stabilizers make fiscal policy expansionary during an economic downturn
THE FINANCIAL CRISIS AND ECONOMIC DOWNTURN OF 2008 AND 2009
CASE STUDYThe 2008-09 Financial Crisis amp Recession
bull 2009 Real GDP fell unemployment rate approached 10
bull Important factors in the crisisndash early 2000s Federal Reserve interest rate policy ndash sub-prime mortgage crisisndash bursting of house price bubble rising foreclosure
ratesndash falling stock pricesndash failing financial institutionsndash declining consumer confidence drop in spending on
consumer durables and investment goods
A Too-Brief and Too-Simple Explanation
bull The price of housing had risen to unsustainable levels
bull When home prices inevitably crashed people suddenly felt poor and cut back their spending plans
bull This fall in planned expenditure brought about the Great Recession of 2008-09
The Housing Bubble Inflates then Deflates
bull The SampP Case-Shiller 20-City Home Price Index went from ndash 100 in Jan 2000 tondash 20654 in April 2006 tondash 14095 in May 2009 tondash 14216 in Dec 2010
bull Why did the housing bubble inflate
The Housing Bubble Reasons
bull The Fed kept the interest rates too low for too long
bull Securitization technology got a lot fancier in the mortgage bond market
bull The government regulators were sleepingbull Pretty much everybody believed that home
prices could never fall
The Housing Bubble Low FFR
bull The Fed had reduced the Federal Funds Rate to fight the Recession of 2001
bull After that recession ended the Fed continued to keep interest rates low until 2004ndash The Fed was watching inflation which remained
tame Consequently the Fed saw little reason to raise interest rates
ndash The Fed did not believe that housing prices had formed a bubble hellip until it was blindingly obvious
The Housing Bubble Securitization
bull In the past people with money did not like to lend money to home buyers because such loans were risky and had unreliable returns
bull 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
bull The financial sector was regulated by people who were ideologically opposed to regulation
bull They turned a blind eye to even the worst lending practices
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
CASE STUDY
The US recession of 2001Causes 1) Stock market decline C
300
600
900
1200
1500
1995 1996 1997 1998 1999 2000 2001 2002 2003
Ind
ex
(19
42
= 1
00
) Standard amp Poorrsquos 500
The US Recession of 2001bull Fiscal stimulus moved IS curve
rightndash Major tax cuts were enacted in
2001 and 2003ndash Government spending was
boostedbull to rebuild NYC andbull to bail out the airline industry
bull Fed printed money and moved LM curve rightndash Interest rate on 3-month
Treasury bills fellbull 64 in 1100bull 33 in 801bull 09 in 703
IS1
Y
rLM1
r1
Y1
IS2
LM2
Y3
All three toolsmdashG T and Mmdashwere used
CASE STUDY
The US recession of 2001bull Monetary policy response shifted LM curve right
Three-month T-Bill Rate
Three-month T-Bill Rate
0
1
2
3
4
5
6
7
010
120
0004
02
2000
070
320
0010
03
2000
010
320
0104
05
2001
070
620
0110
06
2001
010
620
0204
08
2002
070
920
0210
09
2002
010
920
0304
11
2003
Skip
bull I am skipping section 11-2
THE GREAT DEPRESSION
The Great Depression
Unemployment (right scale)
Real GNP(left scale)
120
140
160
180
200
220
240
1929 1931 1933 1935 1937 1939
billi
ons
of 1
958
dolla
rs
0
5
10
15
20
25
30
perc
ent o
f lab
or fo
rce
THE SPENDING HYPOTHESIS
Shocks to the IS curvebull asserts that the
Depression was largely due to an exogenous fall in the demand for goods and services ndash a leftward shift of the IS curve
bull evidence output and interest rates both fell in early 1930s which is what a leftward IS shift would cause
IS
Y
rLM
r1
Y1
THE SPENDING HYPOTHESIS
Reasons for the IS shiftbull Stock market crash exogenous C
ndash Oct-Dec 1929 SampP 500 fell 17ndash Oct 1929-Dec 1933 SampP 500 fell 71
bull Drop in investmentndash ldquocorrectionrdquo after overbuilding in the 1920sndash widespread bank failures in early 1930s made it harder
to obtain financing for investmentbull Contractionary fiscal policy
ndash Politicians raised tax rates in 1932 and cut spending to combat increasing deficits
THE MONEY HYPOTHESIS
A shock to the LM curvebull asserts that the Depression was largely due to
huge fall in the money supplybull evidence M1 fell 25 during 1929-33 bull But two problems with this hypothesis
ndash P fell even more so MP actually rose slightly during 1929-31
ndash nominal interest rates fell which is the opposite of what a leftward LM shift would cause
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull asserts that the severity of the Depression
was due to a huge deflation ndash P fell 25 during 1929-33
bull This deflation was probably caused by the fall in M so perhaps money played an important role after all
bull In what ways does a deflation affect the economy
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The stabilizing effects of deflationbull P (MP ) LM shifts right Ybull Pigou effect
P (MP )
consumersrsquo wealth
C
IS shifts right
Y
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects
of expected deflation E
bull LM curve shifts leftr and I (r ) planned expenditure income and output
bull Also the nominal interest rate decreases (idarr) ndash see IS-LM predictions grid
IS
Y
rLM
r1
Y1
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects of unexpected deflation
debt-deflation theoryP (if unexpected)
transfers purchasing power from borrowers to lenders
borrowers spend less lenders spend more if borrowersrsquo propensity to spend is larger than
lendersrsquo then aggregate spending falls the IS curve shifts left and Y falls
The evidence on output and nominal interest rates
bull Note that other than the money hypothesis all the other hypothesesmdashthe spending hypothesis the debt-deflation hypothesis and the deflationary expectations hypothesismdashpredict falling real GDP and falling nominal interest rates
bull This is exactly what happened in the early stages of the Great Depression
bull The spending hypothesis and the debt-deflation hypothesis both predict falling real interest rates whereas the deflationary expectations hypothesis predicts rising real interest rates
bull Therefore evidence on real interest rates is crucial in identifying suitable explanations for the Great Depression
Why another Depression is unlikelybull Policymakers (or their advisors) now know much more
about macroeconomicsndash The Fed knows better than to let M fall so much
especially during a contractionndash Fiscal policymakers know better than to raise
taxes or cut spending during a contractionbull Federal deposit insurance makes widespread bank
failures very unlikely
bull Automatic stabilizers make fiscal policy expansionary during an economic downturn
THE FINANCIAL CRISIS AND ECONOMIC DOWNTURN OF 2008 AND 2009
CASE STUDYThe 2008-09 Financial Crisis amp Recession
bull 2009 Real GDP fell unemployment rate approached 10
bull Important factors in the crisisndash early 2000s Federal Reserve interest rate policy ndash sub-prime mortgage crisisndash bursting of house price bubble rising foreclosure
ratesndash falling stock pricesndash failing financial institutionsndash declining consumer confidence drop in spending on
consumer durables and investment goods
A Too-Brief and Too-Simple Explanation
bull The price of housing had risen to unsustainable levels
bull When home prices inevitably crashed people suddenly felt poor and cut back their spending plans
bull This fall in planned expenditure brought about the Great Recession of 2008-09
The Housing Bubble Inflates then Deflates
bull The SampP Case-Shiller 20-City Home Price Index went from ndash 100 in Jan 2000 tondash 20654 in April 2006 tondash 14095 in May 2009 tondash 14216 in Dec 2010
bull Why did the housing bubble inflate
The Housing Bubble Reasons
bull The Fed kept the interest rates too low for too long
bull Securitization technology got a lot fancier in the mortgage bond market
bull The government regulators were sleepingbull Pretty much everybody believed that home
prices could never fall
The Housing Bubble Low FFR
bull The Fed had reduced the Federal Funds Rate to fight the Recession of 2001
bull After that recession ended the Fed continued to keep interest rates low until 2004ndash The Fed was watching inflation which remained
tame Consequently the Fed saw little reason to raise interest rates
ndash The Fed did not believe that housing prices had formed a bubble hellip until it was blindingly obvious
The Housing Bubble Securitization
bull In the past people with money did not like to lend money to home buyers because such loans were risky and had unreliable returns
bull 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
bull The financial sector was regulated by people who were ideologically opposed to regulation
bull They turned a blind eye to even the worst lending practices
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
The US Recession of 2001bull Fiscal stimulus moved IS curve
rightndash Major tax cuts were enacted in
2001 and 2003ndash Government spending was
boostedbull to rebuild NYC andbull to bail out the airline industry
bull Fed printed money and moved LM curve rightndash Interest rate on 3-month
Treasury bills fellbull 64 in 1100bull 33 in 801bull 09 in 703
IS1
Y
rLM1
r1
Y1
IS2
LM2
Y3
All three toolsmdashG T and Mmdashwere used
CASE STUDY
The US recession of 2001bull Monetary policy response shifted LM curve right
Three-month T-Bill Rate
Three-month T-Bill Rate
0
1
2
3
4
5
6
7
010
120
0004
02
2000
070
320
0010
03
2000
010
320
0104
05
2001
070
620
0110
06
2001
010
620
0204
08
2002
070
920
0210
09
2002
010
920
0304
11
2003
Skip
bull I am skipping section 11-2
THE GREAT DEPRESSION
The Great Depression
Unemployment (right scale)
Real GNP(left scale)
120
140
160
180
200
220
240
1929 1931 1933 1935 1937 1939
billi
ons
of 1
958
dolla
rs
0
5
10
15
20
25
30
perc
ent o
f lab
or fo
rce
THE SPENDING HYPOTHESIS
Shocks to the IS curvebull asserts that the
Depression was largely due to an exogenous fall in the demand for goods and services ndash a leftward shift of the IS curve
bull evidence output and interest rates both fell in early 1930s which is what a leftward IS shift would cause
IS
Y
rLM
r1
Y1
THE SPENDING HYPOTHESIS
Reasons for the IS shiftbull Stock market crash exogenous C
ndash Oct-Dec 1929 SampP 500 fell 17ndash Oct 1929-Dec 1933 SampP 500 fell 71
bull Drop in investmentndash ldquocorrectionrdquo after overbuilding in the 1920sndash widespread bank failures in early 1930s made it harder
to obtain financing for investmentbull Contractionary fiscal policy
ndash Politicians raised tax rates in 1932 and cut spending to combat increasing deficits
THE MONEY HYPOTHESIS
A shock to the LM curvebull asserts that the Depression was largely due to
huge fall in the money supplybull evidence M1 fell 25 during 1929-33 bull But two problems with this hypothesis
ndash P fell even more so MP actually rose slightly during 1929-31
ndash nominal interest rates fell which is the opposite of what a leftward LM shift would cause
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull asserts that the severity of the Depression
was due to a huge deflation ndash P fell 25 during 1929-33
bull This deflation was probably caused by the fall in M so perhaps money played an important role after all
bull In what ways does a deflation affect the economy
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The stabilizing effects of deflationbull P (MP ) LM shifts right Ybull Pigou effect
P (MP )
consumersrsquo wealth
C
IS shifts right
Y
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects
of expected deflation E
bull LM curve shifts leftr and I (r ) planned expenditure income and output
bull Also the nominal interest rate decreases (idarr) ndash see IS-LM predictions grid
IS
Y
rLM
r1
Y1
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects of unexpected deflation
debt-deflation theoryP (if unexpected)
transfers purchasing power from borrowers to lenders
borrowers spend less lenders spend more if borrowersrsquo propensity to spend is larger than
lendersrsquo then aggregate spending falls the IS curve shifts left and Y falls
The evidence on output and nominal interest rates
bull Note that other than the money hypothesis all the other hypothesesmdashthe spending hypothesis the debt-deflation hypothesis and the deflationary expectations hypothesismdashpredict falling real GDP and falling nominal interest rates
bull This is exactly what happened in the early stages of the Great Depression
bull The spending hypothesis and the debt-deflation hypothesis both predict falling real interest rates whereas the deflationary expectations hypothesis predicts rising real interest rates
bull Therefore evidence on real interest rates is crucial in identifying suitable explanations for the Great Depression
Why another Depression is unlikelybull Policymakers (or their advisors) now know much more
about macroeconomicsndash The Fed knows better than to let M fall so much
especially during a contractionndash Fiscal policymakers know better than to raise
taxes or cut spending during a contractionbull Federal deposit insurance makes widespread bank
failures very unlikely
bull Automatic stabilizers make fiscal policy expansionary during an economic downturn
THE FINANCIAL CRISIS AND ECONOMIC DOWNTURN OF 2008 AND 2009
CASE STUDYThe 2008-09 Financial Crisis amp Recession
bull 2009 Real GDP fell unemployment rate approached 10
bull Important factors in the crisisndash early 2000s Federal Reserve interest rate policy ndash sub-prime mortgage crisisndash bursting of house price bubble rising foreclosure
ratesndash falling stock pricesndash failing financial institutionsndash declining consumer confidence drop in spending on
consumer durables and investment goods
A Too-Brief and Too-Simple Explanation
bull The price of housing had risen to unsustainable levels
bull When home prices inevitably crashed people suddenly felt poor and cut back their spending plans
bull This fall in planned expenditure brought about the Great Recession of 2008-09
The Housing Bubble Inflates then Deflates
bull The SampP Case-Shiller 20-City Home Price Index went from ndash 100 in Jan 2000 tondash 20654 in April 2006 tondash 14095 in May 2009 tondash 14216 in Dec 2010
bull Why did the housing bubble inflate
The Housing Bubble Reasons
bull The Fed kept the interest rates too low for too long
bull Securitization technology got a lot fancier in the mortgage bond market
bull The government regulators were sleepingbull Pretty much everybody believed that home
prices could never fall
The Housing Bubble Low FFR
bull The Fed had reduced the Federal Funds Rate to fight the Recession of 2001
bull After that recession ended the Fed continued to keep interest rates low until 2004ndash The Fed was watching inflation which remained
tame Consequently the Fed saw little reason to raise interest rates
ndash The Fed did not believe that housing prices had formed a bubble hellip until it was blindingly obvious
The Housing Bubble Securitization
bull In the past people with money did not like to lend money to home buyers because such loans were risky and had unreliable returns
bull 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
bull The financial sector was regulated by people who were ideologically opposed to regulation
bull They turned a blind eye to even the worst lending practices
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
CASE STUDY
The US recession of 2001bull Monetary policy response shifted LM curve right
Three-month T-Bill Rate
Three-month T-Bill Rate
0
1
2
3
4
5
6
7
010
120
0004
02
2000
070
320
0010
03
2000
010
320
0104
05
2001
070
620
0110
06
2001
010
620
0204
08
2002
070
920
0210
09
2002
010
920
0304
11
2003
Skip
bull I am skipping section 11-2
THE GREAT DEPRESSION
The Great Depression
Unemployment (right scale)
Real GNP(left scale)
120
140
160
180
200
220
240
1929 1931 1933 1935 1937 1939
billi
ons
of 1
958
dolla
rs
0
5
10
15
20
25
30
perc
ent o
f lab
or fo
rce
THE SPENDING HYPOTHESIS
Shocks to the IS curvebull asserts that the
Depression was largely due to an exogenous fall in the demand for goods and services ndash a leftward shift of the IS curve
bull evidence output and interest rates both fell in early 1930s which is what a leftward IS shift would cause
IS
Y
rLM
r1
Y1
THE SPENDING HYPOTHESIS
Reasons for the IS shiftbull Stock market crash exogenous C
ndash Oct-Dec 1929 SampP 500 fell 17ndash Oct 1929-Dec 1933 SampP 500 fell 71
bull Drop in investmentndash ldquocorrectionrdquo after overbuilding in the 1920sndash widespread bank failures in early 1930s made it harder
to obtain financing for investmentbull Contractionary fiscal policy
ndash Politicians raised tax rates in 1932 and cut spending to combat increasing deficits
THE MONEY HYPOTHESIS
A shock to the LM curvebull asserts that the Depression was largely due to
huge fall in the money supplybull evidence M1 fell 25 during 1929-33 bull But two problems with this hypothesis
ndash P fell even more so MP actually rose slightly during 1929-31
ndash nominal interest rates fell which is the opposite of what a leftward LM shift would cause
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull asserts that the severity of the Depression
was due to a huge deflation ndash P fell 25 during 1929-33
bull This deflation was probably caused by the fall in M so perhaps money played an important role after all
bull In what ways does a deflation affect the economy
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The stabilizing effects of deflationbull P (MP ) LM shifts right Ybull Pigou effect
P (MP )
consumersrsquo wealth
C
IS shifts right
Y
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects
of expected deflation E
bull LM curve shifts leftr and I (r ) planned expenditure income and output
bull Also the nominal interest rate decreases (idarr) ndash see IS-LM predictions grid
IS
Y
rLM
r1
Y1
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects of unexpected deflation
debt-deflation theoryP (if unexpected)
transfers purchasing power from borrowers to lenders
borrowers spend less lenders spend more if borrowersrsquo propensity to spend is larger than
lendersrsquo then aggregate spending falls the IS curve shifts left and Y falls
The evidence on output and nominal interest rates
bull Note that other than the money hypothesis all the other hypothesesmdashthe spending hypothesis the debt-deflation hypothesis and the deflationary expectations hypothesismdashpredict falling real GDP and falling nominal interest rates
bull This is exactly what happened in the early stages of the Great Depression
bull The spending hypothesis and the debt-deflation hypothesis both predict falling real interest rates whereas the deflationary expectations hypothesis predicts rising real interest rates
bull Therefore evidence on real interest rates is crucial in identifying suitable explanations for the Great Depression
Why another Depression is unlikelybull Policymakers (or their advisors) now know much more
about macroeconomicsndash The Fed knows better than to let M fall so much
especially during a contractionndash Fiscal policymakers know better than to raise
taxes or cut spending during a contractionbull Federal deposit insurance makes widespread bank
failures very unlikely
bull Automatic stabilizers make fiscal policy expansionary during an economic downturn
THE FINANCIAL CRISIS AND ECONOMIC DOWNTURN OF 2008 AND 2009
CASE STUDYThe 2008-09 Financial Crisis amp Recession
bull 2009 Real GDP fell unemployment rate approached 10
bull Important factors in the crisisndash early 2000s Federal Reserve interest rate policy ndash sub-prime mortgage crisisndash bursting of house price bubble rising foreclosure
ratesndash falling stock pricesndash failing financial institutionsndash declining consumer confidence drop in spending on
consumer durables and investment goods
A Too-Brief and Too-Simple Explanation
bull The price of housing had risen to unsustainable levels
bull When home prices inevitably crashed people suddenly felt poor and cut back their spending plans
bull This fall in planned expenditure brought about the Great Recession of 2008-09
The Housing Bubble Inflates then Deflates
bull The SampP Case-Shiller 20-City Home Price Index went from ndash 100 in Jan 2000 tondash 20654 in April 2006 tondash 14095 in May 2009 tondash 14216 in Dec 2010
bull Why did the housing bubble inflate
The Housing Bubble Reasons
bull The Fed kept the interest rates too low for too long
bull Securitization technology got a lot fancier in the mortgage bond market
bull The government regulators were sleepingbull Pretty much everybody believed that home
prices could never fall
The Housing Bubble Low FFR
bull The Fed had reduced the Federal Funds Rate to fight the Recession of 2001
bull After that recession ended the Fed continued to keep interest rates low until 2004ndash The Fed was watching inflation which remained
tame Consequently the Fed saw little reason to raise interest rates
ndash The Fed did not believe that housing prices had formed a bubble hellip until it was blindingly obvious
The Housing Bubble Securitization
bull In the past people with money did not like to lend money to home buyers because such loans were risky and had unreliable returns
bull 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
bull The financial sector was regulated by people who were ideologically opposed to regulation
bull They turned a blind eye to even the worst lending practices
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
Skip
bull I am skipping section 11-2
THE GREAT DEPRESSION
The Great Depression
Unemployment (right scale)
Real GNP(left scale)
120
140
160
180
200
220
240
1929 1931 1933 1935 1937 1939
billi
ons
of 1
958
dolla
rs
0
5
10
15
20
25
30
perc
ent o
f lab
or fo
rce
THE SPENDING HYPOTHESIS
Shocks to the IS curvebull asserts that the
Depression was largely due to an exogenous fall in the demand for goods and services ndash a leftward shift of the IS curve
bull evidence output and interest rates both fell in early 1930s which is what a leftward IS shift would cause
IS
Y
rLM
r1
Y1
THE SPENDING HYPOTHESIS
Reasons for the IS shiftbull Stock market crash exogenous C
ndash Oct-Dec 1929 SampP 500 fell 17ndash Oct 1929-Dec 1933 SampP 500 fell 71
bull Drop in investmentndash ldquocorrectionrdquo after overbuilding in the 1920sndash widespread bank failures in early 1930s made it harder
to obtain financing for investmentbull Contractionary fiscal policy
ndash Politicians raised tax rates in 1932 and cut spending to combat increasing deficits
THE MONEY HYPOTHESIS
A shock to the LM curvebull asserts that the Depression was largely due to
huge fall in the money supplybull evidence M1 fell 25 during 1929-33 bull But two problems with this hypothesis
ndash P fell even more so MP actually rose slightly during 1929-31
ndash nominal interest rates fell which is the opposite of what a leftward LM shift would cause
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull asserts that the severity of the Depression
was due to a huge deflation ndash P fell 25 during 1929-33
bull This deflation was probably caused by the fall in M so perhaps money played an important role after all
bull In what ways does a deflation affect the economy
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The stabilizing effects of deflationbull P (MP ) LM shifts right Ybull Pigou effect
P (MP )
consumersrsquo wealth
C
IS shifts right
Y
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects
of expected deflation E
bull LM curve shifts leftr and I (r ) planned expenditure income and output
bull Also the nominal interest rate decreases (idarr) ndash see IS-LM predictions grid
IS
Y
rLM
r1
Y1
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects of unexpected deflation
debt-deflation theoryP (if unexpected)
transfers purchasing power from borrowers to lenders
borrowers spend less lenders spend more if borrowersrsquo propensity to spend is larger than
lendersrsquo then aggregate spending falls the IS curve shifts left and Y falls
The evidence on output and nominal interest rates
bull Note that other than the money hypothesis all the other hypothesesmdashthe spending hypothesis the debt-deflation hypothesis and the deflationary expectations hypothesismdashpredict falling real GDP and falling nominal interest rates
bull This is exactly what happened in the early stages of the Great Depression
bull The spending hypothesis and the debt-deflation hypothesis both predict falling real interest rates whereas the deflationary expectations hypothesis predicts rising real interest rates
bull Therefore evidence on real interest rates is crucial in identifying suitable explanations for the Great Depression
Why another Depression is unlikelybull Policymakers (or their advisors) now know much more
about macroeconomicsndash The Fed knows better than to let M fall so much
especially during a contractionndash Fiscal policymakers know better than to raise
taxes or cut spending during a contractionbull Federal deposit insurance makes widespread bank
failures very unlikely
bull Automatic stabilizers make fiscal policy expansionary during an economic downturn
THE FINANCIAL CRISIS AND ECONOMIC DOWNTURN OF 2008 AND 2009
CASE STUDYThe 2008-09 Financial Crisis amp Recession
bull 2009 Real GDP fell unemployment rate approached 10
bull Important factors in the crisisndash early 2000s Federal Reserve interest rate policy ndash sub-prime mortgage crisisndash bursting of house price bubble rising foreclosure
ratesndash falling stock pricesndash failing financial institutionsndash declining consumer confidence drop in spending on
consumer durables and investment goods
A Too-Brief and Too-Simple Explanation
bull The price of housing had risen to unsustainable levels
bull When home prices inevitably crashed people suddenly felt poor and cut back their spending plans
bull This fall in planned expenditure brought about the Great Recession of 2008-09
The Housing Bubble Inflates then Deflates
bull The SampP Case-Shiller 20-City Home Price Index went from ndash 100 in Jan 2000 tondash 20654 in April 2006 tondash 14095 in May 2009 tondash 14216 in Dec 2010
bull Why did the housing bubble inflate
The Housing Bubble Reasons
bull The Fed kept the interest rates too low for too long
bull Securitization technology got a lot fancier in the mortgage bond market
bull The government regulators were sleepingbull Pretty much everybody believed that home
prices could never fall
The Housing Bubble Low FFR
bull The Fed had reduced the Federal Funds Rate to fight the Recession of 2001
bull After that recession ended the Fed continued to keep interest rates low until 2004ndash The Fed was watching inflation which remained
tame Consequently the Fed saw little reason to raise interest rates
ndash The Fed did not believe that housing prices had formed a bubble hellip until it was blindingly obvious
The Housing Bubble Securitization
bull In the past people with money did not like to lend money to home buyers because such loans were risky and had unreliable returns
bull 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
bull The financial sector was regulated by people who were ideologically opposed to regulation
bull They turned a blind eye to even the worst lending practices
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
THE GREAT DEPRESSION
The Great Depression
Unemployment (right scale)
Real GNP(left scale)
120
140
160
180
200
220
240
1929 1931 1933 1935 1937 1939
billi
ons
of 1
958
dolla
rs
0
5
10
15
20
25
30
perc
ent o
f lab
or fo
rce
THE SPENDING HYPOTHESIS
Shocks to the IS curvebull asserts that the
Depression was largely due to an exogenous fall in the demand for goods and services ndash a leftward shift of the IS curve
bull evidence output and interest rates both fell in early 1930s which is what a leftward IS shift would cause
IS
Y
rLM
r1
Y1
THE SPENDING HYPOTHESIS
Reasons for the IS shiftbull Stock market crash exogenous C
ndash Oct-Dec 1929 SampP 500 fell 17ndash Oct 1929-Dec 1933 SampP 500 fell 71
bull Drop in investmentndash ldquocorrectionrdquo after overbuilding in the 1920sndash widespread bank failures in early 1930s made it harder
to obtain financing for investmentbull Contractionary fiscal policy
ndash Politicians raised tax rates in 1932 and cut spending to combat increasing deficits
THE MONEY HYPOTHESIS
A shock to the LM curvebull asserts that the Depression was largely due to
huge fall in the money supplybull evidence M1 fell 25 during 1929-33 bull But two problems with this hypothesis
ndash P fell even more so MP actually rose slightly during 1929-31
ndash nominal interest rates fell which is the opposite of what a leftward LM shift would cause
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull asserts that the severity of the Depression
was due to a huge deflation ndash P fell 25 during 1929-33
bull This deflation was probably caused by the fall in M so perhaps money played an important role after all
bull In what ways does a deflation affect the economy
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The stabilizing effects of deflationbull P (MP ) LM shifts right Ybull Pigou effect
P (MP )
consumersrsquo wealth
C
IS shifts right
Y
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects
of expected deflation E
bull LM curve shifts leftr and I (r ) planned expenditure income and output
bull Also the nominal interest rate decreases (idarr) ndash see IS-LM predictions grid
IS
Y
rLM
r1
Y1
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects of unexpected deflation
debt-deflation theoryP (if unexpected)
transfers purchasing power from borrowers to lenders
borrowers spend less lenders spend more if borrowersrsquo propensity to spend is larger than
lendersrsquo then aggregate spending falls the IS curve shifts left and Y falls
The evidence on output and nominal interest rates
bull Note that other than the money hypothesis all the other hypothesesmdashthe spending hypothesis the debt-deflation hypothesis and the deflationary expectations hypothesismdashpredict falling real GDP and falling nominal interest rates
bull This is exactly what happened in the early stages of the Great Depression
bull The spending hypothesis and the debt-deflation hypothesis both predict falling real interest rates whereas the deflationary expectations hypothesis predicts rising real interest rates
bull Therefore evidence on real interest rates is crucial in identifying suitable explanations for the Great Depression
Why another Depression is unlikelybull Policymakers (or their advisors) now know much more
about macroeconomicsndash The Fed knows better than to let M fall so much
especially during a contractionndash Fiscal policymakers know better than to raise
taxes or cut spending during a contractionbull Federal deposit insurance makes widespread bank
failures very unlikely
bull Automatic stabilizers make fiscal policy expansionary during an economic downturn
THE FINANCIAL CRISIS AND ECONOMIC DOWNTURN OF 2008 AND 2009
CASE STUDYThe 2008-09 Financial Crisis amp Recession
bull 2009 Real GDP fell unemployment rate approached 10
bull Important factors in the crisisndash early 2000s Federal Reserve interest rate policy ndash sub-prime mortgage crisisndash bursting of house price bubble rising foreclosure
ratesndash falling stock pricesndash failing financial institutionsndash declining consumer confidence drop in spending on
consumer durables and investment goods
A Too-Brief and Too-Simple Explanation
bull The price of housing had risen to unsustainable levels
bull When home prices inevitably crashed people suddenly felt poor and cut back their spending plans
bull This fall in planned expenditure brought about the Great Recession of 2008-09
The Housing Bubble Inflates then Deflates
bull The SampP Case-Shiller 20-City Home Price Index went from ndash 100 in Jan 2000 tondash 20654 in April 2006 tondash 14095 in May 2009 tondash 14216 in Dec 2010
bull Why did the housing bubble inflate
The Housing Bubble Reasons
bull The Fed kept the interest rates too low for too long
bull Securitization technology got a lot fancier in the mortgage bond market
bull The government regulators were sleepingbull Pretty much everybody believed that home
prices could never fall
The Housing Bubble Low FFR
bull The Fed had reduced the Federal Funds Rate to fight the Recession of 2001
bull After that recession ended the Fed continued to keep interest rates low until 2004ndash The Fed was watching inflation which remained
tame Consequently the Fed saw little reason to raise interest rates
ndash The Fed did not believe that housing prices had formed a bubble hellip until it was blindingly obvious
The Housing Bubble Securitization
bull In the past people with money did not like to lend money to home buyers because such loans were risky and had unreliable returns
bull 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
bull The financial sector was regulated by people who were ideologically opposed to regulation
bull They turned a blind eye to even the worst lending practices
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
The Great Depression
Unemployment (right scale)
Real GNP(left scale)
120
140
160
180
200
220
240
1929 1931 1933 1935 1937 1939
billi
ons
of 1
958
dolla
rs
0
5
10
15
20
25
30
perc
ent o
f lab
or fo
rce
THE SPENDING HYPOTHESIS
Shocks to the IS curvebull asserts that the
Depression was largely due to an exogenous fall in the demand for goods and services ndash a leftward shift of the IS curve
bull evidence output and interest rates both fell in early 1930s which is what a leftward IS shift would cause
IS
Y
rLM
r1
Y1
THE SPENDING HYPOTHESIS
Reasons for the IS shiftbull Stock market crash exogenous C
ndash Oct-Dec 1929 SampP 500 fell 17ndash Oct 1929-Dec 1933 SampP 500 fell 71
bull Drop in investmentndash ldquocorrectionrdquo after overbuilding in the 1920sndash widespread bank failures in early 1930s made it harder
to obtain financing for investmentbull Contractionary fiscal policy
ndash Politicians raised tax rates in 1932 and cut spending to combat increasing deficits
THE MONEY HYPOTHESIS
A shock to the LM curvebull asserts that the Depression was largely due to
huge fall in the money supplybull evidence M1 fell 25 during 1929-33 bull But two problems with this hypothesis
ndash P fell even more so MP actually rose slightly during 1929-31
ndash nominal interest rates fell which is the opposite of what a leftward LM shift would cause
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull asserts that the severity of the Depression
was due to a huge deflation ndash P fell 25 during 1929-33
bull This deflation was probably caused by the fall in M so perhaps money played an important role after all
bull In what ways does a deflation affect the economy
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The stabilizing effects of deflationbull P (MP ) LM shifts right Ybull Pigou effect
P (MP )
consumersrsquo wealth
C
IS shifts right
Y
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects
of expected deflation E
bull LM curve shifts leftr and I (r ) planned expenditure income and output
bull Also the nominal interest rate decreases (idarr) ndash see IS-LM predictions grid
IS
Y
rLM
r1
Y1
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects of unexpected deflation
debt-deflation theoryP (if unexpected)
transfers purchasing power from borrowers to lenders
borrowers spend less lenders spend more if borrowersrsquo propensity to spend is larger than
lendersrsquo then aggregate spending falls the IS curve shifts left and Y falls
The evidence on output and nominal interest rates
bull Note that other than the money hypothesis all the other hypothesesmdashthe spending hypothesis the debt-deflation hypothesis and the deflationary expectations hypothesismdashpredict falling real GDP and falling nominal interest rates
bull This is exactly what happened in the early stages of the Great Depression
bull The spending hypothesis and the debt-deflation hypothesis both predict falling real interest rates whereas the deflationary expectations hypothesis predicts rising real interest rates
bull Therefore evidence on real interest rates is crucial in identifying suitable explanations for the Great Depression
Why another Depression is unlikelybull Policymakers (or their advisors) now know much more
about macroeconomicsndash The Fed knows better than to let M fall so much
especially during a contractionndash Fiscal policymakers know better than to raise
taxes or cut spending during a contractionbull Federal deposit insurance makes widespread bank
failures very unlikely
bull Automatic stabilizers make fiscal policy expansionary during an economic downturn
THE FINANCIAL CRISIS AND ECONOMIC DOWNTURN OF 2008 AND 2009
CASE STUDYThe 2008-09 Financial Crisis amp Recession
bull 2009 Real GDP fell unemployment rate approached 10
bull Important factors in the crisisndash early 2000s Federal Reserve interest rate policy ndash sub-prime mortgage crisisndash bursting of house price bubble rising foreclosure
ratesndash falling stock pricesndash failing financial institutionsndash declining consumer confidence drop in spending on
consumer durables and investment goods
A Too-Brief and Too-Simple Explanation
bull The price of housing had risen to unsustainable levels
bull When home prices inevitably crashed people suddenly felt poor and cut back their spending plans
bull This fall in planned expenditure brought about the Great Recession of 2008-09
The Housing Bubble Inflates then Deflates
bull The SampP Case-Shiller 20-City Home Price Index went from ndash 100 in Jan 2000 tondash 20654 in April 2006 tondash 14095 in May 2009 tondash 14216 in Dec 2010
bull Why did the housing bubble inflate
The Housing Bubble Reasons
bull The Fed kept the interest rates too low for too long
bull Securitization technology got a lot fancier in the mortgage bond market
bull The government regulators were sleepingbull Pretty much everybody believed that home
prices could never fall
The Housing Bubble Low FFR
bull The Fed had reduced the Federal Funds Rate to fight the Recession of 2001
bull After that recession ended the Fed continued to keep interest rates low until 2004ndash The Fed was watching inflation which remained
tame Consequently the Fed saw little reason to raise interest rates
ndash The Fed did not believe that housing prices had formed a bubble hellip until it was blindingly obvious
The Housing Bubble Securitization
bull In the past people with money did not like to lend money to home buyers because such loans were risky and had unreliable returns
bull 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
bull The financial sector was regulated by people who were ideologically opposed to regulation
bull They turned a blind eye to even the worst lending practices
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
THE SPENDING HYPOTHESIS
Shocks to the IS curvebull asserts that the
Depression was largely due to an exogenous fall in the demand for goods and services ndash a leftward shift of the IS curve
bull evidence output and interest rates both fell in early 1930s which is what a leftward IS shift would cause
IS
Y
rLM
r1
Y1
THE SPENDING HYPOTHESIS
Reasons for the IS shiftbull Stock market crash exogenous C
ndash Oct-Dec 1929 SampP 500 fell 17ndash Oct 1929-Dec 1933 SampP 500 fell 71
bull Drop in investmentndash ldquocorrectionrdquo after overbuilding in the 1920sndash widespread bank failures in early 1930s made it harder
to obtain financing for investmentbull Contractionary fiscal policy
ndash Politicians raised tax rates in 1932 and cut spending to combat increasing deficits
THE MONEY HYPOTHESIS
A shock to the LM curvebull asserts that the Depression was largely due to
huge fall in the money supplybull evidence M1 fell 25 during 1929-33 bull But two problems with this hypothesis
ndash P fell even more so MP actually rose slightly during 1929-31
ndash nominal interest rates fell which is the opposite of what a leftward LM shift would cause
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull asserts that the severity of the Depression
was due to a huge deflation ndash P fell 25 during 1929-33
bull This deflation was probably caused by the fall in M so perhaps money played an important role after all
bull In what ways does a deflation affect the economy
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The stabilizing effects of deflationbull P (MP ) LM shifts right Ybull Pigou effect
P (MP )
consumersrsquo wealth
C
IS shifts right
Y
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects
of expected deflation E
bull LM curve shifts leftr and I (r ) planned expenditure income and output
bull Also the nominal interest rate decreases (idarr) ndash see IS-LM predictions grid
IS
Y
rLM
r1
Y1
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects of unexpected deflation
debt-deflation theoryP (if unexpected)
transfers purchasing power from borrowers to lenders
borrowers spend less lenders spend more if borrowersrsquo propensity to spend is larger than
lendersrsquo then aggregate spending falls the IS curve shifts left and Y falls
The evidence on output and nominal interest rates
bull Note that other than the money hypothesis all the other hypothesesmdashthe spending hypothesis the debt-deflation hypothesis and the deflationary expectations hypothesismdashpredict falling real GDP and falling nominal interest rates
bull This is exactly what happened in the early stages of the Great Depression
bull The spending hypothesis and the debt-deflation hypothesis both predict falling real interest rates whereas the deflationary expectations hypothesis predicts rising real interest rates
bull Therefore evidence on real interest rates is crucial in identifying suitable explanations for the Great Depression
Why another Depression is unlikelybull Policymakers (or their advisors) now know much more
about macroeconomicsndash The Fed knows better than to let M fall so much
especially during a contractionndash Fiscal policymakers know better than to raise
taxes or cut spending during a contractionbull Federal deposit insurance makes widespread bank
failures very unlikely
bull Automatic stabilizers make fiscal policy expansionary during an economic downturn
THE FINANCIAL CRISIS AND ECONOMIC DOWNTURN OF 2008 AND 2009
CASE STUDYThe 2008-09 Financial Crisis amp Recession
bull 2009 Real GDP fell unemployment rate approached 10
bull Important factors in the crisisndash early 2000s Federal Reserve interest rate policy ndash sub-prime mortgage crisisndash bursting of house price bubble rising foreclosure
ratesndash falling stock pricesndash failing financial institutionsndash declining consumer confidence drop in spending on
consumer durables and investment goods
A Too-Brief and Too-Simple Explanation
bull The price of housing had risen to unsustainable levels
bull When home prices inevitably crashed people suddenly felt poor and cut back their spending plans
bull This fall in planned expenditure brought about the Great Recession of 2008-09
The Housing Bubble Inflates then Deflates
bull The SampP Case-Shiller 20-City Home Price Index went from ndash 100 in Jan 2000 tondash 20654 in April 2006 tondash 14095 in May 2009 tondash 14216 in Dec 2010
bull Why did the housing bubble inflate
The Housing Bubble Reasons
bull The Fed kept the interest rates too low for too long
bull Securitization technology got a lot fancier in the mortgage bond market
bull The government regulators were sleepingbull Pretty much everybody believed that home
prices could never fall
The Housing Bubble Low FFR
bull The Fed had reduced the Federal Funds Rate to fight the Recession of 2001
bull After that recession ended the Fed continued to keep interest rates low until 2004ndash The Fed was watching inflation which remained
tame Consequently the Fed saw little reason to raise interest rates
ndash The Fed did not believe that housing prices had formed a bubble hellip until it was blindingly obvious
The Housing Bubble Securitization
bull In the past people with money did not like to lend money to home buyers because such loans were risky and had unreliable returns
bull 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
bull The financial sector was regulated by people who were ideologically opposed to regulation
bull They turned a blind eye to even the worst lending practices
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
THE SPENDING HYPOTHESIS
Reasons for the IS shiftbull Stock market crash exogenous C
ndash Oct-Dec 1929 SampP 500 fell 17ndash Oct 1929-Dec 1933 SampP 500 fell 71
bull Drop in investmentndash ldquocorrectionrdquo after overbuilding in the 1920sndash widespread bank failures in early 1930s made it harder
to obtain financing for investmentbull Contractionary fiscal policy
ndash Politicians raised tax rates in 1932 and cut spending to combat increasing deficits
THE MONEY HYPOTHESIS
A shock to the LM curvebull asserts that the Depression was largely due to
huge fall in the money supplybull evidence M1 fell 25 during 1929-33 bull But two problems with this hypothesis
ndash P fell even more so MP actually rose slightly during 1929-31
ndash nominal interest rates fell which is the opposite of what a leftward LM shift would cause
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull asserts that the severity of the Depression
was due to a huge deflation ndash P fell 25 during 1929-33
bull This deflation was probably caused by the fall in M so perhaps money played an important role after all
bull In what ways does a deflation affect the economy
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The stabilizing effects of deflationbull P (MP ) LM shifts right Ybull Pigou effect
P (MP )
consumersrsquo wealth
C
IS shifts right
Y
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects
of expected deflation E
bull LM curve shifts leftr and I (r ) planned expenditure income and output
bull Also the nominal interest rate decreases (idarr) ndash see IS-LM predictions grid
IS
Y
rLM
r1
Y1
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects of unexpected deflation
debt-deflation theoryP (if unexpected)
transfers purchasing power from borrowers to lenders
borrowers spend less lenders spend more if borrowersrsquo propensity to spend is larger than
lendersrsquo then aggregate spending falls the IS curve shifts left and Y falls
The evidence on output and nominal interest rates
bull Note that other than the money hypothesis all the other hypothesesmdashthe spending hypothesis the debt-deflation hypothesis and the deflationary expectations hypothesismdashpredict falling real GDP and falling nominal interest rates
bull This is exactly what happened in the early stages of the Great Depression
bull The spending hypothesis and the debt-deflation hypothesis both predict falling real interest rates whereas the deflationary expectations hypothesis predicts rising real interest rates
bull Therefore evidence on real interest rates is crucial in identifying suitable explanations for the Great Depression
Why another Depression is unlikelybull Policymakers (or their advisors) now know much more
about macroeconomicsndash The Fed knows better than to let M fall so much
especially during a contractionndash Fiscal policymakers know better than to raise
taxes or cut spending during a contractionbull Federal deposit insurance makes widespread bank
failures very unlikely
bull Automatic stabilizers make fiscal policy expansionary during an economic downturn
THE FINANCIAL CRISIS AND ECONOMIC DOWNTURN OF 2008 AND 2009
CASE STUDYThe 2008-09 Financial Crisis amp Recession
bull 2009 Real GDP fell unemployment rate approached 10
bull Important factors in the crisisndash early 2000s Federal Reserve interest rate policy ndash sub-prime mortgage crisisndash bursting of house price bubble rising foreclosure
ratesndash falling stock pricesndash failing financial institutionsndash declining consumer confidence drop in spending on
consumer durables and investment goods
A Too-Brief and Too-Simple Explanation
bull The price of housing had risen to unsustainable levels
bull When home prices inevitably crashed people suddenly felt poor and cut back their spending plans
bull This fall in planned expenditure brought about the Great Recession of 2008-09
The Housing Bubble Inflates then Deflates
bull The SampP Case-Shiller 20-City Home Price Index went from ndash 100 in Jan 2000 tondash 20654 in April 2006 tondash 14095 in May 2009 tondash 14216 in Dec 2010
bull Why did the housing bubble inflate
The Housing Bubble Reasons
bull The Fed kept the interest rates too low for too long
bull Securitization technology got a lot fancier in the mortgage bond market
bull The government regulators were sleepingbull Pretty much everybody believed that home
prices could never fall
The Housing Bubble Low FFR
bull The Fed had reduced the Federal Funds Rate to fight the Recession of 2001
bull After that recession ended the Fed continued to keep interest rates low until 2004ndash The Fed was watching inflation which remained
tame Consequently the Fed saw little reason to raise interest rates
ndash The Fed did not believe that housing prices had formed a bubble hellip until it was blindingly obvious
The Housing Bubble Securitization
bull In the past people with money did not like to lend money to home buyers because such loans were risky and had unreliable returns
bull 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
bull The financial sector was regulated by people who were ideologically opposed to regulation
bull They turned a blind eye to even the worst lending practices
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
THE MONEY HYPOTHESIS
A shock to the LM curvebull asserts that the Depression was largely due to
huge fall in the money supplybull evidence M1 fell 25 during 1929-33 bull But two problems with this hypothesis
ndash P fell even more so MP actually rose slightly during 1929-31
ndash nominal interest rates fell which is the opposite of what a leftward LM shift would cause
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull asserts that the severity of the Depression
was due to a huge deflation ndash P fell 25 during 1929-33
bull This deflation was probably caused by the fall in M so perhaps money played an important role after all
bull In what ways does a deflation affect the economy
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The stabilizing effects of deflationbull P (MP ) LM shifts right Ybull Pigou effect
P (MP )
consumersrsquo wealth
C
IS shifts right
Y
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects
of expected deflation E
bull LM curve shifts leftr and I (r ) planned expenditure income and output
bull Also the nominal interest rate decreases (idarr) ndash see IS-LM predictions grid
IS
Y
rLM
r1
Y1
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects of unexpected deflation
debt-deflation theoryP (if unexpected)
transfers purchasing power from borrowers to lenders
borrowers spend less lenders spend more if borrowersrsquo propensity to spend is larger than
lendersrsquo then aggregate spending falls the IS curve shifts left and Y falls
The evidence on output and nominal interest rates
bull Note that other than the money hypothesis all the other hypothesesmdashthe spending hypothesis the debt-deflation hypothesis and the deflationary expectations hypothesismdashpredict falling real GDP and falling nominal interest rates
bull This is exactly what happened in the early stages of the Great Depression
bull The spending hypothesis and the debt-deflation hypothesis both predict falling real interest rates whereas the deflationary expectations hypothesis predicts rising real interest rates
bull Therefore evidence on real interest rates is crucial in identifying suitable explanations for the Great Depression
Why another Depression is unlikelybull Policymakers (or their advisors) now know much more
about macroeconomicsndash The Fed knows better than to let M fall so much
especially during a contractionndash Fiscal policymakers know better than to raise
taxes or cut spending during a contractionbull Federal deposit insurance makes widespread bank
failures very unlikely
bull Automatic stabilizers make fiscal policy expansionary during an economic downturn
THE FINANCIAL CRISIS AND ECONOMIC DOWNTURN OF 2008 AND 2009
CASE STUDYThe 2008-09 Financial Crisis amp Recession
bull 2009 Real GDP fell unemployment rate approached 10
bull Important factors in the crisisndash early 2000s Federal Reserve interest rate policy ndash sub-prime mortgage crisisndash bursting of house price bubble rising foreclosure
ratesndash falling stock pricesndash failing financial institutionsndash declining consumer confidence drop in spending on
consumer durables and investment goods
A Too-Brief and Too-Simple Explanation
bull The price of housing had risen to unsustainable levels
bull When home prices inevitably crashed people suddenly felt poor and cut back their spending plans
bull This fall in planned expenditure brought about the Great Recession of 2008-09
The Housing Bubble Inflates then Deflates
bull The SampP Case-Shiller 20-City Home Price Index went from ndash 100 in Jan 2000 tondash 20654 in April 2006 tondash 14095 in May 2009 tondash 14216 in Dec 2010
bull Why did the housing bubble inflate
The Housing Bubble Reasons
bull The Fed kept the interest rates too low for too long
bull Securitization technology got a lot fancier in the mortgage bond market
bull The government regulators were sleepingbull Pretty much everybody believed that home
prices could never fall
The Housing Bubble Low FFR
bull The Fed had reduced the Federal Funds Rate to fight the Recession of 2001
bull After that recession ended the Fed continued to keep interest rates low until 2004ndash The Fed was watching inflation which remained
tame Consequently the Fed saw little reason to raise interest rates
ndash The Fed did not believe that housing prices had formed a bubble hellip until it was blindingly obvious
The Housing Bubble Securitization
bull In the past people with money did not like to lend money to home buyers because such loans were risky and had unreliable returns
bull 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
bull The financial sector was regulated by people who were ideologically opposed to regulation
bull They turned a blind eye to even the worst lending practices
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull asserts that the severity of the Depression
was due to a huge deflation ndash P fell 25 during 1929-33
bull This deflation was probably caused by the fall in M so perhaps money played an important role after all
bull In what ways does a deflation affect the economy
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The stabilizing effects of deflationbull P (MP ) LM shifts right Ybull Pigou effect
P (MP )
consumersrsquo wealth
C
IS shifts right
Y
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects
of expected deflation E
bull LM curve shifts leftr and I (r ) planned expenditure income and output
bull Also the nominal interest rate decreases (idarr) ndash see IS-LM predictions grid
IS
Y
rLM
r1
Y1
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects of unexpected deflation
debt-deflation theoryP (if unexpected)
transfers purchasing power from borrowers to lenders
borrowers spend less lenders spend more if borrowersrsquo propensity to spend is larger than
lendersrsquo then aggregate spending falls the IS curve shifts left and Y falls
The evidence on output and nominal interest rates
bull Note that other than the money hypothesis all the other hypothesesmdashthe spending hypothesis the debt-deflation hypothesis and the deflationary expectations hypothesismdashpredict falling real GDP and falling nominal interest rates
bull This is exactly what happened in the early stages of the Great Depression
bull The spending hypothesis and the debt-deflation hypothesis both predict falling real interest rates whereas the deflationary expectations hypothesis predicts rising real interest rates
bull Therefore evidence on real interest rates is crucial in identifying suitable explanations for the Great Depression
Why another Depression is unlikelybull Policymakers (or their advisors) now know much more
about macroeconomicsndash The Fed knows better than to let M fall so much
especially during a contractionndash Fiscal policymakers know better than to raise
taxes or cut spending during a contractionbull Federal deposit insurance makes widespread bank
failures very unlikely
bull Automatic stabilizers make fiscal policy expansionary during an economic downturn
THE FINANCIAL CRISIS AND ECONOMIC DOWNTURN OF 2008 AND 2009
CASE STUDYThe 2008-09 Financial Crisis amp Recession
bull 2009 Real GDP fell unemployment rate approached 10
bull Important factors in the crisisndash early 2000s Federal Reserve interest rate policy ndash sub-prime mortgage crisisndash bursting of house price bubble rising foreclosure
ratesndash falling stock pricesndash failing financial institutionsndash declining consumer confidence drop in spending on
consumer durables and investment goods
A Too-Brief and Too-Simple Explanation
bull The price of housing had risen to unsustainable levels
bull When home prices inevitably crashed people suddenly felt poor and cut back their spending plans
bull This fall in planned expenditure brought about the Great Recession of 2008-09
The Housing Bubble Inflates then Deflates
bull The SampP Case-Shiller 20-City Home Price Index went from ndash 100 in Jan 2000 tondash 20654 in April 2006 tondash 14095 in May 2009 tondash 14216 in Dec 2010
bull Why did the housing bubble inflate
The Housing Bubble Reasons
bull The Fed kept the interest rates too low for too long
bull Securitization technology got a lot fancier in the mortgage bond market
bull The government regulators were sleepingbull Pretty much everybody believed that home
prices could never fall
The Housing Bubble Low FFR
bull The Fed had reduced the Federal Funds Rate to fight the Recession of 2001
bull After that recession ended the Fed continued to keep interest rates low until 2004ndash The Fed was watching inflation which remained
tame Consequently the Fed saw little reason to raise interest rates
ndash The Fed did not believe that housing prices had formed a bubble hellip until it was blindingly obvious
The Housing Bubble Securitization
bull In the past people with money did not like to lend money to home buyers because such loans were risky and had unreliable returns
bull 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
bull The financial sector was regulated by people who were ideologically opposed to regulation
bull They turned a blind eye to even the worst lending practices
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The stabilizing effects of deflationbull P (MP ) LM shifts right Ybull Pigou effect
P (MP )
consumersrsquo wealth
C
IS shifts right
Y
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects
of expected deflation E
bull LM curve shifts leftr and I (r ) planned expenditure income and output
bull Also the nominal interest rate decreases (idarr) ndash see IS-LM predictions grid
IS
Y
rLM
r1
Y1
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects of unexpected deflation
debt-deflation theoryP (if unexpected)
transfers purchasing power from borrowers to lenders
borrowers spend less lenders spend more if borrowersrsquo propensity to spend is larger than
lendersrsquo then aggregate spending falls the IS curve shifts left and Y falls
The evidence on output and nominal interest rates
bull Note that other than the money hypothesis all the other hypothesesmdashthe spending hypothesis the debt-deflation hypothesis and the deflationary expectations hypothesismdashpredict falling real GDP and falling nominal interest rates
bull This is exactly what happened in the early stages of the Great Depression
bull The spending hypothesis and the debt-deflation hypothesis both predict falling real interest rates whereas the deflationary expectations hypothesis predicts rising real interest rates
bull Therefore evidence on real interest rates is crucial in identifying suitable explanations for the Great Depression
Why another Depression is unlikelybull Policymakers (or their advisors) now know much more
about macroeconomicsndash The Fed knows better than to let M fall so much
especially during a contractionndash Fiscal policymakers know better than to raise
taxes or cut spending during a contractionbull Federal deposit insurance makes widespread bank
failures very unlikely
bull Automatic stabilizers make fiscal policy expansionary during an economic downturn
THE FINANCIAL CRISIS AND ECONOMIC DOWNTURN OF 2008 AND 2009
CASE STUDYThe 2008-09 Financial Crisis amp Recession
bull 2009 Real GDP fell unemployment rate approached 10
bull Important factors in the crisisndash early 2000s Federal Reserve interest rate policy ndash sub-prime mortgage crisisndash bursting of house price bubble rising foreclosure
ratesndash falling stock pricesndash failing financial institutionsndash declining consumer confidence drop in spending on
consumer durables and investment goods
A Too-Brief and Too-Simple Explanation
bull The price of housing had risen to unsustainable levels
bull When home prices inevitably crashed people suddenly felt poor and cut back their spending plans
bull This fall in planned expenditure brought about the Great Recession of 2008-09
The Housing Bubble Inflates then Deflates
bull The SampP Case-Shiller 20-City Home Price Index went from ndash 100 in Jan 2000 tondash 20654 in April 2006 tondash 14095 in May 2009 tondash 14216 in Dec 2010
bull Why did the housing bubble inflate
The Housing Bubble Reasons
bull The Fed kept the interest rates too low for too long
bull Securitization technology got a lot fancier in the mortgage bond market
bull The government regulators were sleepingbull Pretty much everybody believed that home
prices could never fall
The Housing Bubble Low FFR
bull The Fed had reduced the Federal Funds Rate to fight the Recession of 2001
bull After that recession ended the Fed continued to keep interest rates low until 2004ndash The Fed was watching inflation which remained
tame Consequently the Fed saw little reason to raise interest rates
ndash The Fed did not believe that housing prices had formed a bubble hellip until it was blindingly obvious
The Housing Bubble Securitization
bull In the past people with money did not like to lend money to home buyers because such loans were risky and had unreliable returns
bull 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
bull The financial sector was regulated by people who were ideologically opposed to regulation
bull They turned a blind eye to even the worst lending practices
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
IS-LM PredictionsIS-LM Predictions
IS Curve LM Curve Y r i
Co + Io + G rarr + + +
T larr minus minus minus
MP rarr + minus minus
Eπ rarr + minus +
Lo larr minus + +
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects
of expected deflation E
bull LM curve shifts leftr and I (r ) planned expenditure income and output
bull Also the nominal interest rate decreases (idarr) ndash see IS-LM predictions grid
IS
Y
rLM
r1
Y1
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects of unexpected deflation
debt-deflation theoryP (if unexpected)
transfers purchasing power from borrowers to lenders
borrowers spend less lenders spend more if borrowersrsquo propensity to spend is larger than
lendersrsquo then aggregate spending falls the IS curve shifts left and Y falls
The evidence on output and nominal interest rates
bull Note that other than the money hypothesis all the other hypothesesmdashthe spending hypothesis the debt-deflation hypothesis and the deflationary expectations hypothesismdashpredict falling real GDP and falling nominal interest rates
bull This is exactly what happened in the early stages of the Great Depression
bull The spending hypothesis and the debt-deflation hypothesis both predict falling real interest rates whereas the deflationary expectations hypothesis predicts rising real interest rates
bull Therefore evidence on real interest rates is crucial in identifying suitable explanations for the Great Depression
Why another Depression is unlikelybull Policymakers (or their advisors) now know much more
about macroeconomicsndash The Fed knows better than to let M fall so much
especially during a contractionndash Fiscal policymakers know better than to raise
taxes or cut spending during a contractionbull Federal deposit insurance makes widespread bank
failures very unlikely
bull Automatic stabilizers make fiscal policy expansionary during an economic downturn
THE FINANCIAL CRISIS AND ECONOMIC DOWNTURN OF 2008 AND 2009
CASE STUDYThe 2008-09 Financial Crisis amp Recession
bull 2009 Real GDP fell unemployment rate approached 10
bull Important factors in the crisisndash early 2000s Federal Reserve interest rate policy ndash sub-prime mortgage crisisndash bursting of house price bubble rising foreclosure
ratesndash falling stock pricesndash failing financial institutionsndash declining consumer confidence drop in spending on
consumer durables and investment goods
A Too-Brief and Too-Simple Explanation
bull The price of housing had risen to unsustainable levels
bull When home prices inevitably crashed people suddenly felt poor and cut back their spending plans
bull This fall in planned expenditure brought about the Great Recession of 2008-09
The Housing Bubble Inflates then Deflates
bull The SampP Case-Shiller 20-City Home Price Index went from ndash 100 in Jan 2000 tondash 20654 in April 2006 tondash 14095 in May 2009 tondash 14216 in Dec 2010
bull Why did the housing bubble inflate
The Housing Bubble Reasons
bull The Fed kept the interest rates too low for too long
bull Securitization technology got a lot fancier in the mortgage bond market
bull The government regulators were sleepingbull Pretty much everybody believed that home
prices could never fall
The Housing Bubble Low FFR
bull The Fed had reduced the Federal Funds Rate to fight the Recession of 2001
bull After that recession ended the Fed continued to keep interest rates low until 2004ndash The Fed was watching inflation which remained
tame Consequently the Fed saw little reason to raise interest rates
ndash The Fed did not believe that housing prices had formed a bubble hellip until it was blindingly obvious
The Housing Bubble Securitization
bull In the past people with money did not like to lend money to home buyers because such loans were risky and had unreliable returns
bull 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
bull The financial sector was regulated by people who were ideologically opposed to regulation
bull They turned a blind eye to even the worst lending practices
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects
of expected deflation E
bull LM curve shifts leftr and I (r ) planned expenditure income and output
bull Also the nominal interest rate decreases (idarr) ndash see IS-LM predictions grid
IS
Y
rLM
r1
Y1
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects of unexpected deflation
debt-deflation theoryP (if unexpected)
transfers purchasing power from borrowers to lenders
borrowers spend less lenders spend more if borrowersrsquo propensity to spend is larger than
lendersrsquo then aggregate spending falls the IS curve shifts left and Y falls
The evidence on output and nominal interest rates
bull Note that other than the money hypothesis all the other hypothesesmdashthe spending hypothesis the debt-deflation hypothesis and the deflationary expectations hypothesismdashpredict falling real GDP and falling nominal interest rates
bull This is exactly what happened in the early stages of the Great Depression
bull The spending hypothesis and the debt-deflation hypothesis both predict falling real interest rates whereas the deflationary expectations hypothesis predicts rising real interest rates
bull Therefore evidence on real interest rates is crucial in identifying suitable explanations for the Great Depression
Why another Depression is unlikelybull Policymakers (or their advisors) now know much more
about macroeconomicsndash The Fed knows better than to let M fall so much
especially during a contractionndash Fiscal policymakers know better than to raise
taxes or cut spending during a contractionbull Federal deposit insurance makes widespread bank
failures very unlikely
bull Automatic stabilizers make fiscal policy expansionary during an economic downturn
THE FINANCIAL CRISIS AND ECONOMIC DOWNTURN OF 2008 AND 2009
CASE STUDYThe 2008-09 Financial Crisis amp Recession
bull 2009 Real GDP fell unemployment rate approached 10
bull Important factors in the crisisndash early 2000s Federal Reserve interest rate policy ndash sub-prime mortgage crisisndash bursting of house price bubble rising foreclosure
ratesndash falling stock pricesndash failing financial institutionsndash declining consumer confidence drop in spending on
consumer durables and investment goods
A Too-Brief and Too-Simple Explanation
bull The price of housing had risen to unsustainable levels
bull When home prices inevitably crashed people suddenly felt poor and cut back their spending plans
bull This fall in planned expenditure brought about the Great Recession of 2008-09
The Housing Bubble Inflates then Deflates
bull The SampP Case-Shiller 20-City Home Price Index went from ndash 100 in Jan 2000 tondash 20654 in April 2006 tondash 14095 in May 2009 tondash 14216 in Dec 2010
bull Why did the housing bubble inflate
The Housing Bubble Reasons
bull The Fed kept the interest rates too low for too long
bull Securitization technology got a lot fancier in the mortgage bond market
bull The government regulators were sleepingbull Pretty much everybody believed that home
prices could never fall
The Housing Bubble Low FFR
bull The Fed had reduced the Federal Funds Rate to fight the Recession of 2001
bull After that recession ended the Fed continued to keep interest rates low until 2004ndash The Fed was watching inflation which remained
tame Consequently the Fed saw little reason to raise interest rates
ndash The Fed did not believe that housing prices had formed a bubble hellip until it was blindingly obvious
The Housing Bubble Securitization
bull In the past people with money did not like to lend money to home buyers because such loans were risky and had unreliable returns
bull 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
bull The financial sector was regulated by people who were ideologically opposed to regulation
bull They turned a blind eye to even the worst lending practices
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
THE MONEY HYPOTHESIS AGAIN
The effects of falling pricesbull The destabilizing effects of unexpected deflation
debt-deflation theoryP (if unexpected)
transfers purchasing power from borrowers to lenders
borrowers spend less lenders spend more if borrowersrsquo propensity to spend is larger than
lendersrsquo then aggregate spending falls the IS curve shifts left and Y falls
The evidence on output and nominal interest rates
bull Note that other than the money hypothesis all the other hypothesesmdashthe spending hypothesis the debt-deflation hypothesis and the deflationary expectations hypothesismdashpredict falling real GDP and falling nominal interest rates
bull This is exactly what happened in the early stages of the Great Depression
bull The spending hypothesis and the debt-deflation hypothesis both predict falling real interest rates whereas the deflationary expectations hypothesis predicts rising real interest rates
bull Therefore evidence on real interest rates is crucial in identifying suitable explanations for the Great Depression
Why another Depression is unlikelybull Policymakers (or their advisors) now know much more
about macroeconomicsndash The Fed knows better than to let M fall so much
especially during a contractionndash Fiscal policymakers know better than to raise
taxes or cut spending during a contractionbull Federal deposit insurance makes widespread bank
failures very unlikely
bull Automatic stabilizers make fiscal policy expansionary during an economic downturn
THE FINANCIAL CRISIS AND ECONOMIC DOWNTURN OF 2008 AND 2009
CASE STUDYThe 2008-09 Financial Crisis amp Recession
bull 2009 Real GDP fell unemployment rate approached 10
bull Important factors in the crisisndash early 2000s Federal Reserve interest rate policy ndash sub-prime mortgage crisisndash bursting of house price bubble rising foreclosure
ratesndash falling stock pricesndash failing financial institutionsndash declining consumer confidence drop in spending on
consumer durables and investment goods
A Too-Brief and Too-Simple Explanation
bull The price of housing had risen to unsustainable levels
bull When home prices inevitably crashed people suddenly felt poor and cut back their spending plans
bull This fall in planned expenditure brought about the Great Recession of 2008-09
The Housing Bubble Inflates then Deflates
bull The SampP Case-Shiller 20-City Home Price Index went from ndash 100 in Jan 2000 tondash 20654 in April 2006 tondash 14095 in May 2009 tondash 14216 in Dec 2010
bull Why did the housing bubble inflate
The Housing Bubble Reasons
bull The Fed kept the interest rates too low for too long
bull Securitization technology got a lot fancier in the mortgage bond market
bull The government regulators were sleepingbull Pretty much everybody believed that home
prices could never fall
The Housing Bubble Low FFR
bull The Fed had reduced the Federal Funds Rate to fight the Recession of 2001
bull After that recession ended the Fed continued to keep interest rates low until 2004ndash The Fed was watching inflation which remained
tame Consequently the Fed saw little reason to raise interest rates
ndash The Fed did not believe that housing prices had formed a bubble hellip until it was blindingly obvious
The Housing Bubble Securitization
bull In the past people with money did not like to lend money to home buyers because such loans were risky and had unreliable returns
bull 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
bull The financial sector was regulated by people who were ideologically opposed to regulation
bull They turned a blind eye to even the worst lending practices
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
The evidence on output and nominal interest rates
bull Note that other than the money hypothesis all the other hypothesesmdashthe spending hypothesis the debt-deflation hypothesis and the deflationary expectations hypothesismdashpredict falling real GDP and falling nominal interest rates
bull This is exactly what happened in the early stages of the Great Depression
bull The spending hypothesis and the debt-deflation hypothesis both predict falling real interest rates whereas the deflationary expectations hypothesis predicts rising real interest rates
bull Therefore evidence on real interest rates is crucial in identifying suitable explanations for the Great Depression
Why another Depression is unlikelybull Policymakers (or their advisors) now know much more
about macroeconomicsndash The Fed knows better than to let M fall so much
especially during a contractionndash Fiscal policymakers know better than to raise
taxes or cut spending during a contractionbull Federal deposit insurance makes widespread bank
failures very unlikely
bull Automatic stabilizers make fiscal policy expansionary during an economic downturn
THE FINANCIAL CRISIS AND ECONOMIC DOWNTURN OF 2008 AND 2009
CASE STUDYThe 2008-09 Financial Crisis amp Recession
bull 2009 Real GDP fell unemployment rate approached 10
bull Important factors in the crisisndash early 2000s Federal Reserve interest rate policy ndash sub-prime mortgage crisisndash bursting of house price bubble rising foreclosure
ratesndash falling stock pricesndash failing financial institutionsndash declining consumer confidence drop in spending on
consumer durables and investment goods
A Too-Brief and Too-Simple Explanation
bull The price of housing had risen to unsustainable levels
bull When home prices inevitably crashed people suddenly felt poor and cut back their spending plans
bull This fall in planned expenditure brought about the Great Recession of 2008-09
The Housing Bubble Inflates then Deflates
bull The SampP Case-Shiller 20-City Home Price Index went from ndash 100 in Jan 2000 tondash 20654 in April 2006 tondash 14095 in May 2009 tondash 14216 in Dec 2010
bull Why did the housing bubble inflate
The Housing Bubble Reasons
bull The Fed kept the interest rates too low for too long
bull Securitization technology got a lot fancier in the mortgage bond market
bull The government regulators were sleepingbull Pretty much everybody believed that home
prices could never fall
The Housing Bubble Low FFR
bull The Fed had reduced the Federal Funds Rate to fight the Recession of 2001
bull After that recession ended the Fed continued to keep interest rates low until 2004ndash The Fed was watching inflation which remained
tame Consequently the Fed saw little reason to raise interest rates
ndash The Fed did not believe that housing prices had formed a bubble hellip until it was blindingly obvious
The Housing Bubble Securitization
bull In the past people with money did not like to lend money to home buyers because such loans were risky and had unreliable returns
bull 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
bull The financial sector was regulated by people who were ideologically opposed to regulation
bull They turned a blind eye to even the worst lending practices
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
Why another Depression is unlikelybull Policymakers (or their advisors) now know much more
about macroeconomicsndash The Fed knows better than to let M fall so much
especially during a contractionndash Fiscal policymakers know better than to raise
taxes or cut spending during a contractionbull Federal deposit insurance makes widespread bank
failures very unlikely
bull Automatic stabilizers make fiscal policy expansionary during an economic downturn
THE FINANCIAL CRISIS AND ECONOMIC DOWNTURN OF 2008 AND 2009
CASE STUDYThe 2008-09 Financial Crisis amp Recession
bull 2009 Real GDP fell unemployment rate approached 10
bull Important factors in the crisisndash early 2000s Federal Reserve interest rate policy ndash sub-prime mortgage crisisndash bursting of house price bubble rising foreclosure
ratesndash falling stock pricesndash failing financial institutionsndash declining consumer confidence drop in spending on
consumer durables and investment goods
A Too-Brief and Too-Simple Explanation
bull The price of housing had risen to unsustainable levels
bull When home prices inevitably crashed people suddenly felt poor and cut back their spending plans
bull This fall in planned expenditure brought about the Great Recession of 2008-09
The Housing Bubble Inflates then Deflates
bull The SampP Case-Shiller 20-City Home Price Index went from ndash 100 in Jan 2000 tondash 20654 in April 2006 tondash 14095 in May 2009 tondash 14216 in Dec 2010
bull Why did the housing bubble inflate
The Housing Bubble Reasons
bull The Fed kept the interest rates too low for too long
bull Securitization technology got a lot fancier in the mortgage bond market
bull The government regulators were sleepingbull Pretty much everybody believed that home
prices could never fall
The Housing Bubble Low FFR
bull The Fed had reduced the Federal Funds Rate to fight the Recession of 2001
bull After that recession ended the Fed continued to keep interest rates low until 2004ndash The Fed was watching inflation which remained
tame Consequently the Fed saw little reason to raise interest rates
ndash The Fed did not believe that housing prices had formed a bubble hellip until it was blindingly obvious
The Housing Bubble Securitization
bull In the past people with money did not like to lend money to home buyers because such loans were risky and had unreliable returns
bull 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
bull The financial sector was regulated by people who were ideologically opposed to regulation
bull They turned a blind eye to even the worst lending practices
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
THE FINANCIAL CRISIS AND ECONOMIC DOWNTURN OF 2008 AND 2009
CASE STUDYThe 2008-09 Financial Crisis amp Recession
bull 2009 Real GDP fell unemployment rate approached 10
bull Important factors in the crisisndash early 2000s Federal Reserve interest rate policy ndash sub-prime mortgage crisisndash bursting of house price bubble rising foreclosure
ratesndash falling stock pricesndash failing financial institutionsndash declining consumer confidence drop in spending on
consumer durables and investment goods
A Too-Brief and Too-Simple Explanation
bull The price of housing had risen to unsustainable levels
bull When home prices inevitably crashed people suddenly felt poor and cut back their spending plans
bull This fall in planned expenditure brought about the Great Recession of 2008-09
The Housing Bubble Inflates then Deflates
bull The SampP Case-Shiller 20-City Home Price Index went from ndash 100 in Jan 2000 tondash 20654 in April 2006 tondash 14095 in May 2009 tondash 14216 in Dec 2010
bull Why did the housing bubble inflate
The Housing Bubble Reasons
bull The Fed kept the interest rates too low for too long
bull Securitization technology got a lot fancier in the mortgage bond market
bull The government regulators were sleepingbull Pretty much everybody believed that home
prices could never fall
The Housing Bubble Low FFR
bull The Fed had reduced the Federal Funds Rate to fight the Recession of 2001
bull After that recession ended the Fed continued to keep interest rates low until 2004ndash The Fed was watching inflation which remained
tame Consequently the Fed saw little reason to raise interest rates
ndash The Fed did not believe that housing prices had formed a bubble hellip until it was blindingly obvious
The Housing Bubble Securitization
bull In the past people with money did not like to lend money to home buyers because such loans were risky and had unreliable returns
bull 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
bull The financial sector was regulated by people who were ideologically opposed to regulation
bull They turned a blind eye to even the worst lending practices
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
CASE STUDYThe 2008-09 Financial Crisis amp Recession
bull 2009 Real GDP fell unemployment rate approached 10
bull Important factors in the crisisndash early 2000s Federal Reserve interest rate policy ndash sub-prime mortgage crisisndash bursting of house price bubble rising foreclosure
ratesndash falling stock pricesndash failing financial institutionsndash declining consumer confidence drop in spending on
consumer durables and investment goods
A Too-Brief and Too-Simple Explanation
bull The price of housing had risen to unsustainable levels
bull When home prices inevitably crashed people suddenly felt poor and cut back their spending plans
bull This fall in planned expenditure brought about the Great Recession of 2008-09
The Housing Bubble Inflates then Deflates
bull The SampP Case-Shiller 20-City Home Price Index went from ndash 100 in Jan 2000 tondash 20654 in April 2006 tondash 14095 in May 2009 tondash 14216 in Dec 2010
bull Why did the housing bubble inflate
The Housing Bubble Reasons
bull The Fed kept the interest rates too low for too long
bull Securitization technology got a lot fancier in the mortgage bond market
bull The government regulators were sleepingbull Pretty much everybody believed that home
prices could never fall
The Housing Bubble Low FFR
bull The Fed had reduced the Federal Funds Rate to fight the Recession of 2001
bull After that recession ended the Fed continued to keep interest rates low until 2004ndash The Fed was watching inflation which remained
tame Consequently the Fed saw little reason to raise interest rates
ndash The Fed did not believe that housing prices had formed a bubble hellip until it was blindingly obvious
The Housing Bubble Securitization
bull In the past people with money did not like to lend money to home buyers because such loans were risky and had unreliable returns
bull 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
bull The financial sector was regulated by people who were ideologically opposed to regulation
bull They turned a blind eye to even the worst lending practices
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
A Too-Brief and Too-Simple Explanation
bull The price of housing had risen to unsustainable levels
bull When home prices inevitably crashed people suddenly felt poor and cut back their spending plans
bull This fall in planned expenditure brought about the Great Recession of 2008-09
The Housing Bubble Inflates then Deflates
bull The SampP Case-Shiller 20-City Home Price Index went from ndash 100 in Jan 2000 tondash 20654 in April 2006 tondash 14095 in May 2009 tondash 14216 in Dec 2010
bull Why did the housing bubble inflate
The Housing Bubble Reasons
bull The Fed kept the interest rates too low for too long
bull Securitization technology got a lot fancier in the mortgage bond market
bull The government regulators were sleepingbull Pretty much everybody believed that home
prices could never fall
The Housing Bubble Low FFR
bull The Fed had reduced the Federal Funds Rate to fight the Recession of 2001
bull After that recession ended the Fed continued to keep interest rates low until 2004ndash The Fed was watching inflation which remained
tame Consequently the Fed saw little reason to raise interest rates
ndash The Fed did not believe that housing prices had formed a bubble hellip until it was blindingly obvious
The Housing Bubble Securitization
bull In the past people with money did not like to lend money to home buyers because such loans were risky and had unreliable returns
bull 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
bull The financial sector was regulated by people who were ideologically opposed to regulation
bull They turned a blind eye to even the worst lending practices
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
The Housing Bubble Inflates then Deflates
bull The SampP Case-Shiller 20-City Home Price Index went from ndash 100 in Jan 2000 tondash 20654 in April 2006 tondash 14095 in May 2009 tondash 14216 in Dec 2010
bull Why did the housing bubble inflate
The Housing Bubble Reasons
bull The Fed kept the interest rates too low for too long
bull Securitization technology got a lot fancier in the mortgage bond market
bull The government regulators were sleepingbull Pretty much everybody believed that home
prices could never fall
The Housing Bubble Low FFR
bull The Fed had reduced the Federal Funds Rate to fight the Recession of 2001
bull After that recession ended the Fed continued to keep interest rates low until 2004ndash The Fed was watching inflation which remained
tame Consequently the Fed saw little reason to raise interest rates
ndash The Fed did not believe that housing prices had formed a bubble hellip until it was blindingly obvious
The Housing Bubble Securitization
bull In the past people with money did not like to lend money to home buyers because such loans were risky and had unreliable returns
bull 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
bull The financial sector was regulated by people who were ideologically opposed to regulation
bull They turned a blind eye to even the worst lending practices
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
The Housing Bubble Reasons
bull The Fed kept the interest rates too low for too long
bull Securitization technology got a lot fancier in the mortgage bond market
bull The government regulators were sleepingbull Pretty much everybody believed that home
prices could never fall
The Housing Bubble Low FFR
bull The Fed had reduced the Federal Funds Rate to fight the Recession of 2001
bull After that recession ended the Fed continued to keep interest rates low until 2004ndash The Fed was watching inflation which remained
tame Consequently the Fed saw little reason to raise interest rates
ndash The Fed did not believe that housing prices had formed a bubble hellip until it was blindingly obvious
The Housing Bubble Securitization
bull In the past people with money did not like to lend money to home buyers because such loans were risky and had unreliable returns
bull 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
bull The financial sector was regulated by people who were ideologically opposed to regulation
bull They turned a blind eye to even the worst lending practices
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
The Housing Bubble Low FFR
bull The Fed had reduced the Federal Funds Rate to fight the Recession of 2001
bull After that recession ended the Fed continued to keep interest rates low until 2004ndash The Fed was watching inflation which remained
tame Consequently the Fed saw little reason to raise interest rates
ndash The Fed did not believe that housing prices had formed a bubble hellip until it was blindingly obvious
The Housing Bubble Securitization
bull In the past people with money did not like to lend money to home buyers because such loans were risky and had unreliable returns
bull 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
bull The financial sector was regulated by people who were ideologically opposed to regulation
bull They turned a blind eye to even the worst lending practices
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
The Housing Bubble Securitization
bull In the past people with money did not like to lend money to home buyers because such loans were risky and had unreliable returns
bull 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
bull The financial sector was regulated by people who were ideologically opposed to regulation
bull They turned a blind eye to even the worst lending practices
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
The Housing Bubble Weak Regulators
bull The financial sector was regulated by people who were ideologically opposed to regulation
bull They turned a blind eye to even the worst lending practices
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
The Housing Bubble Inflates
bull The Fedrsquos low-interest policy and financial innovation made it easy for home buyers to borrow money
bull Lax regulation allowed subprime lendingndash That is lending to people who had few assets andor
prospects that would make repayment likely
bull The belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash Home owners began to default on their loansndash Foreclosures increasedndash This flooded the market with more homes for salendash Which led to further declines in home pricesndash These cascading and self-reinforcing home price
declines made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
The Housing Bubble Deflates
bull After mid-2006 home prices started to fallndash The financial institutions that had made mortgage
loans faced huge losses when borrowers began to default
ndash These institutions began to second guess their ability to spot good borrowers So they reduced lending
ndash 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
ndash Business investment spending collapsed
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
The Housing Bubble Deflatesbull After mid-2006 home prices started to fall
ndash Financial institutions were revealed to have suffered huge losses
ndash Non-financial businesses were not getting loans and were shutting down
ndash But a lack of transparency meant that it was not possible to figure out which companies would collapse next
ndash This caused great uncertaintyndash People with money sold off their stocks and bondsndash The decline in stock prices made people feel poorndash Consumption spending fell
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
The Housing Bubble Deflates
bull The collapse of the housing bubble led through a complex chain of causation to major declines in consumption and investment spending
bull One can think of all this as a shift of the IS curve to the left
bull This brings about a recession with falling output and rising unemployment
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
The Fedrsquos Response
bull The Federal Reserve reduced the Federal Funds Rate ndash from 525 in Sept 2007 ndash to essentially zero in Dec 2008
bull The Fed had reached the zero lower bound and could not go any further
bull The Fed is now trying less orthodox measures called quantitative easing to reduce long-term interest rates
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
The Federal Governmentrsquos Response
bull In October 2008 the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall Street
bull 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
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
Slow Recovery
bull The Great Recession officially ended in June 2009
bull But the recovery has been very slowbull Real GDP grew at 31 in the fourth quarter of
2010bull The unemployment rate was at 89 in
February 2011
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
THE GREAT RECESSION CHARTBOOK
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
Interest rates and house prices
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
Change in US house price index and rate of new foreclosures 1999-2009
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
House price change and new foreclosures 2006Q3 ndash 2009Q1N
ew f
ore
clo
sure
s
o
f al
l m
ort
gag
es
Cumulative change in house price index
Nevada
Georgia
Colorado
Texas
AlaskaWyoming
Arizona
California
Florida
S Dakota
Illinois
Michigan
Rhode Island
N Dakota
Oregon
Ohio
New Jersey
Hawaii
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
US bank failures by year 2000-2009
as of July 24 2009
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
Major US stock indexes ( change from 52 weeks earlier)
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
Consumer sentiment and growth in consumer durables and investment spending
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
Real GDP growth and Unemployment
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
The Fed Tried MP Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
But the Fed hit the zero lower bound
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
Falling mortgage rates helped
Note that there is a link between the two rates though weak
Mortgage rates were very low between lsquo04 and lsquo06 They may have contributed to the housing bubble
In hindsight the FFR should have been higher in 2003-06 But inflation was low
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
Record low mortgage rates
The unusually low mortgage rates may have helped to inflate the housing bubble
Mortgage rates are even lower now But credit standards have been tightened In any case the economy is still weak So donrsquot 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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
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 ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
The Stock Market Tanks
In 2007 it becomes clear that banks would get hit by the collapse of the housing bubble
The ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
The ldquoFear Indexrdquo Spikes
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
The ldquoFear Indexrdquo 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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
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 Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
Business Investment Tanks
From 2007 investment which includes new housing absolutely crashed
Unemployment Shot Up
Remember Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
Unemployment Shot Up
Remember Okunrsquos Law
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
Unemployment Shot Up
Remember Okunrsquos Law Because GDP growth has remained below 3 unemployment has remained stubbornly high
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
Inflation Fell Sharply
The Fed pays more attention to the ldquocore inflation raterdquo which ignores food and energy Now you see why The downward trend in core inflation is a worry we donrsquot 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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
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
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-
This recession was special job losses
Horizontal axis shows months Vertical axis shows the ratio of that monthrsquos nonfarm payrolls to the nonfarm payrolls at the start of recession And this doesnrsquot even account for the fact that the working-age population has continued to grow meaning that if the economy were healthy we should have more jobs today than we had before the recession
- Aggregate Demand II Applying the IS-LM Model
- Applying the IS-LM Model
- The IS-LM Model Ch 11 Assumptions
- The IS-LM Model Ch 11 Summary
- Slide 5
- Equilibrium in the IS -LM model
- Shifts of the IS curve
- Slide 8
- Slide 9
- Ch 11 Comparing fiscal policy in the Keynesian Cross and in the IS Curve
- Fiscal Policy is Weakened by the Crowding-Out Effect
- An increase in government purchases graph
- A tax cut
- Shifts of the LM curve
- Slide 15
- Slide 16
- Slide 17
- IS-LM Predictions
- Monetary Policy
- Slide 20
- Slide 21
- Monetary Policy Re-defined
- The Federal Funds Rate
- Slide 24
- Slide 25
- The Zero Lower Bound on Nominal Interest Rates
- Slide 27
- The Zero Lower Bound on Nominal Interest Rates Crisis 2008-09
- Slide 29
- Slide 30
- Slide 31
- The Zero Lower Bound on Nominal Interest Rates Solutions
- Slide 33
- Slide 34
- Slide 35
- Interaction between monetary and fiscal policy
- The Fedrsquos response to G gt 0
- Response 1 Hold M constant
- Response 2 Hold r constant
- Response 3 Hold Y constant
- Estimates of fiscal policy multipliers
- Shocks in the IS -LM model
- Slide 43
- NOW YOU TRY Analyze shocks with the IS-LM Model
- CASE STUDY The US Recession of 2001
- The US Recession of 2001
- Slide 47
- Recall IS-LM Predictions
- Slide 49
- CASE STUDY The US recession of 2001
- Slide 51
- Slide 52
- Skip
- The Great Depression
- Slide 57
- THE SPENDING HYPOTHESIS Shocks to the IS curve
- THE SPENDING HYPOTHESIS Reasons for the IS shift
- THE MONEY HYPOTHESIS A shock to the LM curve
- THE MONEY HYPOTHESIS AGAIN The effects of falling prices
- Slide 62
- Slide 63
- Slide 64
- Slide 65
- The evidence on output and nominal interest rates
- Why another Depression is unlikely
- The financial crisis and economic downturn of 2008 and 2009
- CASE STUDY The 2008-09 Financial Crisis amp Recession
- A Too-Brief and Too-Simple Explanation
- The Housing Bubble Inflates then Deflates
- The Housing Bubble Reasons
- The Housing Bubble Low FFR
- The Housing Bubble Securitization
- The Housing Bubble Weak Regulators
- The Housing Bubble Inflates
- The Housing Bubble Deflates
- Slide 78
- Slide 79
- Slide 80
- The Fedrsquos Response
- The Federal Governmentrsquos Response
- Slow Recovery
- The great recession chartbook
- Interest rates and house prices
- Change in US house price index and rate of new foreclosures 1999-2009
- House price change and new foreclosures 2006Q3 ndash 2009Q1
- US bank failures by year 2000-2009
- Major US stock indexes ( change from 52 weeks earlier)
- Consumer sentiment and growth in consumer durables and investment spending
- Real GDP growth and Unemployment
- The Fed Tried MP Kept Rising
- But the Fed hit the zero lower bound
- Falling mortgage rates helped
- Record low mortgage rates
- The Housing Bubble Inflates and then Deflates
- The Stock Market Tanks
- The ldquoFear Indexrdquo Spikes
- Slide 99
- Consumption Spending Falls
- Business Investment Tanks
- Unemployment Shot Up
- Slide 103
- Inflation Fell Sharply
- A Yawning Budget Deficit
- Slide 106
- Slide 107
- This recession was special job losses
-