Capitol Tech U Doctoral Presentation - April 2024.pptx
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Chapter 14 - Great Recession
1. Chapter 14: The Great Recession and the Short Run
Ryan W. Herzog
Spring 2020
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2. 1 Introduction
2 Financial Considerations in the Short-Run Model
3 Policy Responses to the Financial Crisis
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3. Introduction
Learning Objectives
Introduce ļ¬nancial considerations - a risk premium - into our short-run
model and use this framework to understand the ļ¬nancial crisis.
Study deļ¬ation, bubbles, and the Federal Reserveās balance sheet as
we deepen our understanding of the ļ¬nancial crisis.
Consider various actions that policymakers have taken in response to
recent events.
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4. Introduction
Financial Crises
Contributors to a very large negative shock in AD
The wedge between the fed funds rate and the prevailing interest rates
A household balance-sheet crisis
Substantial uncertainty
Having exhausted conventional monetary policies, the Fed has turned
to unconventional actions.
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5. Financial Considerations in the Short-Run Model
A risk premium is the extra amount of money charged to compensate
for the probability that a loan will not be repaid
This was responsible for the spread in interest rates.
Interest rates moving in the wrong direction
Deepening instead of mitigating the downturn
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7. Financial Considerations in the Short-Run Model
Risk Premium
We can incorporate the risk premium into our short-run model.
R = Rļ¬
+ f (1)
where:
R is the real interest rate
Rļ¬
is the real interest rate at which ļ¬rms borrow in ļ¬nancial markets.
f is the risk premium
During normal times we assume f = 0.
During a ļ¬nancial crisis f rises and interferes with the Fedās ability to
stimulate the economy.
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8. Financial Considerations in the Short-Run Model
A Rising Risk Premium in the IS/MP Framework
To stabilize the economy after the bursting of a housing bubble
The Fed may lower the interest rate to stimulate the economy.
Counteracts the negative aggregate demand shock.
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10. Financial Considerations in the Short-Run Model
Rising Risk Premium
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11. Financial Considerations in the Short-Run Model
The Risk Premium in the AS/AD Framework
Recall that the IS/MP structure feeds into the aggregate demand
curve.
The risk premium works through investment in the IS curve
It shifts the AD curve inward, just like a negative demand shock.
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12. Financial Considerations in the Short-Run Model
The current situation has two related shocks that shift the AD curve
down and to the left.
A decline in housing and equity prices that reduces household wealth
A rise in the risk premium
These shocks result in a deep recession that lowers inļ¬ation below its
target rate.
Deļ¬ation could result as the aggregate price level that declines over
time.
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13. Financial Considerations in the Short-Run Model
Financial Crisis
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14. Financial Considerations in the Short-Run Model
Deriving the New AD Curve
Incorporate the risk premium into the MP curve:
IS curve: ĖY = a ā b(Rt ā r)
MP rule: Rt ā r = m(Ļt ā Ļ)
RP equation: Rt = Rļ¬
t + f
Combining the risk premium equation and the monetary policy rule
gives
Rt ā r = f + m(Ļt ā Ļ) (2)
Substituting this into the IS curve yields the new AD curve
ĖY = a ā bf ā bm(Ļt ā Ļ) (3)
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15. Financial Considerations in the Short-Run Model
In situations where monetary policy rules are functioning:
The AS/AD model is preferable
It tracks the dynamics of the economy in a single graph.
When policy rules break down
The IS/MP-Phillips curve is superior.
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16. Financial Considerations in the Short-Run Model
Dangers of Deļ¬ation
Deļ¬ation was essentially responsible for the Great Depression.
Recall the Fisher equation (it = Rt + Ļt)
When inļ¬ation is negative, it raises the real interest rate.
In normal times, the central bank can handle this by lowering the
nominal interest rate.
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17. Financial Considerations in the Short-Run Model
Periods of Deļ¬ation
The Great Depression:
The Fed would not lower the nominal interest rate because of inļ¬ation
concerns.
This caused a serious recession.
The more insidious situation:
The nominal interest rate is already low.
Nominal interest rates have a zero lower bound, i.e. canāt be negative.
Fed āruns out of roomā with monetary policy.
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18. Financial Considerations in the Short-Run Model
Deļ¬ation: Liquidity Trap
A liquidity trap is a situation in which the volume of transactions in
some ļ¬nancial markets falls sharply (extremely high quantity demand
for money).
This makes it diļ¬cult to value certain ļ¬nancial assets.
It also raises questions about the overall value of the ļ¬rms holding
those assets.
These dynamics can destabilize the economy and lead to a
deļ¬ationary spiral
Situation in which negative inļ¬ation raises the real interest rate,
causing a recession to deepen
This in turn causes worse deļ¬ation, which further raises the real
interest rate and worsens the recession.
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19. Policy Responses to the Financial Crisis
Looking at current monetary policy, it appears expansionary.
This is misleading. What appears to be a low fed funds rate has not
translated into lower interest rates for ļ¬rms and households.
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20. Policy Responses to the Financial Crisis
The Taylor Rule and Monetary Policy
Recall our simple policy rule. Which is the fed funds rate as a function
of the gap between the current inļ¬ation rate and some target rate
The Taylor rule goes further by allowing the current level of short-run
output to inļ¬uence the fed funds rate.
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21. Policy Responses to the Financial Crisis
Taylor Rule Prediction
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22. Policy Responses to the Financial Crisis
Short-run Output
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23. Policy Responses to the Financial Crisis
Core Inļ¬ation
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24. Policy Responses to the Financial Crisis
Money Supply
Excessively tight monetary policy by the Federal Reserve and the
ensuing deļ¬ation was the principal cause of the Great Depression.
Fed is currently focused on stimulating the economy and preventing
deļ¬ation.
Rapid expansion of the money supply at the end of 2008 and
beginning of 2009.
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25. Policy Responses to the Financial Crisis
Growth Rate of Money Supply Measures
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26. Policy Responses to the Financial Crisis
Should Monetary Policy Response to Asset Prices?
With the beneļ¬t of hindsight it appears that there was a bubble in
the housing market in the mid-2000s.
What is the correct monetary policy response in the face of inļ¬ated
asset prices?
Bernanke argued in 2000:
It is often diļ¬cult to tell if there is a bubble in real time.
Even if it is known that there is a bubble, standard monetary policy is
too coarse an instrument to deal with the problem.
Policymakers should use more precise instruments including capital
requirements and the regulation of lending standards
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27. Policy Responses to the Financial Crisis
Asset Bubbles - Stock Prices
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28. Policy Responses to the Financial Crisis
Asset Bubbles - Home Prices
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29. Policy Responses to the Financial Crisis
The Fedās Balance Sheet
When conventional monetary policy failed, the Federal Reserve and
the Treasury created new policies.
Goal: provide liquidity and capital to ļ¬nancial institutions.
The Fed has dramatically reshaped its balance sheet.
The size of the balance sheet more than doubled, growing by more
than $2 trillion.
The composition of assets and liabilities also changed signiļ¬cantly.
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30. Policy Responses to the Financial Crisis
On the asset side:
Lending was expanded to the rest of the economy.
This included ļ¬nancial institutions and nonļ¬nancial corporations.
On the liability side
The Fed has not ļ¬nanced additional lending by printing money.
The funds have come from borrowing from the U.S. Treasury and bank
excess reserves.
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31. Policy Responses to the Financial Crisis
The Fedās Balance Sheet
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32. Policy Responses to the Financial Crisis
The Troubled Asset Relief Program (TARP)
Economists agree that restoring the ļ¬nancial system is crucial, but
there is debate over what policy is best.
Purchases of ātoxicā assets because banks possess bad assets, which
limits lending.
Capital injections into ļ¬nancial institutions (the original TARP included
$25 billion in each large ļ¬nancial institution
Complete reorganizations of ļ¬nancial institutions as government steps
in and reorganizes debt into new equity claims for the former debt
holders
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33. Policy Responses to the Financial Crisis
The Fiscal Stimulus
In February 2009, President Obama signed a $787 billion stimulus
package.
Tax cuts and new government spending
Increased the deļ¬cit to 10 percent of GDP in 2009 (only 3 percent in
2008)
Economists agree a ļ¬scal stimulus is necessary.
Economists disagree over types of spending and relative weight on tax
cuts vs. new spending
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34. Policy Responses to the Financial Crisis
The Ricardian equivalence argument
Suggests that high spending today must be ļ¬nanced by higher future
taxes
Reduces the current impact of the stimulus package
The CBO estimates that
Short-run output would reach -7.4 percent without a stimulus package
However, even with the stimulus packageĖOs best-case scenario, the
recession will still be long and deep.
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35. Policy Responses to the Financial Crisis
Financial Reform
How do we prevent major problems?
Gain greater understanding of volatile prices (housing, stocks,
bubbles)
Understand the downside of moral hazard
Realize that there are costs that come with all the beneļ¬ts of major
ļ¬nancial intervention and restructuring
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36. Policy Responses to the Financial Crisis
āMoral hazardā - With bailouts, institutions may undertake
excessively risky investments in the future.
āToo big to failā - Description given to large ļ¬nancial institutions
which suggests that the government had no choice but to step in and
provide liquidity and capital when the banks were in trouble.
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37. Policy Responses to the Financial Crisis
Squam Lake Group suggested guidelines for ļ¬nancial reform.
Create a systemic regulator
Enhance capital requirements
Link executive compensation to long-term performance
Require convertible debt
Require āliving willsā
Main cost of bailouts:
Borne by people outside of the ļ¬nance industry
Measured by lost jobs and forgone GDP
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38. Policy Responses to the Financial Crisis
Macroeconomic Research after the Financial Crisis
Did macroeconomists fail the country?
No research was available to provide rules for what to do in this
situation.
Research has been limited by technology.
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39. Policy Responses to the Financial Crisis
New models are more advanced and include
Frictions such as sticky inļ¬ation and limited ļ¬nancial markets
Heterogeneous consumers
Imperfect ļ¬nancial markets
Allowing for more roles of government
Generally, a large increase in macroeconomic research since the
recession
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