background for prof. brad delong’s april 17 lecture...

AnnouncementsIntroduction

How Can An Economy Become Depressed?Potential Policy Responses to Depressed Economies

How Policy Responses Affect Macroeconomic VariablesSummary

Reminders for Next WeekOpen Office Hours Until 9:30pm

Background for Prof. Brad Delong’s April 17Lecture: “Fiscal Policy in a Depressed Economy”

Econ 191: Background Lecture 6

Dawn Powers

April 10, 2012

Dawn Powers Background for April 17: “Fiscal Policy in a Depressed Economy”





Outline

1 Announcements

2 Introduction

3 How Can An Economy Become Depressed?

4 Potential Policy Responses to Depressed Economies

5 How Policy Responses Affect Macroeconomic Variables






Announcements

Graded revised research topic comments will be available inIssi’s office hours this Friday, April 13.Graded preliminary results will be available in lecture nextTuesday, April 17.Visit Professor Delong’s website to preview next week’s slides:http://delong.typepad.com/sdj/2012/04/econ-191-spring-2012-uc-berkeley-fiscal-policy-in-the-great-recession-april-17-2012.htmlLit reviews not previously collected are available tonight.






Next Week’s Topic“Fiscal Policy in a Depressed Economy”

Next week, Professor Delong will discuss:Lloyd Metzler (1951). "Wealth, Saving, and the Rate ofInterest."Gauti Eggertson and Michael Woodford (2002). "The ZeroBound on Interest Rates and Optimal Monetary Policy."Gabriel Chodorow-Reich, Laura Feiveson, Zachary Liscow, andWilliam Gui Woolston (2011). "Does State Fiscal ReliefDuring Recessions Increase Employment? Evidence from theAmerican Recovery and Reinvestment Act."Jan Hazius and Sven Jari Stehn (2011). "The Case for aNominal GDP Level Target."Christina D. Romer (2011). "What Do We Know About theEffects of Fiscal Policy? Separating Evidence from Ideology."Dawn Powers Background for April 17: “Fiscal Policy in a Depressed Economy”






Visit Professor Delong’s website to preview other topics he willdiscuss:

http://delong.typepad.com/sdj/2012/04/econ-191-spring-2012-uc-berkeley-fiscal-policy-in-the-great-recession-april-17-2012.html

(Or, Google “Brad Delong Econ 191,” and click on the firstsearch result.







This week, Dawn will discussHow an economy can become depressed: The 2007-2009financial crisisPotential policy responses to depressed economiesHow different policy responses theoretically affectmacroeconomic variables

IS/LM, AD/AS models

Resources used in building today’s lecture include Mishkin (2012),various posts from Brad Delong’s blog, “Grasping Reality with theInvisible Hand,” and lecture notes from Brad Delong’s 2009 Econ202B Macroeconomics class.






How Can An Economy Become Depressed?The 2007-2009 Financial Crisis

How can an economy become depressed?Several types of financial crises are possible:

Bank runs:1 Depositors suddenly withdraw a significant amount of their

deposits.

2 Because banks lend out most of its deposits, they may have

insufficient funds to repay a large amount of these deposits

immediately, and so go bankrupt.

E.g.: Bank of U.S. (1931), Northern Rock PLC (2007)(Note: A less severe form of bank runs are credit crunches,whereby banks are reluctant to lend because they worry thatthey have insufficient funds available.)








Asset bubbles and crashes:1 Bubble: The price of a financial asset (e.g. stocks) exceeds

the present value of its expected future income. However, it

continues to be purchased–not because of a perceived increase

in its intuitive value, but because speculators in the market

hope to sell the asset to someone else at an even higher price.

2 Crash: Many asset holders decide to sell the asset, causing the

price to fall quickly.

E.g. 1929 U.S. stock market crash, U.S. tech bubble (2000),U.S. housing bubble (2007)








Currency (balance of payments) crises:1 Investors quickly sell a country’s currency when its value is

high in order to cause devaluation of the currency, so that

investors can re-purchase the currency at a much lower price.

2 Countries with fixed exchange rates often do not have the

large amount of reserves necessary to maintain the exchange

rate, and must often devalue the currency or risk financial

collapse.

3 Currency crises are often coupled with a country’s defaulting

on foreign debt.

E.g. Asian financial crisis (1997), Argentina financial crisis(1999)







The 2007-2009 financial crisis:Three main factors:

1 Unregulated financial innovation in mortgage markets2 Agency problems in mortgage markets3 Asymmetric information in the credit rating process.







Three main factors:Unregulated financial innovation in mortgage markets

Before 2000, only the most credit-worthy borrowers couldobtain residential mortgages (bank loans for large real estatepurchases using the real estate as collateral).







Three main factors:Unregulated financial innovation in mortgage markets

Technological advances:1 Allowed numerical credit scores to be assigned to households,

predicting the likelihood of mortgage default

2 Enabled smaller loans (like mortgages) to be bundled together

easily into securitized debt: mortgage-backed securities

=> Lower transaction costs + ability to spread risk acrossmany individuals/institutions=> Banks became able to offer subprime mortgages, and moreeagerly approved less solvent borrowers for loans







Three main factors:Agency problems in mortgage markets

The mortgage brokers who originated the loans had lesserincentive to evaluate whether the borrower would default onthe loan, since the buyers of mortgage-backed securities wouldsoon take on the riskRisk-loving investors invested in housing, since they coulddefault on the loan at any timeMortgage brokers, because they made profit from transactioncommissions, were incentivized to sign up as many mortgageloans as possible. This sometimes lead to mortgage applicationfraud by brokers.







Three main factors:Agency problems in mortgage markets

Commercial and investment banks earned large fees fromunderwriting mortgage-backed securities, and so had weakincentives to make sure the ultimate holders of the securitieswere paid off.Insurance companies like AIG earned large fees from writingfinancial insurance contracts, and so also had weak incentivesto make sure the ultimate holders of the securities were paidoff.







Three main factors:Asymmetric information in the credit rating process

Credit rating agencies rate debt securities by their probabilityof default, but also make money advising clients on how tostructure their financial instruments.=> Conflict of interest may have produced inaccurate ratingsof clients’ debt instruments.







Impacts:U.S. residential housing marketFinancial institutions’ balance sheetsShadow banking systemGlobal financial marketsFailures of major financial firms







Impacts:U.S. residential housing market:

The growth of the subprime lending market increased thedemand for housing and thus housing pricesRising housing prices caused subprime borrowers to expect alower probability of default, and thus take larger and moreloansThe growing distance between housing prices and housing“fundamentals” (purchase/renting cost, housing cost relative tomedian income) eventually caused the housing price bubble toburst.Many home prices fell below the amount of the mortgage,greatly incentivizing struggling homeowners to walk away fromtheir mortgages and give the house to the lender.







Impacts:Financial institutions’ balance sheets:

Rising defaults on mortgages caused the value ofmortgage-backed securities to collapse, leading banks and otherfinancial institutions holding securities to have less net worth.In order to improve their asset/liability ratio, these institutionssold off assets and restricted credit to HHs and businesses.Less credit to HHs and businesses lead to decreases in C and I,and thus aggregate demand (more later).







Impacts:Shadow banking system:

Shadow banking system: Hedge funds, investment banks,and other non-depository financial firms, which are not astightly regulated as banks, but who help fund elements of thefinancial system such as low interest-rate mortgages and autoloans.Financial institutions borrow from the shadow banking systemthrough repurchase agreements, where assets likemortgage-backed securities are used as collateral.With the value of mortgage-backed securities falling, theamount of collateral required to borrow from the shadowbanking system increased as much as 50%.







Impacts:Shadow banking system:

In order to raise funds for collateral, financial institutions hadto sell off their assets very quickly, and did so by engaging infire sales, whereby they offered these assets at a lower price.These fire sales lead to further decreases in value formortgage-backed securities, and thus higher collateralrequirements, and thus more fire sales, etc.







Impacts:Global financial markets:

BNP Paribas suspended redeeming of money market fundshares in funds which had sustained large lossesEuropean banks also began to hoard cashNorthern Rock and other European financial institutionscollapsed in 2007European countries actually experienced a more severedownturn than in the US, especially where banks had highexposure to mortgage markets and high short-term borrowingin the repurchase market.







Impacts:Failures of major financial firms:

March 2008: Bear Stearns, the fifth-largest investment bank inthe United States, which had invested heavily in subprimerelated securities, had a run on its repurchase funding and wasforced to sell itself to J.P. Morgan for less than 5% of its 2007valueJuly 2008: U.S. Treasury and the Federal Reserve bails out andthen assumes governance of Fannie Mae and Freddie Mac, twoprivately owned government-sponsored enterprises thattogether insured over $5 trillion of mortgages ormortgage-backed assets, after suffering substantial losses fromtheir holdings of subprime securities.







Impacts:Failures of major financial firms:

Sept. 2008:1 Merrill Lynch, the third-largest investment bank who also

suffered large losses on its holding of subprime securities,

announced its sale to Bank of America for a price 60% below

its 2007 value.

2 Lehman Brothers, the fourth-largest investment bank by asset

size with over $600 billion in assets and 25,000 employees,

filed for bankruptcy–the largest in U.S. history.

3 AIG, an insurance firm with assets over $1 trillion, had to

make payouts on possible losses in over $400 billion worth of

insurance contracts. The Federal Reserve lent AIG $85 billion

when it suffered an extreme liquidity crisis due to a credit

rating downgrade.Dawn Powers Background for April 17: “Fiscal Policy in a Depressed Economy”






Worsening and height of the crisis:Sept. 2008: U.S. House of Representatives, fearing voterbacklash for bailing out Wall Street, votes down a $700 billiondollar bailout package proposed by the Bush administration

A week later, the bill passes, but...

Oct. 2008: Worst weekly stock market decline in US history.






Potential Policy Responses to Depressed Economies

Governments affect the macroeconomy primary through two policychannels:

Fiscal policy: Government spending and taxing behaviorIn order to stimulate the economy, a government may increasespending and decrease taxation.E.g. The 2008 U.S. Emergency Economic Stabilization Act






Potential Policy Responses to Depressed Economies

Governments affect the macroeconomy primary through two policychannels:

Monetary policy: Actions of a country’s central bank withrespect to money supply

In order to stimulate the economy, a government’s centralbank may increase the money supply in order to lower theinterest rate, which (A) decreases the cost of investment and(B) increase consumers’ opportunity cost of holding money(versus spending it).E.g. In the US, the Federal Reserve sells U.S. Treasury bonds.






How do different policy responses theoretically affectmacroeconomic variables?The IS/MP and AD/AS models

What, in theory, is the causal chain between fiscal or monetarypolicy and improvements in macroeconomic indicators?

We will use IS/LM, AD/AS models to answer this question.







The IS curveRecall from intermediate macroeconomics that the IS curvetells us, for each given level of the real interest rate r , whataggregate output Y must be for the goods market to be inequilibrium (Y = AE = C + I + G + NX ):







The IS curve

Source: Mishkin (2012) Dawn Powers Background for April 17: “Fiscal Policy in a Depressed Economy”






The IS curveIntuition for the IS curve’s (downward sloping) shape:

r increases => C , I , NX decrease => AE decreases => Ymust be lower for it to equal AE (and thus satisfy the goodsmarket equilibrium).







The IS curveNote that a change in the real interest rate that affectsequilibrium aggregate output Y causes only a movement alongthe IS curve.

A shift in the IS curve, by contrast, occurs when equilibriumoutput changes at each given real interest rate.







The IS curveFactors that shift the IS curve:

Source: Mishkin (2012)

Note: “Autonomous” here means that the relevant variable is unrelated to othervariables in the IS model, such as output or interest rates.







The MP curveRecall that the monetary policy (MP) curve indicates therelationship between the real interest rate the central bank setsand the inflation rate:

r = r̄ + λπwhere r̄ is the component of the real interest rate set by thecentral bank, λ is the responsiveness of the interest rate to theinflation rate, and π is the inflation rate.







The MP curve

Source: Mishkin (2012)Dawn Powers Background for April 17: “Fiscal Policy in a Depressed Economy”






The MP curveIntuition for the MP curve’s upward slope:

Y increases => π increasesπ increases => r̄ increases => r increasesr increases => Y decreases => π decreases







The MP curveNote that a change in the real interest rate r that affectsinflation π causes only a movement along the MP curve. (I.e.An “automatic adjustment,” such as that caused by the TaylorRule)

A shift in the MP curve, by contrast, occurs when the centralbank changes r̄ , the autonomous (and discretionary) changesto monetary policy.

1 The MP curve shifts up if autonomous monetary policy is

tightened (r̄ increases => r increases).

2 The MP curve shifts down if autonomous monetary policy is

loosened (r̄ decreases => r decreases).







The MP curve







The AD curveRecall that the aggregate demand (AD) curve indicates therelationship between the aggregate output Y and the inflationrate π when the goods market is in equilibrium:

Y = [C+I+G+NX−mpc ∗T ]∗ 11−mpc −

c+d+e1−mpc ∗(r+λπ)

where mpc is the marginal propensity to consume, T is taxrevenue, and c , d , e, and λ are (constant) parameters of themodel.







The AD curveRecall that the aggregate demand (AD) curve indicates therelationship between the aggregate output Y and the inflationrate π when the goods market is in equilibrium.

The AD curve uses the shared vertical variable of the IS andMP curves, r , to link the two horizontal variables of the IS andMP curves, (1) aggregate output Y and (2) the inflation rateπ:







The AD curve








The AD curveNote that a change in the inflation rate π causes only amovement along the AD curve.A shift in the AD curve, by contrast, occurs for the same fivereasons the IS curve shifts, and shifts the AD curve in thesame direction:







The AD curveA shift in the AD curve can also occur through autonomouschanges in monetary policy r̄ :

An autonomous tightening of monetary policy (r̄ increases =>r increases) shifts the MP curve up, causes upward movementalong the IS curve, and thus shifts the AD curve to the left:







The AD curve








The AD curveSimilarly, an autonomous easing of monetary policy (r̄decreases => r decreases) shifts the AD curve to the right.







The AS curvesRecall that the aggregate supply (AS) curve represents therelationship between the total quantity of output that firms arewilling to produce, Y , and the inflation rate π:

π = πe + γ(Y − Y P) + ρ

where π is current inflation, πe is expected inflation, Y P ispotential output, and ρ is any price shock (shift in inflationindependent of labor markets or expected inflation).







The AS curvesThere are 2 AS curves: The long run AS (LRAS) curve andthe short-run AS (SRAS) curve.







The AS curves1 LRAS: In the long run, wages and prices are fully flexible, and

the LRAS is determined by labor, capital, technology, and thenatural rate of unemployment.

As a result, the LRAS curve is vertical at the level of potentialoutput, Y P .

2 SRAS: In the short run, wages and prices take time to adjustto economic conditions.

As a result, the SRAS curve is upward sloping, but not vertical;as output rises relative to potential, inflation rises from itscurrent level.







The AS curves








The AS curvesFactors shifting the LRAS:

Shocks to the natural rate of unemployment and technologyLong-run changes in the amounts of labor or capital that affectthe amount of output the economy can produce







The AS curvesFactors shifting the SRAS:

Expected Inflation. When expected inflation rises, workers andfirms will want to raise wages and prices more, causinginflation to rise. => SRAS shifts up- and leftward.Price Shocks. Supply restrictions or workers pushing for higherwages can cause firms to raise prices, causing inflation to rise.=> SRAS shifts up- and leftward.








Persistent Output Gap. When output remains high relative topotential output, the output gap is persistently positive. Laborand product markets remain tight, increasing current andexpected inflation => SRAS shifts up- and leftward.(The reverse is true when output remains low relative topotential output.)







Policy responses to a negative AD shock:If there is a negative shock to AD, the government can chooseto affect no fiscal or monetary policy, causing a negativeoutput gap and thus a downward shift of the SRAS curve asthe economy moves back to long-run equilibrium:







Negative shock to AD + No fiscal or monetary policy:







Policy responses to a negative AD shock:If there is a negative shock to AD, Congress can enactexpansionary fiscal policy to shift the IS curve and thus theAD curve back out and avoid an output gap that causes theSRAS to shift down:







Negative shock to AD + Expansionary fiscal policy:








Policy responses to a negative AD shock:If there is a negative shock to AD, an autonomous easing ofmonetary policy can shift the AD curve back out and avoid anoutput gap that causes the SRAS to shift down:







Negative shock to AD + Expansionary monetary policy:







Policy responses to a negative (temporary) AS shock:If there is a negative shock to AS (e.g. from a temporarysupply shock, such as a spike in the price of oil), thegovernment can choose to affect no fiscal or monetarypolicy, causing a negative output gap and thus an upwardshift of the SRAS curve:







Negative (temporary) AS shock + No fiscal or monetaryresponse:







Policy responses to a negative (temporary) AS shock:If there is a negative (temporary) shock to AS, the Fed canenact contractionary monetary policy to shift the MP curveup, and thus the AD curve left. The resulting output gapcauses the SRAS curve to shift back downward.When the monetary policy is no longer needed becauseinflation has subsided, the MP curve is shifted back downward,which shifts the AD curve back out:







Negative shock to AS + Contractionary monetary policy:







Hand Out Attendance Sheet

Hand Out Attendance Sheet






Summary

Several types of economic crises exist, including bank runs,asset bubble crashes, and currency (balance of payments)crises.Three interrelated problems contributed to the 2007-2009financial crisis:

1 Unregulated financial innovation in mortgage markets2 Agency problems in mortgage markets3 Asymmetric information in the credit rating process.






Summary

Governments affect the macroeconomy primary through twopolicy channels: fiscal and monetary policy.The IS/MP and AD/AS models can help us understand thechannels through which fiscal and monetary policy can affectmacroeconomic variables in depressed economies.






Reminders for Next Week

Finish reading papers for Prof. Delong’s lecture next week.Check out Prof. Delong’s posted slides for next week.Pick up revised research q’s in OH FridayPreliminary results (and remaining revised research q’s) will bereturned next Tuesday in lecture.Reminder: Deadline for final paper is May 1 at 5pm. Drop ahard copy in Issi Romem’s mailbox, and email the paper tomyself and Issi: [email protected] [email protected]






Open Office Hours Until 9:30pm

Open Office Hours Until 9:30pm


background for prof. brad delong’s april 17 lecture...

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