Chapter 12

The Recession of 2007-2009: Causes and Policy

Responses

Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

12-2

Chapter Outline• The Economy Before 2007• Housing

– How Much Is a House Really Worth? – Mortgages – How to Make a Bubble – Pop Goes the Bubble!

• The Effect on the Overall Economy • The Response to the Recession• Summary

12-3

The Overall Economy Prior to the Recession

10,800.010,900.011,000.011,100.011,200.011,300.011,400.011,500.011,600.011,700.0

GD

P (

Bill

ion

s, 2

000)

GDP in billions of chained 2000 dollars RGDP at Long Run Expected Growth

12-4

Gas Prices

150170190210230250270290310330350

1/3

/20

05

3/3

/20

05

5/3

/20

05

7/3

/20

05

9/3

/20

05

11

/3/2

00

5

1/3

/20

06

3/3

/20

06

5/3

/20

06

7/3

/20

06

9/3

/20

06

11

/3/2

00

6

1/3

/20

07

3/3

/20

07

5/3

/20

07

7/3

/20

07

9/3

/20

07

Pri

ce

of

Ga

so

line

in C

en

ts

12-5

100.00

120.00

140.00

160.00

180.00

200.00

220.00

240.00

Jan

-00

Jul-

00

Jan

-01

Jul-

01

Jan

-02

Jul-

02

Jan

-03

Jul-

03

Jan

-04

Jul-

04

Jan

-05

Jul-

05

Jan

-06

Jul-

06

Jan

-07

Jul-

07

Case Shiller Index of Housing

12-6

250

300

350

400

450

500

Year.Quarter

Ho

us

ing

Sta

rts

in T

ho

us

an

ds

Housing Starts

12-7

600000

800000

1000000

1200000

1400000

1600000

1800000

2000

.01

2000

.07

2001

.01

2001

.07

2002

.01

2002

.07

2003

.01

2003

.07

2004

.01

2004

.07

2005

.01

2005

.07

2006

.01

2006

.07

2007

.01

2007

.07

Deb

t in

Mil

lio

ns

Revolving Credit Non-Revolving Credit

Debt

12-8

0

1

2

3

4

5

6Ju

n-03

Sep

-03

Dec

-03

Mar

-04

Jun-

04

Sep

-04

Dec

-04

Mar

-05

Jun-

05

Sep

-05

Dec

-05

Mar

-06

Jun-

06

Sep

-06

Dec

-06

Mar

-07

Jun-

07

Date

Rat

e

Fed-Funds Rate

12-9

How to Make a Bubble• Fundamental Determinants of

Housing Value– Location– Amenities– Interest rate

• Non-Fundamental Determinants– Expectations that prices will rise in the

future causing increased demand now. This is a prescription for a bubble.

12-10

Vocabulary of 2008• Securitization: The process by which mortgages are

bundled into groups and sold as investment instruments.– Done by Fannie Mae and Freddie Mac– Geographically diversity

• Credit Default Swap– Insurance against the loss of principal– Unregulated– ING AIG were large purveyors as were many

investment banks• Goldman Sachs• Lehman Bros

12-11

0

1

2

3

4

5

6

9/3

/20

07

10

/3/2

00

7

11

/3/2

00

7

12

/3/2

00

7

1/3

/20

08

2/3

/20

08

3/3

/20

08

4/3

/20

08

5/3

/20

08

6/3

/20

08

7/3

/20

08

8/3

/20

08

9/3

/20

08

10

/3/2

00

8

11

/3/2

00

8

12

/3/2

00

8

1/3

/20

09

Fed Funds Rate

12-12

GDP Drops

11,400.0

11,450.0

11,500.0

11,550.0

11,600.0

11,650.0

11,700.0

11,750.0

2007.3 2007.4 2008.1 2008.2 2008.3 2008.4

Year

RG

DP

$b

illi

on

s (

20

00

)

12-13

Unemployment Rises

4

6

8

10

12

14

16

20

06

.01

20

06

.03

20

06

.05

20

06

.07

20

06

.09

20

06

.11

20

07

.01

20

07

.03

20

07

.05

20

07

.07

20

07

.09

20

07

.11

20

08

.01

20

08

.03

20

08

.05

20

08

.07

20

08

.09

20

08

.11

20

09

.01

Unemployment Rate UR+DW UR+DW+Under

12-14

Job Losses

-800

-600

-400

-200

0

200

400

Year.Month

Ne

t C

ha

ng

e in

Jo

bs

(0

00

)

12-15

AS-AD ModelAS

PI

RGDP

AD1

RGDP*

PI*

AD2

Shock

12-16

Obama Stimulus Plan

12-17

AS-AD Model:Assist Nondiscretionary Fiscal

Policy Through StatesAS

PI

RGDP

AD1

RGDP*

PI*

AD2

Shock

AD3

NDFP

12-18

AS-AD Model:Discretionary Fiscal Policy

ASPI

RGDP

AD1

RGDP*

PI*

AD2

Shock

AD3 DFP

NDFP

12-19

Plan Elements: Tax Cuts

12-20

Plan Elements: Medicaid, Unemployment Extensions, Health

Insurance

12-21

Plan Elements: Spending on Projects