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The Current Financial Crisis – that‘s Macro in a nutshell

Learn about the current financial crisis and its macroeconomic implications including bursting bubbles in housing and stock markets, real effects like recession, and ways to mitigate crises. Explore the causes of banking and stock market crises, and the impact on GDP and unemployment rates. A comparison with the 1930s crisis and insights on policy reactions provide a comprehensive overview.

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The Current Financial Crisis – that‘s Macro in a nutshell

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  1. The Current Financial Crisis –that‘s Macro in a nutshell Introduction to Macroeconomics Lecture I

  2. What‘s it about • bursted bubble in the housing market (house prices fell by 16% in 1 year in US) • banking crisis • stock market crisis • real effects: recession in the US (and in Europe)

  3. House price index US

  4. The Dow Jones Index

  5. Growth rate of US GDP

  6. Unemployment rate 1998-2008

  7. How does a bubble work? • Example: 2 goods – cookies, stones (no consumption value) • today: exchange 1 cookie – 1 stone • tomorrow: expect 1.5 cookies – 1 stone • - make profits if buy stone today to sell it tomorrow: 0.5 cookies • but: tomorrow everybody realizes that stone has no value – buyers of stones today have made loss of 1 cookie (bubble has disappeared)

  8. So bubble is a redistribution of wealth from buyers to sellers of bubble • Example of bubbles: stocks, houses • Why are there real effects of a bursting bubble? Because bubble was an asset against which could borrow (eg from foreign, from future). American house owners (=consumers) feel much poorer than a year ago – consume less – less demand – output falls.

  9. Specific problems of mortgages • Consumers got mortgage with little collateral • expected house price to rise such that could consume out of increase in house price and pay back mortgage • Expected interest rates to remain low • Expected labor income to remain constant or rise

  10. In fact: - increase in the interest rate (due to good economic conditions) – many defaults on mortgages – demand for houses decreases – price of houses falls – house owners feel poorer – consume less – economic activity falls – house owners become unemployed – more defaults on mortgages and decrease in the house price….

  11. Why a banking crisis? • 1) lenders guaranteeing mortgages (Fanny Mae, Freddy Mac) • 2) Mortgages bundled and sold on financial markets („derivatives“) • Idea: diversification reduces risk (not true since risk depends on Macro environment) • These financial products held mostly by investment banks (Lehman brothers, Bear Stearns…)

  12. Why a banking crisis? • As bubble disappeared and borrowers defaulted on loans – value of banks‘ assets declined • Effect 1) banks cannot afford to lend (no short term liquidities) - credit crunch – firms cannot get funds for investment • Effect 2) investors lose confidence in banks, withdraw their funds („bank run“) • Result: banks have to sell assets to be able to pay their lenders („fire sales“)

  13. What can be done? • Central banks inject money – to provide the banks with short term funds for lending (to prevent liqudity crisis) • State: takes over defaulted banks, buys up bad loans to improve banks‘ balance sheets (to prevent banking crisis and restore investors‘ confidence) – Bernanke and Paulson plan – costly to US taxpayer (700 billion $)

  14. Why a stock market crises? • Fire sales of assets by banks increase supply – stock prices decline

  15. Why a real economic downturn? • 1) Banks refuse to lend money for new investment projects – investment supply decreases – less investment – GDP falls • 2) Consumers feel poorer because of reduced value of their savings (houses, stocks) – consume less – final goods demand decreases – GDP falls • 3) since GDP falls (less production) firms demand less labor – unemployment increases

  16. Comparison with Crisis of 1930‘s • In October 1929 stock market crisis in US („black Thursday“) • US stockmarket lost 20% of value in a month (bubble disappeared) • Crisis lasted from 1929 until mid 1930‘s • Crisis lead to a crash of banking system („bank runs“) • Consumers not willing to spend • State trying to keep budget in balance • Central bank was inactive • consequence: extremely high unemployment rates (>25% in 1933)

  17. US GDP 1920-1940

  18. Reaction to crisis • John Maynard Keynes: General Theory of Employment, Interest and Money (1936) • Sees crisis as consequence of wrong policy (restrictive monetary and fiscal policy) • Advocates expansive monetary policy and expansive fiscal policy (to increase aggregate investment and demand)

  19. Reaction of Policy • 1933-34 „New Deal“ (F.D. Roosevelt) • Reform of financial system – introduction of deposit insurance – split of banking system into savings banks and investment banks. • increase in government spending to increase aggregate demand • Introduction of minimum wages, social security to increase private demand

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