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Understanding the Great Recession Economics 122 : Fall 2010

Understanding the Great Recession Economics 122 : Fall 2010. Using macro to understand the current recession. Let’s analyze the history of the recession to illustrate some of the major macro issues/tools Underlying forces: Increasing leverage with lower perceived risks The housing bubble

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Understanding the Great Recession Economics 122 : Fall 2010

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  1. Understanding the Great Recession Economics 122: Fall 2010

  2. Using macro to understand the current recession Let’s analyze the history of the recession to illustrate some of the major macro issues/tools Underlying forces: • Increasing leverage with lower perceived risks • The housing bubble • A “run on the banks” and the Lehman bankruptcy • The crash in asset prices • Decline in wealth leading to declining I and C. • International transmissions • IS-TR curve interpretation • Liquidity trap! • Governmental response in monetary and fiscal policies • The trough in late 2009 • The long stagnation to reach full employment (?)

  3. The bubble economy

  4. Trends in volatility of US stock prices Historical lows Note: Implied volatility is a measure of the equity price variability implied by the market prices of call options on equity futures. Historical volatility is calculated as a rolling 100-day annualized standard deviation of equity price changes. Volatilities are expressed in percent rate of change. VIX is CBOE index.

  5. Leveraging the US economy Rising leverage of US economy Source: Federal Reserve flow of funds data.

  6. The result on housing prices • Rising perceived wealth of households 1995-2006. • Then catastrophic loss of wealth 2006-2009

  7. Then people wake up from the dream to the nightmare of falling wealth …

  8. Mortgage delinquencies for subprime mortgages Source: IMF, Global Financial Stability Report, Oct 2008 at imf.org

  9. The loss of paper wealth Wealth loss of $12 trillion ($100,000 per household)

  10. The impact on households and consumption

  11. Consumption function: Ct = β1 Ypt + β2 Wt Savings rate: s = 1 – β1 - β2 Wt /Ypt Predictions of consumption theory

  12. Bank runs Series of bank runs. Different from earlier (Depression era) because was the run by large depositors (run on the repo). Bear Stearns and Lehman were wiped out in a week.

  13. Bank losses* * Note that US bank equity was around $1000 billion in 2010.

  14. Chicken little

  15. The Lehman Bankruptcy A central event in the crisis. Market fundamantalists worried that continued bailouts would lead to “moral hazard” and worse future problems. So on September 15, 2008, government decided to let Lehman go bankrupt. Catastrophic results: - markets froze up (people could not make transactions) - stock market went down 30 % in a month and US dollar ROSE almost 20 %. - market fundamentalism lasted just 36 hours (!) - then bailout of AIG, Citibank, BofA, TARP, GM, etc. - Fed opened up several new facilities to steady markets “An economy in free fall” in the fall of 2008.

  16. Risk on Mature Govt Debt (US, etc.) CDS = risk that security will default. These are US and similar Treasury bonds!

  17. A risk measure on commercial paper Source: Federal Reserve page on commercial paper. These are short-term promissory note or unsecured money market obligation, issued by prime rated commercial firms and financial companies. This shows medium-grade (A2/P2) minus top grade (AA).

  18. Risk premiums on top-rated securities IMF

  19. Impact of Credit Crunch on Investment

  20. Macroeconomic impacts

  21. Macroeconomic impacts Rewrite augmented IS and TR curves as follows: IS: Y = C(Y,W) +I(rr) + G + NX Y = C(Y,W) +I(i - π + δ) + G + (X – M) TR: i = f(Y, π) rr = risky real rate = i - π + δ, where δ is the risk premium Have adverse IS shifts to W, δ, and NX Fed lowers i in standard manner, but real interest rate for businesses goes up! TR = Taylor rule (or LM in old-fashioned theory)

  22. Before crisis Taylor Rule (TR) iff IS(i ff - π + risk premium) i* 2006 Y

  23. After financial crisis TR iff IS(i ff - π + low risk premium) i* IS’(i ff - π + high risk premium) 2008 Y

  24. World output trends

  25. Policy Responses (thanks to Keynes’s theories) Gwendolen Darwin Raverat

  26. Financial Market Support Measures 2007-2010

  27. Unconventional Fed Measures: the Fed Balance Sheet Treasuries = normal stuff!; CPLF = commercial paper funding facility; MBS = mortgage-backed securities

  28. Fed balance sheet before and after the crisis

  29. Before Fed expansion LM iff IS(i ff - π + risk premium) IS’ i* 2008 Y

  30. After Fed expansion LM LM’ iff IS(i ff - π + risk premium) IS’ i* 2009 Y

  31. After Fed and Treasury recapitalization (TARP) and other measures which lowered the spread iff LM’ IS’’ IS’ i* 2010 Y

  32. Fiscal Policy in the Liquidity Trap:Components of US stimulus legislation Source: CBO, presentation of Elmendorf, June 2009

  33. Without stimulus TR iff IS(2008) i* Y

  34. With stimulus TR iff IS(2008) IS(2010) i* Y

  35. CBO’s estimate of impact of stimulus on economy My forecast Source: CBO, presentation of Elmendorf, June 2009,; Nordhaus, Nov 2010.

  36. When will it ever end?

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