Week 12_Lisa_SII2013 [Compatibility Mode].pdf

7/27/2019 Week 12_Lisa_SII2013 [Compatibility Mode].pdf

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Chapter 14

TheGreat Recession

and the

Short-Run Model

By Charles I. Jones

Media Slides Created By

Dave Brown

Penn State University


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The Great Recession

and the Short-Run Model

In chapter 14, we:

Introduce financial considerationsa riskpremiuminto our short-run model anduse 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.


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14.2 Financial Considerations

in the Short-Run Model

A risk premium An extra amount of money charged to

compensate for the probability that a loan willnot be repaid

This was responsible for the spread in

interest rates. Interest rates moving in the wrong direction

Deepening instead of mitigating the downturn

A Risk Premium


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


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We can incorporate the risk premium intoour short-run model.

Realinterestrate

Real interest rate atwhich firms borrow infinancial markets

Riskpremium


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During normal times

we assume p = 0.

During a financial crisis

prises and interferes with the Fedsability to stimulate the economy.


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A Rising Risk Premium inthe IS/MP Framework

To stabilize the economy after thebursting of a housing bubble

The Fed may lower the interest rate tostimulate the economy.

Counteracts the negative aggregatedemand shock.


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The financial crisis raises interestrates despite the Feds efforts,producing a deep recession at pointD.


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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.


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Case Study: Deriving the New AD Curve

Recall

Combining the risk premium equation andthe monetary policy rule gives

Substituting this into the IS curve yields thenew AD curve


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The current situation has two related

shocks that shift the AD curve down and tothe 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 theeconomy towards a LR equilibrium, butat high costs


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What should the Fed do under these

circumstances?

The astute student will notice that anatural answer is that the Fed shouldtake additional actions and cut the fedfunds rate even further, so that thefinal real interest rate is sufficiently

low. This is, in fact, precisely what the Fed

tried to do. However, this approachran into a problem: the fed funds ratefell to zero, so there was no room for

the Fed to cut the rate further.


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Deflation, disinflation

Deflation A negative rate of inflation

The aggregate price level that declines

over time.

Disinflation A positive rate of inflation that is decliningover time


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The Dangers o De!ation

Deflation was essentially responsible forthe Great Depression.

Recall the Fisher equation. When inflation is negative, it raises the real

interest rate.

In normal times, the central bank can handlethis by lowering the nominal interest rate.


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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 inflationconcerns.

This caused a serious recession.


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2. The second and more insidious

situation

The nominal interest rate is already low.

Nominal interest rates have a zero lowerbound.

Nominal interest rates cant be negative.

Fed runs out of room with monetary policy.

Fed policy rates arealready very low


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Small increases in the risk premium cantheoretically be offset by the centralbank lowering its target rate.

When the target rate reaches zero,however, this option is no longeravailable.

This characterizes the situation in200809 and is one justification for the

additional unconventional measuresundertaken by the Federal Reserve.


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Remember: investment decisions (I) depend on the REALINTEREST 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 theeconomy.

A liquidity trap: the nominal interest rate is very low, which makes

it agents indifferent between holding money (liquid form offinancial portfolio choice) and interest-bearing bonds.

Situation in which the volume of transactions in some financialmarkets falls sharply

This makes it difficult to value certain financial assets. It also raises questions about the overall value of the firmsholding those assets.

Liquidity trap


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These dynamics can destabilize theeconomy.

A deflationary spiral Situation in which negative inflation raises

the real interest rate, causing a recession todeepen

This in turn causes worse deflation, which

further raises the real interest rate andworsens the recession.


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14.3 Policy Responses to theFinancial Crisis

Looking at current monetary policy, itappears expansionary.

This is misleading.

What appears to be a low fed funds ratehas not translated into lower interest ratesfor firms and households.


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Governs how

aggressivelymonetary policyresponds toinflation

Inflationtarget

Currentinflation

Simple Monetary Policy Rule: inflation targeting

Long runinterestrate

Realinterestrate


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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 andsome target rate

The Taylor rule goes further. Also allows the current level of short-run

output to influence the fed funds rate.


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The Money Su##!y

Excessively tight monetary policy by theFederal Reserve and the ensuingdeflation was the principal cause of theGreat Depression.

Fed is currently focused on stimulatingthe economy and preventing deflation.

Rapid expansion of the money supply atthe end of 2008 and beginning of 2009


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Taylor: the Fed response torisk is incorrect

The market turmoil in the interbank market was not a liquidityproblem of the kind that could be alleviated simply by centralbank liquidity tools.

Rather it was inherently a counterparty risk issue, which linkedback to the underlying cause of the financial crisis.

This was not a situation like the Great Depression where justprinting money or providing liquidity was the solution; rather itwas due to fundamental problems in the financial sector relatingto risk.


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

With the benefit of hindsight it appearsthat there was a bubble in the housingmarket in the mid-2000s.

This raises the question: What is the correct monetary policy

response in the face of inflated assetprices?


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Bernanke argued in 2000 It is often difficult to tell if there is a bubble inreal time.

Even if it is known that there is a bubble,standard monetary policy is too coarse aninstrument to deal with the problem.

Policymakers should use more preciseinstruments.

capital requirements

the regulation of lending standards

Wh th ti f t k i t


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Whenever the ratio of stock prices tocompany earnings gets too far away from its

mean, it tends to revert back. Notice that thismeasure reached its two highest peaks in1929 and 2000.


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Faced with the threat of deflation and afed funds rate that is essentially zero,policymakers pursued a range of

unconventional policies. Troubled Asset Relief Program (TARP)

Feds direct purchases of mortgage-

backed securities and commercial paper

Fiscal stimulus program

Going forward, thoughtful and prudentfinancial reform is needed.

Th T %! d A t R !i P


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The Trou%!ed Asset Re!ie Program

Economists agree that restoring the financialsystem 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 financialinstitutions government steps in and reorganizes debt into

new equity claims for the former debt holders

Fi ! Sti !


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Fis"a! Stimu!us

In February 2009, President Obamasigned a $787 billion stimulus package. Tax cuts and new government spending

Increased the deficit to 10 percent of GDP in2009

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


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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 itslimits.

Second, from its early stages, the recession was expected tobe long lasting, so that it was clear that fiscal stimuluswould have ample time to yield a beneficial impact despite

implementation lags. The aggressive fiscal response hasbeen warranted given the exceptional circumstances, butit has further exposed some drawbacks of discretionaryfiscal policy for more normal fluctuations in particular

lags in formulating, enacting, and implementingappropriate fiscal measures.

The crisis has also shown the importance of having fiscalspace, as some economies that entered the crisis with

high levels of government debt had limited ability to usefiscal policy.


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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.


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In Australia


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Counter-cyclical fiscal policy


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Growth rate in Australia


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The Ricardian equivalence argumentagainst active fiscal policy

The Ricardian equivalence argument,discussed in Chapter 10, was also afactor: high spending must be financed

by higher taxes in the future, and theprospect of these taxes may reduce thecurrent impact of the stimulus package.

The Ricardian equivalence argument


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The Ricardian equivalence argument

against active fiscal policy: when Grises, C drops and so the fiscal multipliermay be close to zero

It relies on very special assumptionsThe Ricardian equivalence hypothesis isA rise in G today requires either higher taxes today or

higher taxes in the future

If T(t+1) increases its effect on current macroeconomicaggregate (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 currentconsumption drops in the face of expected higher taxes in the future

Fi i ! R


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Finan"ia! Reorm

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 withall the benefits of major financialintervention and restructuring


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Moral hazard

With bailouts, institutions may undertakeexcessively risky investments in the future.

Too big to fail

Description given to large financial

institutions

Suggests that the government had nochoice but to step in and provide liquidity

and capital when the banks were in trouble.


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Gain insight into how firms fail undernormal circumstances

Firm reorganization

Debt written to zero

Former debtholders given equity claimsinto newly reorganized firm


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A rising risk premium can be analyzedin the IS/MPPhillips curve and AS/ADframeworks.

The AS/AD framework is best suited tonormal times when a well designedmonetary policy rule is functioning.

In abnormal situations the IS/MPapproach is superior.


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The lender of last resortdebate

Central Banks/IMF: should a CentralBank/IMF provide bailout?

Two main contrasting issues:

Issues of moral hazard

Debt hangovers reduce growth rates

and their ability to cope with social andeconomic emergencies.

Week 12_Lisa_SII2013 [Compatibility Mode].pdf

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