ec404-lecture4

The banking sector and the IS/PC/MR model The financial crisis The credit crunch

Macroeconomic CSI: The 2008 financial crisisand the credit crunch

Rodolphe Desbordes

http://www.rodolphedesbordes.com/

http://www.rodolphedesbordes.com/


Table of Contents I

1 The banking sector and the IS/PC/MR model

2 The financial crisis

3 The credit crunch


The banking sector

1 QI: The central bank sets r0.2 QI: Commercial banks ‘borrow’ reserves from the central bank at the rate r0.3 QII: They want to make a profit, they lend at the rate rL = (1 + m)r0.4 QIII: Commercial banks supply the volume of loans LS necessary to satisfy the

demand of loans LD , which depends on the price level, real output and rL.5 QIV: Loans (L) create deposits (D), which are backed up by reserves (DR).


The banking sector and the IS/PC/MR model

The only modification is that the IS curve depends now on the loan rate ofinterest rL.The central bank still sets the interest rate r0 and the banking sector reflectschanges in r0 in rL.


Revisiting the permanent AD shock

LD’’

B

1 Positive AD shock [Z ] Y0−YeYe

> 0, π0 − πT > 0, LD , the demand for loans is veryhigh at rL = (1 + m)r0.

2 The central bank raises r0 to r ′′0 . Commercial banks raise rL to r ′′L .3 In the next period [B], Y1−Ye

Ye< 0, π1 < π0, L′′D < LD .


A stylised narrative I

1 After the 2001 recession, the Fed prolonged its low-interest rate policy.Borrowing was cheap.

2 Interest rates were also low in other countries.

3 The low interest rates (short-term and medium-term) fueled a globalhousing boom.

4 This housing boom led financial institutions to relax their lendingrequirements. They made subprime loans, including to NINJA (Noincome, no job and no asset) households.

5 They did not really care because they could (partially) get rid of them byrepackaging these subprime loans into mortgage/asset-backedsecurities (MBS) that they sold to investors all over the world.


A stylised narrative II

6 Investors, such as other financial institutions, bought these MBSbecause they provided a high return and because rating agenciesassured them that MBS were safe investments.

7 The Fed, and other central banks, worried by rising inflationarypressures, increased their interest rate targets over the period2005-2007.

8 Many subprime borrowers could no more pay their mortgage payments.

9 Residential investment (spending on the construction of new housesand apartment buildings) and the associated consumption on durablegoods fell (first AD shock).

10 The MBS, whose returns were derived from the mortgage interestpayments, became worthless.


A stylised narrative III

11 Financial institutions which had invested in MBS, often by borrowing alot, made huge losses.

12 Banks stopped trusting each other. It was harder and more expensiveto borrow and they preferred to keep any excess money they had inreserves. The credit crunch started in mid-2008 (second AD shock).


Source: http://www.nytimes.com/imagepages/2008/09/16/business/16primer.span.ready.html

http://www.nytimes.com/imagepages/2008/09/16/business/16primer.span.ready.html


Source: http://cfec.ca/en/conference/2008/taylor.pdf

The line “counterfactual” depicts what would have happened if the Taylor rulehad been followed, according to a statistically estimated model of housing starts.

Inappropriate expansionary monetary policy played a role in the crisis of 2008.

http://cfec.ca/en/conference/2008/taylor.pdf


The fall of bank lending in the UK: businesses

Source: http://www.bankofengland.co.uk/publications/other/monetary/TrendsAugust10.pdf

http://www.bankofengland.co.uk/publications/other/monetary/TrendsAugust10.pdf


The fall of bank lending in the UK: mortgages




The fall of bank lending in the UK: consumers




Credit crunch

Loans

Interest rates

r_0

r_L

r_L’

LL’Rationing

Mark-up in

crease

A

BC

LDLD’

A credit crunch is an increase in the cost of obtaining a loan from commercial banks,potentially coupled with a rationing of bank loans [A→ C].

Higher mark-up m increases the cost of a loan [A→ B].

Rationing reduces the availability of loans, even when individuals are wiling topay a higher interest rate. Banks have higher requirements for borrowers toqualify for loans than normal [B → C].


Impact on aggregate demand

Output

Interest rate

r_L

r_L’

ISIS’

Rationing Higher mark-up

A

BC

The loan rate of interest is higher and, at a given interest rate level, a fraction of potentialborrowers are excluded from the market. Higher costs and more stringent requirementsreduce debt-financed spending.

Along the IS curve: rL → r ′L:movement along the IS curve, investment and otherdebt-financed components of AD, e.g. consumption of durable goods fall[A→ B].

Shift of the IS curve: At a given level of the interest rate, a fraction of the desireddebt-financed spending cannot occur. IS curve shifts to the left [B → C].


Impact on output and inflation

Output

MR

PC

PC1

Ye

Target

Impact credit crunch

A

C

D

Deflationary spiral

The credit crunch is a negative AD shock.

AD falls, output falls, inflation falls [A→ C].

If the central bank does not intervene OR commercial banks are unwilling toease credit conditions, output remains stuck at a low level and inflation falls todangerous levels [C → D].

ec404-lecture4

Documents

banking sector reflectschanges

financial crisis3

financial crisisand

credit cruncha

rate rl

credit crunchrevisiting

ispcmr model2

ispcmr modelthe