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Understanding the Great RecessionEconomics 122: Fall 2010
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Using macro to understand the current recession
Let’s analyze the history of the recession to illustrate some of the major macro issues/tools
Underlying forces:1. Increasing leverage with lower perceived risks2. The housing bubble3. A “run on the banks” and the Lehman bankruptcy4. The crash in asset prices5. Decline in wealth leading to declining I and C.6. International transmissions7. IS-TR curve interpretation8. Liquidity trap!9. Governmental response in monetary and fiscal policies10.The trough in late 200911.The long stagnation to reach full employment (?)
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The bubble economy
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Trends in volatility of US stock prices
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Note: Implied volatility is a measure of the equity price variability implied by the market prices of call options on equity futures. Historical volatility is calculated as a rolling 100-day annualized standard deviation of equity price changes. Volatilities are expressed in percent rate of change. VIX is CBOE index.
Historical lows
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Leveraging the US economy
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0
1
2
3
4
5
0
2
4
6
8
10
1930 1940 1950 1960 1970 1980 1990 2000 2010
Total financial assets/ KTotal financial assets/ GDP
Source: Federal Reserve flow of funds data.
Rising leverage of US economy
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The result on housing prices
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1. Rising perceived wealth of households 1995-2006.
2. Then catastrophic loss of wealth 2006-2009
0
40
80
120
160
200
1985 1990 1995 2000 2005 2010
Real housing prices[1987-1995 = 100]
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Then people wake up from the dream to the nightmare of
falling wealth …
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Mortgage delinquencies for subprime mortgages
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Source: IMF, Global Financial Stability Report, Oct 2008 at imf.org
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The loss of paper wealth
9
4.0
4.5
5.0
5.5
6.0
6.5
60 65 70 75 80 85 90 95 00 05 10
Household net worth/disposable income
Wealth loss of $12 trillion ($100,000 per household)
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The impact on households and consumption
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-16,000
-12,000
-8,000
-4,000
0
4,000
8,000
12,000
16,000
-300
-200
-100
0
100
200
300
400
500
00 01 02 03 04 05 06 07 08 09 10
Change in net worth (left scale)Change in consumption (right scale)
Techbubble
Financialbankcrisis
Billions of 2005 $
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Predictions of consumption
theory
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Consumption function:Ct = β1 Y
pt + β2 Wt
Savings rate:s = 1 – β1 - β2 Wt /Y
pt
.14
.16
.18
.20
.22
.24
.26
0
2
4
6
8
10
12
60 65 70 75 80 85 90 95 00 05 10
Wealth-income ratio (inverted, left scale)Personal savings rate (right scale)
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Bank runs
Series of bank runs.Different from earlier (Depression era) because was
the run by large depositors (run on the repo).Bear Stearns and Lehman were wiped out in a week.
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Bank losses*
13* Note that US bank equity was around $1000 billion in 2010.
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Chicken little
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The Lehman Bankruptcy
A central event in the crisis.Market fundamantalists worried that continued bailouts
would lead to “moral hazard” and worse future problems.
So on September 15, 2008, government decided to let Lehman go bankrupt.
Catastrophic results:- markets froze up (people could not make transactions)- stock market went down 30 % in a month and US dollar ROSE almost 20 %.- market fundamentalism lasted just 36 hours (!)- then bailout of AIG, Citibank, BofA, TARP, GM, etc.- Fed opened up several new facilities to steady markets
“An economy in free fall” in the fall of 2008.15
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Risk on Mature Govt Debt (US, etc.)
16CDS = risk that security will default. These are US and similar Treasury bonds!
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A risk measure on commercial paper
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Source: Federal Reserve page on commercial paper. These are short-term promissory note or unsecured money market obligation, issued by prime rated commercial firms and financial companies. This shows medium-grade (A2/P2) minus top grade (AA).
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18IMF
Risk premiums on
top-rated securities
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Impact of Credit Crunch on Investment
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.10
.11
.12
.13
.14
.15
.16
.17
.18
5.5
6.0
6.5
7.0
7.5
8.0
8.5
9.0
9.5
2005 2006 2007 2008 2009 2010
Investment/ Potential GDPBaa bond rate
Creditcrisis
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Macroeconomic impacts
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Macroeconomic impacts
Rewrite augmented IS and TR curves as follows:
IS: Y = C(Y,W) +I(rr) + G + NX
Y = C(Y,W) +I(i - π + δ) + G + (X – M)
TR: i = f(Y, π)
rr = risky real rate = i - π + δ, where δ is the risk premium
Have adverse IS shifts to W, δ, and NX
Fed lowers i in standard manner, but real interest rate for businesses goes up!
TR = Taylor rule (or LM in old-fashioned theory)
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iff
Y
IS(i ff - π + risk premium)
i*
Taylor Rule (TR)
2006
Before crisis
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iff
Y
IS(i ff - π + low risk premium)
i*
TR
2008
After financial crisis
IS’(i ff - π + high risk premium)
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World output trends
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Policy Responses (thanks to Keynes’s theories)
Gwendolen Darwin Raverat
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Financial Market Support Measures 2007-2010
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Unconventional Fed Measures: the Fed Balance Sheet
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Treasuries = normal stuff!; CPLF = commercial paper funding facility; MBS = mortgage-backed securities
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Fed balance sheet before and after the crisis
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iff
Y
IS(i ff - π + risk premium)
i*
LM
IS’
2008
Before Fed expansion
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iff
Y
IS(i ff - π + risk premium)
i*
LM
IS’
LM’
2009
After Fed expansion
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iff
Y
i*
IS’
LM’
2010
After Fed and Treasury recapitalization (TARP) and other measures which lowered the spread
IS’’
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Fiscal Policy in the Liquidity Trap:Components of US stimulus legislation
32Source: CBO, presentation of Elmendorf, June 2009
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iff
Y
i*
TR
IS(2008)
Without stimulus
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iff
Y
i*
TR
IS(2008) IS(2010)
With stimulus
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CBO’s estimate of impact of stimulus on economy
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My forecast
Source: CBO, presentation of Elmendorf, June 2009,; Nordhaus, Nov 2010.
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When will it ever end?