Presentation on theme: "Aggregate Demand II: Applying the IS-LM Model"— Presentation transcript:
1 Aggregate Demand II: Applying the IS-LM Model Chapter 12 of Macroeconomics, 8th edition, by N. Gregory MankiwECO62 Udayan Roy
2 Applying the IS-LM Model 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 runSection 12-3 extends section 12-1 by looking closely atThe Great Depression of the 1930s, andThe Great recession ofWarning: I will skip section 12-2! Very sorry!
3 The IS-LM Model: Ch. 11 Assumptions Y = C + I + GC = Co + Cy ✕ (Y – T)I = Io − IrrG and T are exogenousM = Md = L(i) ✕ P ✕ YL(i) = Lo – Li ✕ ii = r + EπM, P and Eπ are exogenous
4 The IS-LM Model: Ch. 11 Summary Y = C + I + GC = Co + Cy ✕ (Y – T)I = Io − IrrG and T are exogenousM = Md = L(i) ✕ P ✕ YL(i) = Lo – Li ✕ ii = r + EπM, P and Eπ are exogenous
5 The IS-LM Model: Ch. 11 Summary Short-run equilibrium in the goods market is represented by a downward-sloping IS curve linking Y and r.Short-run equilibrium in the money market is represented by an upward-sloping LM curve linking Y and r.The intersection of the IS and LM curves determine the short-run equilibrium values of Y and r.The IS curve shifts right if there is:an increase in Co + Io + G, ora decrease in T.The LM curve shifts right if:M/P or Eπ increases, orLo decreasesYrLMIS
6 Equilibrium in the IS -LM model The IS curve represents equilibrium in the goods market.YrLMISr1The LM curve represents money market equilibrium.Review/recap of the very end of Chapter 11.Y1
7 Shifts of the IS curve Recall from Chapter 11 that the consumption function is C(Y – T) = Co + Cy ✕ (Y – T), andThe investment function is I(r) = Io – Ir ✕ rRecall also that the IS curve shifts right if there is:an increase in Co + Io + G, ora decrease in T.As a result, both Y and r increaseLMr1ISYY1
8 Shifts of the IS curverSimilarly, the IS curve shifts left if there is:a decrease in Co + Io + G, oran increase in T.As a result, both Y and r decreaseLMr1ISYY1
9 Shifts of the IS curverIn other words, we can make the following predictions:LMr1IS-LM PredictionsYrCo + Io + G+T−ISYY1
10 Ch. 11: Comparing fiscal policy in the Keynesian Cross and in the IS Curve In the Keynesian Cross model, expansionary fiscal policy boosts GDP by an amount dictated by the multipliers.Keynesian CrossK.C. Spending MultiplierK.C. Tax-Cut MultiplierIn 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)IS Curve
11 Fiscal Policy is Weakened by the Crowding-Out Effect We have just seen that, in the IS-LM model, expansionary fiscal policy (G↑ or T↓)leads to higher interest rates, whichexerts downward pressure on investment spending, whichexerts downward pressure on GDP and jobs.This negative aspect of expansionary fiscal policy is called the crowding-out effectThis effect was absent in the Keynesian Cross modelThus, fiscal policy is less effective in the IS-LM model than in the Keynesian Cross model
12 An increase in government purchases: graph 1. IS curve shifts rightYrcausing GDP to rise.LMIS2IS1r2Y22.r1Y12. This raises money demand, causing the interest rate to rise…1.Chapter 11 showed that an increase in G causes the IS curve to shift to the right by (G)/(1-MPC).3. …which reduces investment, so the final increase in Y3.
13 A tax cutConsumers save (1MPC) of the tax cut, so the initial boost in spending is smaller for T than for an equal G…and the IS curve shifts byYrLMIS2IS1r22.Y2r1Y11.1.Chapter 11 used the Keynesian Cross to show that a decrease in T causes the IS curve to shift to the right by (-MPCT)/(1-MPC).If your students ask why the IS curve shifts to the right when there’s a negative sign in the expression for the shift, remind them that T < 0 for a tax cut, so the expression actually is positive.The term showing the distance of the shift in the IS curve is almost the same as in the case of a government spending increase, where the numerator of the fraction equals (1) for government spending rather than (-MPC) for the tax cut. Here’s the intuition: Every dollar of a government spending increase adds to aggregate spending. However, for tax cuts, the fraction (1-MPC) of the tax cut leaks into saving, so aggregate spending only rises by MPC times the tax cut.…so the effects on r and Y are smaller for T than for an equal G.2.2.
17 Shifts of the LM curverRecall from Ch. 11 that, if expected inflation (Eπ) increases (decreases), the LM curve shifts down (up) by the exact same amount!Therefore, if Eπ decreases, r will increase, but by a smaller amount.Therefore, i = r + Eπ will decrease.LMr1ISYY1
18 IS-LM Predictions IS-LM Predictions IS Curve LM Curve Y r i Co + Io + G→+T←−M/PEπLoAt this point, you should be able to do problems 1, 2, 3 (a) – (f), 4, and 5 on pages 352 – 353 of the textbook. Please try them.
19 Monetary PolicyThe practice of changing the quantity of money (M) in order to affect the macroeconomic outcome is called monetary policyan increase in the quantity of money (M↑) is called expansionary monetary policy, andA decrease in the quantity of money (M↓) is called contractionary monetary policy
20 Shifts of the LM curverWhen the central bank of a country makes changes to the quantity of money (M),only the LM curve changes, andthe real interest rate (r) changes in the opposite directionAs 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.LMr1ISYY1
21 Shifts of the LM curve One can think of the central bank as targeting M and affecting r and i in the process, or astargeting r and/or i and adjusting M to achieve the targetLMr1ISYY1
22 Monetary Policy Re-defined Therefore, one can re-define expansionary and contractionary monetary policy as follows:Monetary policy is expansionary when the central bank attempts to reduce interest rates (real and nominal), andMonetary policy is contractionary when the central bank attempts to increase the interest rates (real and nominal)
23 The Federal Funds RateIn 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 RateHaving 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
24 The Federal Funds RateThe Federal Funds Rate is the interest rate that banks charge each other for overnight loansIf the Fed wishes the FFR to be 1.8%, all it has to do is to announce thatit will lend money to any bank at 1.8% interest andwill pay 1.8% interest on deposits received from any bank
25 The Federal Funds RateGiven that the Fed expresses its monetary policy in terms of the target value of the Federal Funds Rate, we can re-define monetary policy as follows:Monetary policy is expansionary when the Fed seeks to reduce the federal funds rate, andMonetary policy is contractionary when the Fed seeks to increase the federal funds rateKeep 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
26 The Zero Lower Bound on Nominal Interest Rates We have seen that, when faced with a recession, the central bank canIncrease the money supply (M↑)Thereby shifting the LM curve rightThereby reducing the real interest rate (r = i − Eπ ↓) and the nominal interest rate (i = r + Eπ↓) and increasing GDP (Y↑) to drag the economy out of the recessionLMr1ISYY1
27 The Zero Lower Bound on Nominal Interest Rates The problem is that there is a limit to how low the nominal interest rate can beNominal interest rates (such as the federal funds rate) cannot be negativeTo deal with the 2008 economic crisis, the Fed reduced the FFR to zeroBut the recession persistedUnfortunately, the Fed could not reduce interest rates below zero: monetary policy had reached its limitLMr1ISYY1
28 The Zero Lower Bound on Nominal Interest Rates: Crisis 2008-09 Downloaded from on January 21, 2013.
29 The Zero Lower Bound on Nominal Interest Rates r = i − Eπiminimum = 0Therefore, rminimum = iminimum − Eπ = 0 − EπTherefore, rminimum = − EπFor example, if Eπ = −3%, then rminimum = − Eπ = 3%LMr12.1%ISYY1
30 The Zero Lower Bound on Nominal Interest Rates For example, in the diagram, the central bank will have to reduce the real interest rate to r = 2.1% in order to end the recessionBut suppose expected inflation is Eπ = − 3%Then, the nominal interest rate would have to be brought down to i = r + Eπ = 2.1 – 3.0 = – 0.9%Which, alas, is impossibleLMr12.1%ISYY1This example also shows how dangerous it can be if we have deflation and people begin to expect the deflation to continue
31 The Zero Lower Bound on Nominal Interest Rates If the nominal interest rate has been reduced all the way down to zero, and the economy is still stuck in a recession, the economy is said to beat the zero lower bound, orin a liquidity trapSee page 350 of the textbook
32 The Zero Lower Bound on Nominal Interest Rates: Solutions When an economy is in a liquidity trap, monetary policy cannot be used to reduce interest rates any furtherBut is there nothing else that can be done to bring the economy back to life?Yes, there is!Expansionary fiscal policy can be usedAnd there’s something else that the monetary authorities (the central bank) can do: make a credible promise to be irresponsible!See “Japan’s Trap” by Paul Krugman, May 1998,
33 The Zero Lower Bound on Nominal Interest Rates: Solutions In my example,the central bank needs to reduce the real interest rate to r = 2.1% to end the recessionBut expected inflation is Eπ = − 3%So, the nominal interest rate would have to be brought down to i = – 0.9%, which, alas, is impossibleRecall that the LM curve shifts right if either M or Eπ increasesIf 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 − 3% to +1%Then the nominal interest rate required for full-employment will be i = r + Eπ = = 3.1%, which is definitely attainableLMr12.1%ISYY1The zero-lower-bound problem can be solved if the central bank can credibly promise to be irresponsible!
34 The Zero Lower Bound on Nominal Interest Rates: Solutions Although this chapter assumes a closed economy, in reality foreign trade does matter.So, the central bank canprint domestic currency, anduse it to buy foreign currency,thereby making the domestic currency cheaper relative to the foreign currency,thereby stimulating exports,thereby ending the recession!
35 The Zero Lower Bound on Nominal Interest Rates: Solutions Even when short-term interest rates such as the federal funds rate are at zero percent, the central bank can print money and make long-term loans to the government, to businesses, to home-buyers who need mortgages, etc.This would reduce long-term interest rates directly, thereby stimulating spending by the borrowersThis strategy—called quantitative easing—may also end a recession
36 Interaction between monetary and fiscal policy IS-LM Model: Monetary and fiscal policy variables (M, G, and T ) are exogenous.Real world: Monetary policymakers may adjust M in response to changes in fiscal policy, or vice versa.Such responses by the central bank may affect the effectiveness of fiscal policy
37 The Fed’s response to G > 0 Suppose the government increases G.Possible Fed responses:1. hold M constant2. hold r constant3. hold Y constantIn each case, the effects of G on Y are different…
38 Response 1: Hold M constant When G increases, the IS curve shifts right.YrLMIS2IS1If Fed holds M constant, then LM curve does not shift.r2Y2r1Y1As a result, interest rates rise. This has a crowding-out effect. Consequently, GDP increases, but not a lot.
39 Response 2: Hold r constant If Congress raises G, the IS curve shifts right.YrLM1IS2LM2IS1To keep r constant, Fed increases M to shift LM curve right.r2Y2r1Y1Y3Results:
40 Response 3: Hold Y constant LM2If Congress raises G, the IS curve shifts right.YrLM1Y1IS2r3IS1To keep Y constant, Fed reduces M to shift LM curve left.r2Y2r1Results:At this point, you should be able to do problem 7 on page 353 of the textbook. Please try it.
41 Estimates of fiscal policy multipliers from the DRI macroeconometric modelEstimated value of Y / GEstimated value of Y / TAssumption about monetary policyFed holds money supply constant0.600.26The preceding slides show that the impact of fiscal policy on GDP depends on the Fed’s response (or lack thereof). This slide shows estimates of the fiscal policy multipliers under different assumptions about monetary policy; these estimates are consistent with the theoretical results on the preceding slides.First, the slide shows estimates of the government spending multiplier for the two different monetary policy scenarios. Then, the slide reveals the tax multiplier estimates. (If you wish, you can turn off the animation so that everything appearing on the slide appears at one time. Just click on the “Slide Show” pull-down menu, then on “Custom animation…”, then uncheck all of the boxes next to the elements of the screen that you do not wish to be animated.Regarding the estimates: First, note that the estimates of the fiscal policy multipliers are smaller (in absolute value) when the money supply is held constant than when the interest rate is held constant. This is consistent with the results from the IS-LM model presented in the preceding few slides.Second, notice that the tax multiplier is smaller than the government spending multiplier in each of the monetary policy scenarios. This should make sense from material presented earlier in this chapter: the government spending multiplier (for a constant money supply) is 1/(1-MPC), while the tax multiplier is only (-MPC)/(1-MPC).Fed holds nominal interest rate constant1.931.19A 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.
42 Shocks in the IS -LM model IS shocks: exogenous changes in the demand for goods & services.Examples:stock market boom or crash change in households’ wealth Cchange in business or consumer confidence or expectations I and/or C
43 Shocks in the IS -LM model LM shocks: exogenous changes in the demand for money.Examples:a wave of credit card fraud increases demand for money.more ATMs or the Internet reduce money demand.
44 NOW YOU TRY: Analyze shocks with the IS-LM Model Use the IS-LM model to analyze the effects of 1. a boom in the stock market that makes consumers wealthier. 2. after a wave of credit card fraud, consumers using cash more frequently in transactions. For each shock, a. use the IS-LM diagram to show the effects of the shock on Y and r. b. determine what happens to C, I, and the unemployment rate.Earlier slides showed how to use the IS-LM model to analyze fiscal and monetary policy. Now is a good time for students to get some hands-on practice with the model. Also, note that part (b) helps students learn that shocks and policies can potentially affect all of the model’s endogenous variables, not just the ones that are measured on the axes.After working this exercise, your students will better understand the case study on the 2001 U.S. recession that immediately follows.Suggestion: Instead of having students work on these exercises individually, get them into pairs. One student of each pair works on the first shock, the other student works on the second shock. Give them 5 minutes to work individually on the analysis of the shock. Then, allow 10 minutes (5 for each student) for students to present their results to their partners. This activity gives students immediate application and reinforcement of the concepts, so students learn them better and will then better understand and appreciate the remainder of your lecture on Chapter 11.Answers:1a. The IS curve shifts to the right, because consumers feel they can afford to spend more given this exogenous increase in their wealth. This causes Y and r to rise.1b. C rises for two reasons: the stock market boom, and the increase in income. I falls, because r is higher. u falls, because firms hire more workers to produce the extra output that is demanded.2a. (This is a continuation of the in-class exercise at the end of the PowerPoint presentation of Chapter 10.) The increase in money demand shifts the LM curve to the left: We are assuming that all other exogenous variables, including M and P, remain unchanged, so an increase in money demand causes an increase in the value of r associated with each value of Y (this can be seen easily using the Liquidity Preference diagram). This translates to an upward (i.e. leftward) shift in the LM curve. This shift causes Y to fall and r to rise.2b. The fall in income causes a fall in C. The increase in r causes a fall in I. The fall in Y causes an increase in u.
49 The U.S. Recession of 2001 r LM r1 IS Y Y1 Why? Demand shocks moved the IS curve leftThe “tech bubble” ended and stocks fell 25% between 8/00 and 8/019/11 attacks led to a 12% fall in stock prices in one week and a huge rise in uncertaintyScandals at Enron, WorldCom and other corporations led to stock price declines and a decline in trust and a rise in uncertaintyLower household wealth reduced Co and higher uncertainty reduced IoLMr1ISYY1
50 CASE STUDY: The U.S. recession of 2001 Causes: 1) Stock market decline C30060090012001500199519961997199819992000200120022003Index (1942 = 100)Standard & Poor’s 500Starting in mid-2000, the S&P 500 begins a downward trend. The fall in stock prices eroded the wealth of millions of U.S. consumers. They responded by reducing consumption.
51 The U.S. Recession of 2001 Fiscal stimulus moved IS curve right Major tax cuts were enacted in 2001 and 2003Government spending was boostedto rebuild NYC, andto bail out the airline industryFed printed money and moved LM curve rightInterest rate on 3-month Treasury bills fell6.4% in 11/003.3% in 8/010.9% in 7/03LM1LM2r1IS2IS1Y1Y3YAll three tools—G, T and M—were used
52 CASE STUDY: The U.S. recession of 2001 Monetary policy response: shifted LM curve rightThree-month T-Bill Rate123456701/01/200004/02/200007/03/200010/03/200001/03/200104/05/200107/06/200110/06/200101/06/200204/08/200207/09/200210/09/200201/09/200304/11/2003Easier monetary policy shifted the LM curve to the right, causing interest rates to fall, as shown in this graph.
53 What is the Fed’s policy instrument? The news media commonly report the Fed’s policy changes as interest rate changes, as if the Fed has direct control over market interest rates.In fact, the Fed targets the federal funds rate – the interest rate banks charge one another on overnight loans.The Fed changes the money supply and shifts the LM curve to achieve its target.Other short-term rates typically move with the federal funds rate.Chapter 18 discusses monetary policy in detail.
54 What is the Fed’s policy instrument? Why does the Fed target interest rates instead of the money supply?1) They are easier to measure than the money supply.2) The Fed might believe that LM shocks are more prevalent than IS shocks. If so, then targeting the interest rate stabilizes income better than targeting the money supply. (See end-of-chapter Problem 7 on p.353.)
57 Unemployment (right scale) The Great Depression24030Unemployment (right scale)2202520020billions of 1958 dollars180percent of labor force1516010This chart presents data from Table 12-2 on pp of the text. For data sources, see notes accompanying that table.Things to note:1. The magnitude of the fall in output and increase in unemployment. In 1933, the unemployment rate is over 25%!!2. There’s a very strong negative correlation between output and unemployment.Real GNP (left scale)1405120192919311933193519371939
58 THE SPENDING HYPOTHESIS: Shocks to the IS curve asserts that the Depression was largely due to an exogenous fall in the demand for goods and services – a leftward shift of the IS curve.evidence: output and interest rates both fell in early 1930s, which is what a leftward IS shift would cause.rLMr1ISYY1
59 THE SPENDING HYPOTHESIS: Reasons for the IS shift Stock market crash exogenous COct-Dec 1929: S&P 500 fell 17%Oct 1929-Dec 1933: S&P 500 fell 71%Drop in investment“correction” after overbuilding in the 1920swidespread bank failures in early 1930s made it harder to obtain financing for investmentContractionary fiscal policyPoliticians raised tax rates in 1932 and cut spending to combat increasing deficits.In item 2, I’m using the term “correction” in the stock market sense.
60 THE MONEY HYPOTHESIS: A shock to the LM curve asserts that the Depression was largely due to huge fall in the money supply.evidence: M1 fell 25% duringBut, two problems with this hypothesis:P fell even more, so M/P actually rose slightly duringnominal interest rates fell, which is the opposite of what a leftward LM shift would cause.
61 THE MONEY HYPOTHESIS AGAIN: The effects of falling prices asserts that the severity of the Depression was due to a huge deflation:P fell 25% duringThis deflation was probably caused by the fall in M, so perhaps money played an important role after all.In what ways does a deflation affect the economy?
62 THE MONEY HYPOTHESIS AGAIN: The effects of falling prices The stabilizing effects of deflation:P (M/P ) LM shifts right YPigou effect:P (M/P ) consumers’ wealth C IS shifts right Y
63 IS-LM Predictions IS-LM Predictions IS Curve LM Curve Y r i Co + Io + G→+T←−M/PEπLo
64 THE MONEY HYPOTHESIS AGAIN: The effects of falling prices The destabilizing effects of expected deflation: ELM curve shifts leftr and I (r ) planned expenditure income and output Also, the nominal interest rate decreases (i↓):see IS-LM predictions gridrLMr1ISThe textbook (starting p. 345) uses an “extended” IS-LM model, which includes both the nominal interest rate (measured on the vertical axis) and the real interest rate (which equals the nominal rate less expected inflation). Because money demand depends on the nominal rate, which is measured on the vertical axis, the change in expected inflation doesn’t shift the LM curve. However, investment depends on the real interest rate, so the fall in expected inflation shifts the IS curve: each value of i is now associated with a higher value of r, which reduces investment and shifts the IS curve to the left. Results: income falls, i falls, and r rises --- which is exactly what happened from 1929 to 1931 (see table 11-2 on pp ).This slide gives the basic intuition, which students often can grasp more quickly and easily than the graphical analysis. After you cover this material in your lecture, it will be easier for your students to grasp the analysis on ppYY1
65 THE MONEY HYPOTHESIS AGAIN: The effects of falling prices 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 borrowers’ propensity to spend is larger than lenders’, then aggregate spending falls, the IS curve shifts left, and Y fallsBut doesn’t the lower P shift the LM curve to the right? It should. However, the debt-deflation theory could still be correct if the left shift of the IS curve dominates the right shift of the LM curve.
66 The evidence on output and nominal interest rates Note that, other than the money hypothesis, all the other hypotheses—the spending hypothesis, the debt-deflation hypothesis, and the deflationary expectations hypothesis—predict falling real GDP and falling nominal interest ratesThis is exactly what happened in the early stages of the Great DepressionThe spending hypothesis and the debt-deflation hypothesis both predict falling real interest rates, whereas the deflationary expectations hypothesis predicts rising real interest ratesTherefore, evidence on real interest rates is crucial in identifying suitable explanations for the Great Depression
67 Why another Depression is unlikely Policymakers (or their advisors) now know much more about macroeconomics:The Fed knows better than to let M fall so much, especially during a contraction.Fiscal policymakers know better than to raise taxes or cut spending during a contraction.Federal deposit insurance makes widespread bank failures very unlikely.Automatic stabilizers make fiscal policy expansionary during an economic downturn.Examples of automatic stabilizers:the income tax: people pay less taxes automatically if their income fallsunemployment insurance: prevents income - and hence spending - from falling as much during a downturnThis topic is discussed in Chapter 14.
68 The financial crisis and economic downturn of 2008 and 2009
69 CASE STUDY The 2008-09 Financial Crisis & Recession 2009: Real GDP fell, unemployment rate approached 10%Important factors in the crisis:early 2000s Federal Reserve interest rate policysub-prime mortgage crisisbursting of house price bubble, rising foreclosure ratesfalling stock pricesfailing financial institutionsdeclining consumer confidence, drop in spending on consumer durables and investment goodsThe following slides are meant to complement rather than substitute for the new Case Study appearing in the textbook. These slides contain a wealth of data on various aspects of the current economic crisis. My hope is that these slides will spark lively discussion in your class, as students develop a context for understanding key parts of the crisis and evaluate how the parts fit together (and fit with the textbook models).Of course, the crisis is more complicated than can be captured by a few slides or a 2-page case study in a textbook. I encourage you to assign your students additional readings, writing projects, or class presentations on the crisis. This is an exciting time to be learning macroeconomics!
70 A Too-Brief and Too-Simple Explanation The price of housing had risen to unsustainable levels.When home prices inevitably crashed, people suddenly felt poor and cut back their spending plans.This fall in planned expenditure brought about the Great Recession of
71 The Housing Bubble Inflates, then Deflates The S&P Case-Shiller 20-City Home Price Index went from100 in Jan 2000, toin April 2006, toin May 2009, toin Dec 2010Why did the housing bubble inflate?
72 The Housing Bubble: Reasons The Fed kept the interest rates too low for too longSecuritization technology got a lot fancier in the mortgage bond marketThe government regulators were sleepingPretty much everybody believed that home prices could never fall
73 The Housing Bubble: Low FFR The Fed had reduced the Federal Funds Rate to fight the Recession of 2001.After that recession ended, the Fed continued to keep interest rates low until 2004The Fed was watching inflation, which remained tame. Consequently, the Fed saw little reason to raise interest rates.The Fed did not believe that housing prices had formed a bubble … until it was blindingly obvious
74 The Housing Bubble: Securitization In the past, people with money did not like to lend money to home buyers because such loans were risky and had unreliable returnsBut the advent of new financial technologies called securitization and tranching made people with money suddenly eager to lend to home buyers
75 The Housing Bubble: Weak Regulators The financial sector was regulated by people who were ideologically opposed to regulationThey turned a blind eye to even the worst lending practices
76 The Housing Bubble Inflates The Fed’s low-interest policy and financial innovation made it easy for home buyers to borrow moneyLax regulation allowed subprime lendingThat is, lending to people who had few assets and/or prospects that would make repayment likelyThe belief that home prices would keep rising made it unnecessary to worry about the credit worthiness of borrowers
77 The Housing Bubble Deflates After mid-2006, home prices started to fallHome owners began to default on their loansForeclosures increasedThis flooded the market with more homes for saleWhich led to further declines in home pricesThese cascading and self-reinforcing home price declines made people feel poorConsumption spending fell
78 The Housing Bubble Deflates After mid-2006, home prices started to fallThe financial institutions that had made mortgage loans faced huge losses when borrowers began to defaultThese institutions began to second guess their ability to spot good borrowers. So, they reduced lendingEven 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 bankruptBusiness investment spending collapsed
79 The Housing Bubble Deflates After mid-2006, home prices started to fallFinancial institutions were revealed to have suffered huge lossesNon-financial businesses were not getting loans and were shutting downBut a lack of transparency meant that it was not possible to figure out which companies would collapse nextThis caused great uncertaintyPeople with money sold off their stocks and bondsThe decline in stock prices made people feel poorConsumption spending fell
80 The Housing Bubble Deflates The collapse of the housing bubble led, through a complex chain of causation, to major declines in consumption and investment spendingOne can think of all this as a shift of the IS curve to the leftThis brings about a recession, with falling output and rising unemployment
81 The Fed’s Response The Federal Reserve reduced the Federal Funds Rate from 5.25% in Sept 2007to essentially zero in Dec 2008The Fed had reached the zero lower bound and could not go any furtherThe Fed is now trying less orthodox measures, called quantitative easing, to reduce long-term interest rates
82 The Federal Government’s Response In October 2008, the outgoing Bush administration enacted the Troubled Assets Recovery Program (TARP) that spent $700 billion to revive Wall StreetIn 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
83 Slow Recovery The Great Recession officially ended in June 2009 But the recovery has been very slowReal GDP grew at 3.1% in the fourth quarter of 2010The unemployment rate was at 8.9% in February 2011
85 Interest rates and house prices Setting the stage for the economic crisis:The recession of 2001 prompted the Federal Reserve to cut the Fed Funds rate steeply over the period This is one explanation for the drop in mortgage rates that occurred over the same period. As these rates fell, housing prices rose, as shown here by the Case-Shiller 20-city composite index – a measure of average housing prices in 20 major U.S. real estate markets.(Off-topic, possibly: Another explanation for the behavior of rates and house prices: a global savings glut from abroad flowed into the U.S.)Sources:House price index is fromor Google “Case Shiller Index”Interest rate data is from FRED, the Federal Reserve Bank of St. Louis database, at
86 Change in U.S. house price index and rate of new foreclosures, 1999-2009 The housing bubble pops, driving up foreclosure rates:The data show rapid house price appreciation in the early to mid 2000s, which falls starting in 2005 and turns negative in 2007.Looking at the period , the rate of house price appreciation falls while the rate of new foreclosure starts rises.How to interpret these data:New foreclosure starts is the number of new foreclosures in the quarter as a percentage of the total number of mortgages.The house price data shown is the percentage change in the U.S. index from four quarters earlier. (Note: this is a different house price index than the one on the previous slide, though both tell the same story.)Sources:Mortgage Banker’s Association (for foreclosure starts) and Federal Housing Finance Authority (for house price indexes).
87 House price change and new foreclosures, 2006:Q3 – 2009Q1 NevadaFloridaIllinoisOhioMichiganCaliforniaGeorgiaNew foreclosures, % of all mortgagesArizonaColoradoRhode IslandTexasNew JerseyStates with the biggest price drops tended to have the most new foreclosures:The horizontal axis measures the cumulative change in the state’s house price index during 2006:3 – 2009:1. The vertical axis measures the number ofnew foreclosure starts in the state as a percentage of all outstanding mortgages in the state, summed over the period 2006:3 – 2009:1.This graph shows that states with larger housing price crashes tended to have higher foreclosure rates.Sources:Mortgage Banker’s Association (for foreclosure starts) and Federal Housing Finance Authority (for house price indices).HawaiiS. DakotaOregonWyomingAlaskaN. DakotaCumulative change in house price index
88 U.S. bank failures by year, 2000-2009 The housing market crisis led to rising bank failures.source: FDIC, this page lists all of the banks that have failed by name.** as of July 24, 2009.
89 Major U.S. stock indexes (% change from 52 weeks earlier) Recent stock market behavior plays an important role:This chart begins at the end of 1999, when the tech stock bubble was about to pop. In , you can see the fall in stock prices (especially in the Nasdaq composite, which heavily weights tech stocks). This drop in stock prices was a factor in the 2001 recession.All three indeces registered negative growth until about June Growth was strong for a while until moderating in about July Stock price growth bounced around between about 0 and 20% through the end of 2007, then turned sharply negative in 2008.source: finance.yahoo.com,Dow Jones Industrial Average symbol: ^DJIS&P500 symbol: ^GSPCNasdaq Composite Index symbol: ^IXICclick on “historical prices”specify frequency, date range
90 Consumer sentiment and growth in consumer durables and investment spending Consumer confidence crashes, bringing down durables and investment spending:The University of Michigan Index of Consumer Sentiment is a measure of consumer confidence and is highly correlated with the more famous “Consumer Confidence Index” published by the Conference Board. (I’m using the U-M index because it’s free and in the public domain, while the Conference Board index is proprietary and not free.)The graph shows a strong relation among the three series: as consumer confidence falls, consumer spending on durables slows down and turns negative, as does investment spending.Sources:Durables and investment from the Bureau of Economic Analysis, U.S. Dept of CommerceConsumer Sentiment Index from the University of Michigan Survey Research CenterAll three series obtained from FRED,
91 Real GDP growth and Unemployment Result: the strongest recession in decades2001 recession: GDP growth falls, unemployment risesrecovery: GDP growth speeds up, then slows down but remains positive. Unemployment, a lagging indicator, begins coming down in mid-2003.: The housing crisis, rising foreclosure rates, failing financial institutions, falling consumer confidence, and falling consumer and business spending finally take their toll, sending the economy into the strongest recession in decades.
94 Falling mortgage rates helped Mortgage rates were very low between ‘04 and ‘06. They may have contributed to the housing bubbleNote that there is a link between the two rates, though weakIn hindsight, the FFR should have been higher in But inflation was low.
95 Record low mortgage rates Mortgage rates are even lower now. But credit standards have been tightened. In any case, the economy is still weak. So, don’t expect another housing bubble.The unusually low mortgage rates may have helped to inflate the housing bubble.
103 Unemployment Shot UpRemember Okun’s Law? Because GDP growth has remained below 3%, unemployment has remained stubbornly high.
104 Inflation Fell Sharply The Fed pays more attention to the “core inflation rate,” which ignores food and energy. Now you see why. The downward trend in core inflation is a worry: we don’t need deflation.
105 A Yawning Budget Deficit! Has government spending risen at an unusually rapid rate? Not really.The main budgetary problem has been caused by the crashing tax revenues.
106 A Yawning Budget Deficit! Has government spending risen at an unusually rapid rate? Not really.The main budgetary problem has been caused by the crashing tax revenues.
107 A Yawning Budget Deficit! Has government spending risen at an unusually rapid rate? Not really.The main budgetary problem has been caused by the crashing tax revenues.
108 This recession was special: job losses Horizontal axis shows months. Vertical axis shows the ratio of that month’s nonfarm payrolls to the nonfarm payrolls at the start of recession. And this doesn’t 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.