1. McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. The Severe Contraction: An October 2008 through March 2009 Update

2. Overview U.S. recession began in December 2007 due in part to: –Steep decline in housing prices –Mortgage loan crisis –Financial market collapse GDP fell 6.3% from 2007 to 2008 Unemployment rose to 8.1%

3. Banks and Other Financial Institutions In the 2007-2009 period, the banking system failed to promote economic growth and stability. –Bank lending collapsed –The Fed and the U.S. Treasury infused money to promote liquidity

4. Uncertainty, Expectations, and Shocks The Severe Contraction is a good example of an economy exposed to a negative demand shock. –Sticky prices from December 2007 to February 2009 –Decrease in total demand resulted in declining real output

5. GDP = C + I g + G + X n Real GDP during the fourth quarter of 2008 dropped by 6.3% on an annual basis. –Gross investment expenditures fell by 23% –Net exports fell by 6.1% –Personal consumption expenditures fell by 4.3%

6. The Circular Flow Revisited The recent recession has dampened the major spending and income flows. GDP, NDP, NI, and PI all declined.

7. Production Possibilities Analysis Real GDP declined during the Severe Contraction but not the economy’s production capacity. –The economy moved to a point inside the PPC Prolonged recessions can adversely affect the supply factors of economic growth.

8. Productivity Acceleration The recession had not altered the recent long-run productivity trend. The rate of productivity growth in 2008 matched the 2.7% annual trend-line growth of productivity since 1995.

9. Phases of the Business Cycle The economy peaked in December 2007 and entered the recession phase. The latest recession is the sharpest and longest recession since 1982, but is not likely to be a depression.

10. U.S. Recessions since 1950 Table 26.1 can be updated by adding “2007” at the bottom of column 1 and question marks at the bottom of columns 2 and 3. The NBER declared the start of the current recession as December 2007.

11. Causation: A First Glance The view that business cycles can result from unexpected financial bubbles and bursts is the most likely cause of the current recession.

12. Cyclical Impacts In the latest recession, the outputs of capital goods and consumer durables were hit the hardest, having fallen 22% and 22.1% respectively, on an annual basis by fourth quarter 2008.

13. Unemployment The type of unemployment that increases during recession is cyclical unemployment. This helps to explain the higher unemployment rates during the current recession.

14. The Labor Force, Employment, and Unemployment Between November 2008 and February 2009, unemployment rose by more than 5 million people and the unemployment rate rose from 4.7% to 8.1%. Unemployment numbers will likely worsen before improving.

15. Actual and Potential GDP The latest recession has caused a negative GDP gap. Actual GDP was well below potential GDP from late 2007 through March 2009.

16. Unequal Burdens Between 2007 and 2008, the unemployment rates for some groups of workers, including construction, manufacturing, and retail workers, and African- Americans and Hispanics, rose more rapidly than for other groups.

17. Facts of Inflation The current recession has removed the demand-pull inflation that began in 2007. Inflation has declined to near zero, prompting concerns of deflation which can worsen a recession.

18. Last Word: The Stock Market and the Economy The decline in stock prices from late 2008 through early 2009: –produced a huge negative wealth effect that reduced consumer spending –constrained the ability of firms to expand their operations by selling stock

19. The Income-Consumption and Income-Saving Relationship The Severe Contraction has temporarily changed the current consumption and saving behavior in the economy. –Households have increased savings and reduced consumption, illustrating a paradox of thrift

20. The Interest-Rate—Investment Relationship Although interest rates declined to near zero, investment spending actually declined 23% in the fourth quarter of 2008. –The investment demand curve shifted inward by more than the investment-increasing effects of the decline of real interest rates

21. The Volatility of Investment The recent recession reinforces the central point that economic investment (in real terms) is extremely volatile relative to real GDP.

22. The Multiplier Effect During a recession, the multiplier effect runs in the opposite direction. –A decrease in spending creates a multiple decrease in GDP However, the size of the multiplier in the U.S. economy is not known.

23. Recessionary Expenditure Gap Figure 28.7a can be used to portray the current recession. During the Severe Contraction, both after-tax consumption and investment expenditures declined, and the AE line shifts downward, producing a negative gap.

24. The U.S. government followed Keynes’ solution by: –Providing tax rebate checks in 2008 –Enacting a $787 billion stimulus package Both policies target closing a recessionary expenditure gap. Recessionary Expenditure Gap

25. International Economic Linkages The U.S. downturn reduced U.S. imports which further lowered U.S. real GDP. The World Trade Organization has projected that world trade will shrink by 9% 2009, the largest collapse since World War II.

26. Recession and Cyclical Unemployment The Severe Contraction can be depicted in Figure 29.9 –Decrease in aggregate demand stems from declining consumer spending and investment spending. –With sticky prices, a full-strength multiplier occurred and real GDP declined sharply.

27. Aggregate Demand and Aggregate Supply It is now known that a recession actually began in December 2007 and worsened in the last quarter of 2008. Furthermore, the stabilization policies used in 2008 to try to prevent recession were unsuccessful.

28. Last Word: Has the Impact of Oil Prices Diminished? The rise in oil prices during the summer of 2008 turned out to be a speculative bubble that burst when world economies slowed. Changes in oil prices—even spectacular ones—seem to have less of an effect on aggregate supply than they once did.

29. Expansionary Fiscal Policy The Economic Stimulus Act of 2009 was not as expansionary or long-lasting as anticipated. More current legislation seeks to try to boost aggregate demand through low and middle-income tax-cuts and large increases in government expenditures.

30. Automatic or Built-In Stabilizers Automatic stabilizers have not had sufficient force to offset the overall drop in aggregate demand. The size of the Federal budget deficit has increased due to the decline in taxes resulting from the reduction of GDP.

31. Federal Deficits and Surpluses as Percentages of GDP As a percentage of GDP, the Federal budget deficit was -3.2% in 2008. As a percentage of potential GDP, the standardized budget deficit rose from -1.4% in 2007 to -2.5% in 2008. –Fiscal policy was expansionary in 2008

32. Budget Deficits and Projections Updated projected deficits and surpluses in millions of nominal dollars 2009 = -1,3902012 = -264 2010 = -7032013 = -257 2011 = -4982014 = -250

33. Offsetting State and Local Finance Although state and local fiscal policies are often pro-cyclical, the $787 billion fiscal package of 2009 sought to reduce this problem by giving aid dollars to state governments.

34. The Public Debt Public debt is projected to rise $11.5 trillion dollars in 2009. As a percentage of GDP, the portion of the public debt that is held by the public will also rise.

35. The Investment Demand Curve Critics fear the deficit and debt created by the stimulus package of 2009 will raise interest rates and crowd-out private investment. Proponents believe the infrastructure spending will expand private investment.

36. Last Word: The Leading Economic Indicators The LEI index provided some forewarning of the recession. The LEI index plummeted rapidly from June 2008 through November 2008, correctly forecasting the severe decline in fourth quarter real GDP of 2008.

37. Money and Banking Widespread securitization, rising adjustable-rate mortgage interest rates, plummeting housing prices, growing mortgage loan defaults and failing financial banks pushed Congress to pass the Troubled Asset Relief Program (TARP) in late 2008.

38. Fed Functions and the Money Supply The Fed’s role as lender-of-last resort is critical to the U.S. financial industry. The Fed has been highly active in lending money to the financial industry during the Severe Contraction.

39. Major U.S. Financial Institutions Changes to “Examples” in the Table –Wachovia was acquired by Wells Fargo –Washington Mutual was acquired by Chase –Remove Golden West –Note: Merrill Lynch is now part of Bank of America –Remove Lehman Brothers –Goldman Sachs and Morgan Stanley are bank holding companies (commercial banks)

40. Last Word: The Bank Panics of 1930 to 1933 No major run on banks have occurred due to FDIC. Insurance coverage increased to $250,000 per account. The increase in bank reserves in February 2009 resulted in more reserves than checkable deposits!

41. The Demand for Money During the Severe Contraction, transaction demand for money decreased but asset demand for money increased. The Fed greatly increased the money supply. –This shift in supply overpowered the shift in demand

42. The Consolidated Balance Sheet of the Federal Reserve Banks During the Severe Contraction: –Assets rose due to huge a rise in Fed owned securities and loans to financial institutions –Liabilities rose as commercial bank reserves jumped when the Fed began paying interest on these reserves

43. Targeting the Federal Funds Rate By December 2008, the federal funds rate target ranged from zero to a quarter percent. The increase in the supply of federal funds was achieved through the term auction facility and open- market operations.

44. The Prime Interest Rate and the Federal Funds in the U.S. The decline in the Federal funds rate to near zero lowered the prime interest rate to 3.25 percent by February 2009.

45. Recent U.S. Monetary Policy A number of new lender-of-last- resort facilities were created to ensure and maintain liquidity. The facilities are designed to help banks, households, and businesses in various ways.

46. Cyclical Asymmetry The Fed has created billions of dollars of excess reserves. Yet, lending by banks was sluggish throughout the first 15 months of the recession. This exemplifies a liquidity trap.

47. Risk Systemic risk has affected almost all financial investments in 2007 and 2008, including real estate. Only a few assets such as U.S. securities and gold were spared.

48. The Securities Market Line The Fed lowered the risk-free interest rate resulting in a much lower intercept of the SML. Although interest rates fell, stock market prices did not rise in 2007 and 2008 as expected; the SML became steeper.

49. Recession and the Extended AD-AS Model In theory, a lower price level shifts AS to the right and real GDP “self- corrects” back to potential output and full employment. – Process is too slow and too costly Target active monetary and fiscal policy to shift AD to the right.

50. The Phillips Curve The current recession follows the general pattern of the Phillips Curve: –rising unemployment rate –declining inflation rate

51. Taxation and Aggregate Supply Tax rebates of 2008 and tax cuts in 2009 stimulus package are mainly demand-side tax cuts.

52. What Causes Macro Instability? Bursting of the housing bubble initiated forces that led to the recession. Housing bubble fueled by: –A too-loose monetary policy –Large international capital inflows –“Pass the risk” lending practices –Poor financial regulations

53. Some Key Facts The Severe Contraction has diminished world trade. In 2008, Japanese exports fell 35%; German exports fell 21%. Gains from specialization based on comparative advantage have waned.

54. Increased Domestic Employment Argument Recessions amplify arguments for trade protections to stem domestic job losses. Such policies may provoke retaliation by other nations, thus dampening exports.

55. The World Trade Organization Doha Round of international trade negotiations have stalled during the Severe Contraction. Recessions are not generally conducive for achieving trade deals.

56. Flexible Exchange Rates The value of the U.S. dollar has appreciated since Dec. 2007. –Lower demand for imports has depreciated the value of other currencies relative to the dollar –“Flight to safety” by foreign investors to U.S. securities also increased the demand for dollars

57. Recent U.S. Trade Deficits From 2007 to 2008, the goods deficit remained roughly unchanged. However, the goods and services deficit and the current account deficit fell.