10.

Great Recession I
the worst recession since the Great
Depression of the 1930s.
The causes of the financial crisis that began
in the summer of 2007 and where the
economy currently stands.
How the current financial crisis compares to
previous recessions and to previous financial
crises in the United States and around the
world.

10.2 Recent Shocks to the

Macroeconomy
What shocks to the macroeconomy
have caused the global financial crisis?
Housing prices
Global saving glut
Subprime lending and rise in interest rates
Previous financial turmoil
Oil prices

Housing Prices
Housing prices tripled between 1996
and 2006.
Housing bubble

Between mid-2006 and the first quarter

of 2012, the national index for housing
prices plummeted by 42 percent.
The bubble burst

The Global Saving Glut

The current financial turmoil was caused
partly by prior financial crises.
Ben Bernanke March 2005: global saving glut
Glut = excess

The United States had an excess of savings

with desire to invest.
Higher investment demand contributed to
rising asset prices in the housing market.

Subprime Lending and

the Rise in Interest Rates
The savings glut led to low interest rates,
and many borrowers took out mortgages to
buy homes between 2000 and 2006.
Many of these borrowers were subprime
poor credit records
high debt-to-income ratios.

Between 2004 and 2006, the Fed raised its

interest rate from 1.25 to 5.25 percent.

 The Taylor rule demonstrated that rates

had been too low in previous years.
However, many subprime borrowers were
now facing mortgages that were increasing
from their initial teaser rates.
By August 2007 nearly 16 percent of subprime
mortgages with adjustable rates (as opposed
to fixed rates) were in default. This led to a
downward spiral of the housing market.

Federal funds rate

It is the interest rate paid from one bank
to another for overnight loans.
However, the Fed can actually control
the level of the fed funds rate.
It will be discussed in ch 12.

The Financial Turmoil of 2007-2009

Before the crisis, subprime mortgages
were sold to investors through a financial
innovation known as securitization.
Securitization
The process of pooling a group of financial
instruments, such as mortgages, and then
slicing them up in a different way and selling
off the pieces.
Meant to diversify risk.

 As mortgages were developed and traded,

it became difficult to know how much risk
an individual bank was exposed to.
August 2007: flight to safety.
Lenders put funds in T-bills: T-bills (U.S.
Treasury bills) are safer.

 Liquidity crisis
The volume of transactions in some financial
markets falls sharply.
Makes it difficult to value certain financial
assets.
raises questions about the overall value of the
firms holding those assets.

Financial markets plunged and the S&P

index dropped 50 percent from its peak in
November 2007. Other stock indices
include DJI and Nasdaq.

Oil Prices
To make matters worse, oil prices were
extremely volatile in this period.
2002: $20 per barrel.
Summer of 2008: $140 per barrel.
December 2008: $40 per barrel.
2009Present: $80 to $100 per barrel.

 The oil price increase was caused by:

Demands from China, India, and the Middle
East.
Short-term supply disruptions.

The economic slowdown helped to

alleviate oil demand pressures.
It is possible that price speculation also
played a role.

10.3 Macroeconomic Outcomes

The recession, starting in December
2007, was first visible in unemployment.
By 2009:
Output was 7 percent below potential.
Unemployment peaked at 10 percent.

February 2010:
8.5 million jobs lost

A Comparison to Previous Recessions

Compared to an average of all
recessions since 1950, this recession is
significantly worse.
A striking difference about this recession
is the decrease in consumption that
occurred: why is the decrease in
consumption is striking?

Inflation
Volatile oil prices caused sharp swings
in inflation for all items in 2008.
In the recession, core inflation (all items
excluding food and fuel) declined
slightly.

10.4 Some Fundamentals of

Financial Economics
It is helpful to understand some basic
financial principles in order to
understand the crisis as a whole.

Balance Sheets
Balance sheet
Accounting tool with assets on the left side and
liabilities and net worth on the right side.
The two sides sum to the same value when net
worth is included.

Assets
Items of value that an institution owns: loans,
investments, cash and reserves.

 Liability
An amount that is owed to someone else:
deposits, short-term and long-term debts.

Equity = capital
The difference between total assets and total
liabilities on a balance sheet.
Represents the value of an institution to its
shareholders or owners.
Also known as net worth or capital.

 Banks are also subject to a number of

financial regulations that apply to their
balance sheets.
The reserve requirement
A mandate that financial institutions keep a
certain percent of their deposits in a special
account with the central bank.

The capital requirement

The legal obligation that a financial institution
have a certain ratio of its assets supported by
capital on its balance sheet.

Leverage
Leverage
The ratio of total liabilities to net worth.
This ratio magnifies any changes in the
value of assets and liabilities in terms of
the return to shareholders.
This principle also applies to homeowners.

 If a bank is highly leveraged, it may make

Large gains off of small increases in market
prices: incentives to increase leverage.
Large losses off a small decrease in prices:
risk of high leverage ratio.

Insolvency
Situation in which the liabilities of a bank or
other company exceed its assets.

Before the financial crisis, many

investment banks were highly leveraged.

Bank Runs and Liquidity Crises

The Great Depression of the 1930s was
caused by nearly all depositors converging on
banks at once and demanding the return of
their deposits.
Bank run
A situation in which depositors or creditors
worry about a financial institutions solvency
and its ability to repay its deposits or shortterm debt.
Everyone runs to withdraw all funds, and
the bank cant meet all these requests.