Chapter 14

The Great Recession and the Short-Run Model

By Charles I. Jones
Media Slides Created By

Dave Brown Penn State University

The Great Recession and the Short-Run Model

In chapter 14, we:

Introduce financial considerationsa risk premiuminto our short-run model and use this framework to understand the financial crisis. Study deflation, bubbles, and the Federal Reserves balance sheet as we deepen our understanding of the financial crisis. Consider various actions that policymakers have taken in response to recent events.

14.2 Financial Considerations in the Short-Run Model

A Risk Premium A risk premium
An extra amount of money charged to compensate for the probability that a loan will not be repaid

This was responsible for the spread in interest rates.

Interest rates moving in the wrong direction Deepening instead of mitigating the downturn

THE FINANCIAL CRISIS AND THE POLICY RESPONSES: AN EMPIRICAL ANALYSIS OF WHAT WENT WRONG John B. Taylor, NBER WP, 2009

 We can incorporate the risk premium into our short-run model.

Real interest rate

Real interest rate at which firms borrow in financial markets

Risk premium

 During normal times

we assume p = 0.

During a financial crisis

p rises and interferes with the Feds ability to stimulate the economy.

A Rising Risk Premium in the IS/MP Framework

To stabilize the economy after the bursting of a housing bubble
The Fed may lower the interest rate to stimulate the economy. Counteracts the negative aggregate demand shock.

The financial crisis raises interest rates despite the Feds efforts, producing a deep recession at point D.

The Risk Premium in the AS/AD Framework

Recall that the IS/MP structure
feeds into the aggregate demand curve.

The risk premium

Works through investment in the IS curve It shifts the AD curve inward, just like a negative demand shock.

Case Study: Deriving the New AD Curve

Recall Combining the risk premium equation and the monetary policy rule gives Substituting this into the IS curve yields the new AD curve

 The current situation has two related shocks that shift the AD curve down and to the left.
A decline in housing and equity prices that reduces household wealth A rise in the risk premium

These shocks result in a deep recession that lowers inflation below its target rate. The AS curve shits as well and would contribute to the adjustment of the economy towards a LR equilibrium, but at high costs

What should the Fed do under these circumstances?

The astute student will notice that a natural answer is that the Fed should take additional actions and cut the fed funds rate even further, so that the final real interest rate is sufficiently low. This is, in fact, precisely what the Fed tried to do. However, this approach ran into a problem: the fed funds rate fell to zero, so there was no room for the Fed to cut the rate further.

Deflation, disinflation
Deflation
A negative rate of inflation The aggregate price level that declines over time.

Disinflation
A positive rate of inflation that is declining over time

The Dangers o De !ation

Deflation was essentially responsible for the Great Depression. Recall the Fisher equation.
When inflation is negative, it raises the real interest rate. In normal times, the central bank can handle this by lowering the nominal interest rate.

 Two situations in which problems arise. 1. The first took place during the Great Depression. The Fed would not lower the nominal interest rate because of inflation concerns. This caused a serious recession.

2. The second and more insidious Fed policy rates are situation
already very low

The nominal interest rate is already low. Nominal interest rates have a zero lower bound. Nominal interest rates cant be negative. Fed runs out of room with monetary policy.

 Small increases in the risk premium can theoretically be offset by the central bank lowering its target rate. When the target rate reaches zero, however, this option is no longer available. This characterizes the situation in 200809 and is one justification for the additional unconventional measures undertaken by the Federal Reserve.

Liquidity trap
Remember: investment decisions (I) depend on the REAL INTEREST RATE When the real interest rate exceeds the MPK Firms and households do not wish to invest. Deflation curtails the ability of monetary policy to stimulate the economy. A liquidity trap: the nominal interest rate is very low, which makes it agents indifferent between holding money (liquid form of financial portfolio choice) and interest-bearing bonds. Situation in which the volume of transactions in some financial markets falls sharply This makes it difficult to value certain financial assets. It also raises questions about the overall value of the firms holding those assets.

 These dynamics can destabilize the economy. A deflationary spiral

Situation in which negative inflation raises the real interest rate, causing a recession to deepen This in turn causes worse deflation, which further raises the real interest rate and worsens the recession.

14.3 Policy Responses to the Financial Crisis

Looking at current monetary policy, it appears expansionary. This is misleading.
What appears to be a low fed funds rate has not translated into lower interest rates for firms and households.

 Simple Monetary Policy Rule: inflation targeting Real interest rate Long run interest rate

Current inflation

Inflation target

Governs how aggressively monetary policy responds to inflation

The Tay!or Ru!e and Monetary Po!i"y

Recall our simple policy rule.
The fed funds rate as a function of the gap between the current inflation rate and some target rate

The Taylor rule goes further.

Also allows the current level of short-run output to influence the fed funds rate.

The Money Su##!y

Excessively tight monetary policy by the Federal Reserve and the ensuing deflation was the principal cause of the Great Depression. Fed is currently focused on stimulating the economy and preventing deflation.
Rapid expansion of the money supply at the end of 2008 and beginning of 2009

Taylor: the Fed response to risk is incorrect

The market turmoil in the interbank market was not a liquidity problem of the kind that could be alleviated simply by central bank liquidity tools. Rather it was inherently a counterparty risk issue, which linked back to the underlying cause of the financial crisis. This was not a situation like the Great Depression where just printing money or providing liquidity was the solution; rather it was due to fundamental problems in the financial sector relating to risk.

Case Study: Shou!d Monetary Po!i"y Res#ond to Asset Pri"es$

With the benefit of hindsight it appears that there was a bubble in the housing market in the mid-2000s. This raises the question:
What is the correct monetary policy response in the face of inflated asset prices?

 Bernanke argued in 2000

It is often difficult to tell if there is a bubble in real time. Even if it is known that there is a bubble, standard monetary policy is too coarse an instrument to deal with the problem. Policymakers should use more precise instruments. capital requirements the regulation of lending standards

Whenever the ratio of stock prices to company earnings gets too far away from its mean, it tends to revert back. Notice that this measure reached its two highest peaks in 1929 and 2000.

 Faced with the threat of deflation and a fed funds rate that is essentially zero, policymakers pursued a range of unconventional policies.
Troubled Asset Relief Program (TARP) Feds direct purchases of mortgagebacked securities and commercial paper Fiscal stimulus program

Going forward, thoughtful and prudent financial reform is needed.

The Trou%!ed Asset Re!ie Program

Economists agree that restoring the financial system is crucial, but there is debate over what policy is best. Purchases of toxic assets
banks possess bad assets, which limits lending.

Capital injections into financial institutions

the original TARP $25 billion in each large financial institution

Complete reorganizations of financial institutions

government steps in and reorganizes debt into new equity claims for the former debt holders

Fis"a! Stimu!us
In February 2009, President Obama signed a $787 billion stimulus package.
Tax cuts and new government spending Increased the deficit to 10 percent of GDP in 2009
only 3 percent in 2008

Economists agree.
A fiscal stimulus is necessary.

Economists disagree.
Types of spending Relative weight on tax cuts vs. new spending

The return of fiscal policy: Automatic Stabilizers or Countercyclical fiscal policy?

The crisis has returned fiscal policy to centre stage for two main reasons. First, monetary policy had reached its limits. Second, from its early stages, the recession was expected to be long lasting, so that it was clear that fiscal stimulus would have ample time to yield a beneficial impact despite implementation lags. The aggressive fiscal response has been warranted given the exceptional circumstances, but it has further exposed some drawbacks of discretionary fiscal policy for more normal fluctuations in particular lags in formulating, enacting, and implementing appropriate fiscal measures. The crisis has also shown the importance of having fiscal space, as some economies that entered the crisis with high levels of government debt had limited ability to use 41 fiscal policy.

Fiscal policy is back

The US Congressional Budget Office (CBO) estimates that
Short-run output would reach -7.4 percent without a stimulus package However, even with the stimulus packages best-case scenario, the recession will still be long and deep.

In Australia

Counter-cyclical fiscal policy

Growth rate in Australia

The Ricardian equivalence argument against active fiscal policy

The Ricardian equivalence argument, discussed in Chapter 10, was also a factor: high spending must be financed by higher taxes in the future, and the prospect of these taxes may reduce the current impact of the stimulus package.

 The Ricardian equivalence argument against active fiscal policy: when G rises, C drops and so the fiscal multiplier may be close to zero
It relies on very special assumptions A rise in G today requires either higher taxes today oris The Ricardian equivalence hypothesis
higher taxes in the future If T(t+1) increases its effect on current macroeconomic aggregate (AD) depends on expectations:
Does current consumption reacts to expectations of taxes in the future? What theories of consumption support this view? What is the evidence? It is only if agents predict the future correctly (in average) that current consumption drops in the face of expected higher taxes in the future

Finan"ia! Re orm
How do we prevent major problems?
Gain greater understanding of volatile prices housing, stocks, bubbles Understand the downside of moral hazard Realize that there are costs that come with all the benefits of major financial intervention and restructuring

 Moral hazard
With bailouts, institutions may undertake excessively risky investments in the future.

Too big to fail

Description given to large financial institutions Suggests that the government had no choice but to step in and provide liquidity and capital when the banks were in trouble.

 Gain insight into how firms fail under normal circumstances

Firm reorganization Debt written to zero Former debtholders given equity claims into newly reorganized firm

 A rising risk premium can be analyzed in the IS/MPPhillips curve and AS/AD frameworks. The AS/AD framework is best suited to normal times when a well designed monetary policy rule is functioning. In abnormal situations the IS/MP approach is superior.

The lender of last resort debate

Central Banks/IMF: should a Central Bank/IMF provide bailout? Two main contrasting issues: Issues of moral hazard Debt hangovers reduce growth rates and their ability to cope with social and economic emergencies.