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 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 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 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 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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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 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 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 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 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 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 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 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 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 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 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 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 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 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

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 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

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

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

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

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

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

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

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

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 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 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

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 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

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 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

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

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 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 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 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 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 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 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 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

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 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 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 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

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 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

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

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 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 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 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 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 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

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 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 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 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 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 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 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

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 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

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

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

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

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

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

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

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 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

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

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

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 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