quantifying the forces leading to the collapse of gdp after the

Quantifying the Forces Leading

to the Collapse of GDP after

the Financial Crisis

Robert E. HallHoover Institution and Department of Economics

Stanford University

Structural and Cyclical Elements in Macroeconomics

Federal Reserve Bank of San Francisco16 March 2012

·1

A key question today

Why does a decline in product demand raiseunemployment?

Moot in normal times because under a wide class ofobjective functions, the central bank will fully offset shiftsin product demand, leaving unemployment constant.

The exception occurs when the interest rate is pinned atthe zero lower bound.

In this setting, the real interest rate is minus the rate ofinflation.

·

2

A key question today

Why does a decline in product demand raiseunemployment?

Moot in normal times because under a wide class ofobjective functions, the central bank will fully offset shiftsin product demand, leaving unemployment constant.

The exception occurs when the interest rate is pinned atthe zero lower bound.

In this setting, the real interest rate is minus the rate ofinflation.

·

2

A key question today

Why does a decline in product demand raiseunemployment?

Moot in normal times because under a wide class ofobjective functions, the central bank will fully offset shiftsin product demand, leaving unemployment constant.

The exception occurs when the interest rate is pinned atthe zero lower bound.

In this setting, the real interest rate is minus the rate ofinflation.

·

2

A key question today

Why does a decline in product demand raiseunemployment?

Moot in normal times because under a wide class ofobjective functions, the central bank will fully offset shiftsin product demand, leaving unemployment constant.

The exception occurs when the interest rate is pinned atthe zero lower bound.

In this setting, the real interest rate is minus the rate ofinflation.

·

2

Response to shock with standard

DMP labor market

0 010

‐0.005

0.000

0.005

0.010

0.015

0.020Infla

tion

 rate

‐0.025

‐0.020

‐0.015

‐0.010

0.00 0.02 0.04 0.06 0.08 0.10 0.12 0.14

Unemployment rate

Labor market Product market

3

Extended DMP model

Unemployment depends negatively on the rate of inflation.

Higher inflation raises employers’ incentives to recruit newworkers.

The rest of the talk is about the mechanism underlying thenegative dependence.

·

4

Extended DMP model

Unemployment depends negatively on the rate of inflation.

Higher inflation raises employers’ incentives to recruit newworkers.

The rest of the talk is about the mechanism underlying thenegative dependence.

·

4

Extended DMP model

Unemployment depends negatively on the rate of inflation.

Higher inflation raises employers’ incentives to recruit newworkers.

The rest of the talk is about the mechanism underlying thenegative dependence.

·

4

Equilibration with a Negative

Dependence of DMP

Unemployment on Inflation

2

3

4

5

6Infla

tion

 rate

Product market

0

1

2

0 5 10 15

Unemployment rate

Labor market

5

Basic conclusion

If the DMP curve is steeper than the product-market curve,a drop in product demand raises inflation.

Evidence is reasonably conclusive that a drop in productdemand lowers inflation.

Thus, to explain the observation that inflation falls whenunemployment rises by introducing a dependence of DMPunemployment on the inflation rate, the DMP labor-marketcurve must be flatter than the product-market curve.

·

6

Basic conclusion

If the DMP curve is steeper than the product-market curve,a drop in product demand raises inflation.

Evidence is reasonably conclusive that a drop in productdemand lowers inflation.

Thus, to explain the observation that inflation falls whenunemployment rises by introducing a dependence of DMPunemployment on the inflation rate, the DMP labor-marketcurve must be flatter than the product-market curve.

·

6

Basic conclusion

If the DMP curve is steeper than the product-market curve,a drop in product demand raises inflation.

Evidence is reasonably conclusive that a drop in productdemand lowers inflation.

Thus, to explain the observation that inflation falls whenunemployment rises by introducing a dependence of DMPunemployment on the inflation rate, the DMP labor-marketcurve must be flatter than the product-market curve.

·

6

Getting inflation into the

wage-determination function

Walsh (2003): Sticky prices result in variations in marketpower, which enters the DMP model because higher marketpower lowers the revenue contribution of a worker.

This mechanism seems be falling out of favor in NewKeynesian thinking.

V. Ramey (2010) questions empirical evidence ofcountercyclical variations in markups.

·

7

Getting inflation into the

wage-determination function

Walsh (2003): Sticky prices result in variations in marketpower, which enters the DMP model because higher marketpower lowers the revenue contribution of a worker.

This mechanism seems be falling out of favor in NewKeynesian thinking.

V. Ramey (2010) questions empirical evidence ofcountercyclical variations in markups.

·

7

Getting inflation into the

wage-determination function

Walsh (2003): Sticky prices result in variations in marketpower, which enters the DMP model because higher marketpower lowers the revenue contribution of a worker.

This mechanism seems be falling out of favor in NewKeynesian thinking.

V. Ramey (2010) questions empirical evidence ofcountercyclical variations in markups.

·

7

Gertler-Sala-Trigari (2008)

based on Gertler-Trigari (2009)

Newly-hired workers inherit a nominal wage from mostrecent nominal bargain.

Inflation erodes the real wage and raises J , loweringunemployment.

Equilibrium sticky wage as in Hall (2005): J needs toremain in bargaining set between bargains, but this is not ahard condition to satisfy.

No departure from strict rationality.

·

8

Gertler-Sala-Trigari (2008)

based on Gertler-Trigari (2009)

Newly-hired workers inherit a nominal wage from mostrecent nominal bargain.

Inflation erodes the real wage and raises J , loweringunemployment.

Equilibrium sticky wage as in Hall (2005): J needs toremain in bargaining set between bargains, but this is not ahard condition to satisfy.

No departure from strict rationality.

·

8

Gertler-Sala-Trigari (2008)

based on Gertler-Trigari (2009)

Newly-hired workers inherit a nominal wage from mostrecent nominal bargain.

Inflation erodes the real wage and raises J , loweringunemployment.

Equilibrium sticky wage as in Hall (2005): J needs toremain in bargaining set between bargains, but this is not ahard condition to satisfy.

No departure from strict rationality.

·

8

Gertler-Sala-Trigari (2008)

based on Gertler-Trigari (2009)

Newly-hired workers inherit a nominal wage from mostrecent nominal bargain.

Inflation erodes the real wage and raises J , loweringunemployment.

Equilibrium sticky wage as in Hall (2005): J needs toremain in bargaining set between bargains, but this is not ahard condition to satisfy.

No departure from strict rationality.

·

8

The U.S. economy in October 2008

and October 2009, while at the

zero lower bound

1.8

2.0

2.2

2.4

2.6

2.8

3.0Infla

tion

 rate

Product market

October 2008: 

October 2009: Inflation 1.5%, Unemployment 10.1%

3.5 percentage point  shift

1.0

1.2

1.4

1.6

0 5 10 15

Unemployment rate

Labor market

Inflation 1.9%, Unemployment 6.6%

9

Inflation and Unemployment

after the Crisis

0.0

0.5

1.0

1.5

2.0

2.5

3.0

0 2 4 6 8 10 12

Infla

tion rate, p

ercent per year

Unemployment rate, percent

2008:4through 2011:4

2007:1through 2008:3

4.2 percentage point increase

0.63 percentage point decrease

10

The U.S. Economy in December

2007 and December 2009

1.8

2.0

2.2

2.4

2.6

2.8

3.0Infla

tion

 rate

Product market

October 2008: 

October 2009: Inflation 1.5%, Unemployment 10.1%

3.5 percentage point  shift

1.0

1.2

1.4

1.6

0 5 10 15

Unemployment rate

Labor market

Inflation 1.9%, Unemployment 6.6%

11

Two types of households

βP

(cP,t+1

cP,t

)−1/σ

(1 + rt) = 1

βI

(cI,t+1

cI,t

)−1/σ

(1 + rI,t) = 1

rI,t = rt + ρ[vt − bt]+

cI,t = wt−1nt−1 − (1 + rt−1)vt−1 −ρ

2

([vt−1 − bt−1]

+)2

+ vt.

·

12

Two types of households

βP

(cP,t+1

cP,t

)−1/σ

(1 + rt) = 1

βI

(cI,t+1

cI,t

)−1/σ

(1 + rI,t) = 1

rI,t = rt + ρ[vt − bt]+

cI,t = wt−1nt−1 − (1 + rt−1)vt−1 −ρ

2

([vt−1 − bt−1]

+)2

+ vt.

·

12

Two types of households

βP

(cP,t+1

cP,t

)−1/σ

(1 + rt) = 1

βI

(cI,t+1

cI,t

)−1/σ

(1 + rI,t) = 1

rI,t = rt + ρ[vt − bt]+

cI,t = wt−1nt−1 − (1 + rt−1)vt−1 −ρ

2

([vt−1 − bt−1]

+)2

+ vt.

·

12

Two types of households

βP

(cP,t+1

cP,t

)−1/σ

(1 + rt) = 1

βI

(cI,t+1

cI,t

)−1/σ

(1 + rI,t) = 1

rI,t = rt + ρ[vt − bt]+

cI,t = wt−1nt−1 − (1 + rt−1)vt−1 −ρ

2

([vt−1 − bt−1]

+)2

+ vt.

·

12

Financial friction

ft =1

qt

[αytkt

+ (1 − δ)qt+1

]− 1 − rt.

·

13

Borrowing by impatient

households

vt = (1 + rt−1)vt−1 +ρ

2

([vt − bt]

+)2 − wt−1nt−1 + cI,t.

bt = vt − xt

·

14

Borrowing by impatient

households

vt = (1 + rt−1)vt−1 +ρ

2

([vt − bt]

+)2 − wt−1nt−1 + cI,t.

bt = vt − xt

·

14

Taylor rule

rN,t = [τ0 + τππt − τuut]+

·

15

Investment/GDP Ratio and

Comprehensive Unemployment

Rate, 2005 to 2022

5

10

15

20

25

30

35

40

0

5

10

15

20

25

30

2005 2007 2009 2011 2013 2015 2017 2019 2021

Percen

t

Percen

t

Investment/GDP, left scale

Comprehensive unemployment rate, right scale

16

The Implied Values of the

Financial Friction

0

2

4

6

8

10

12

14

16

2009 2012 2015 2018 2021

Percen

t per year

17

Implied Values of the Tightening

of the Borrowing Constraint as

a Percent of Total Consumption

‐6

‐4

‐2

0

2

4

6

2009 2012 2015 2018 2021

Percen

t of p

er‐cap

ita con

sumption

18

Model Solution with Financial

Friction Only

0.00

0.05

0.10

0.15

0.20

0.25

2009 2011 2013 2015 2017 2019

Compreh

ensive une

mploymen

t rate

Actual and projected

Model solution with financial friction only

19

Burden of Deleveraging as a

Percent of Consumption

‐5

0

5

10nt of con

sumption

‐15

‐10

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Perce

20