Macroeconomic Theory. Economics 104 Spring 2018 Linus Yamane

Transcription

1 Macroeconomic Theory Economics 104 Spring 2018 Linus Yamane

2 Classical Long Run Model Level of output is determined by the Production Function Y = F(K,L) Level of K, L exogenous Who gets the output? Y = wl + rk w = MP of labor r = MP of capital

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4 Why does supply = demand? The real interest rate adjusts to make sure the supply of goods equals the demand for goods at the aggregate level. The demand for loans equals the supply of loans

5 Implications Expansionary fiscal policy Increase G or decrease T No effect on output Interest rates increase Investment falls Complete crowding out Increased investment demand Interest rates increase No effect on output Level of investment does not change

6 Money and Inflation Money - any generally acceptable means of payment in exchange for good and services and in settling debts Serves as medium of exchange unit of value store of value standard of deferred payment

7 Stages of History Autarky no trade, no specialization, no money Barter trade good for goods Money» Need double coincidence of wants Commodity money (shells, metals, coins ) Fiat money (legal tender, paper money) Bank money (checking accounts)

8 Money

9 Billions of Dollars 4000 Money Supply: M Year

10 Billions of Dollars Money Supply: M Year

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12 National Money (since 1862) Billions $ Currency $1, Checkable Deposits $2, M1: Transactions Money $3, Savings Accounts $10, M2: Broad Money $13, December 2017

13 denomination Currency in Circulation (approx. in 2016) bills in circulation (billions) percent Value (billions) percent % $ % % $ % % $ % % $ % % $ % % $ % % $1, % Total 39.7 $1,460.1

14 Other terms MZM : money zero maturity M2 + all money market funds time deposits $15,276.7 billion (Dec 2017) Monetary Base : high powered money Currency + bank reserves $3, billion (Dec 2017)

15 Money Supply Federal Reserve sets the nation s nominal money supply Fed has some political independence Control money supply with 3 tools Reserve requirement Discount rate Open market operations Control of money supply is monetary policy

16 Money Supply High powered money = H = currency + reserves = C + R Money supply = M = currency + deposits = C + D H (money multiplier) = M Money multiplier m depends on the currency/deposit ratio and the reserve/deposit ratio

17 Derivation

18 billions of dollars 4500 Monetary Base (High powered money) Monetary base = currency + bank reserves year

19 Billions of Dollars 3000 Bank Reserves at the Fed Year

20 Federal Reserve Balance Sheet Billions $ 2017 Assets Liabilities Gold 11 Currency 1,537 Treasury Securities 2,246 Reserves 2,287 Mortgage Backed Securities 1,771 Deposits other than Reserves 195 Other 433 Other 41 Total $4,461 Total $4,461

21 Credit Easing Policy Tools /3/2007 1/3/2008 1/3/2009 1/3/2010 1/3/2011 1/3/2012 1/3/2013 1/3/2014 1/3/2015 1/3/2016 1/3/2017 1/3/2018 Lending to Financial Institutions Traditional Security Holdings Long-Term Treasury Purchases Liquidity to Key Credit Markets Federal Agency Debt and Mortgage-Backed Securities Purchases

22 Money Multiplier: M

23 Velocity 12 Velocity of M Year

24 Wizard of Oz Allegory about monetary policy Yellow brick road Cowardly Lion Dorothy Tornado Oz Ruby Slippers Gold standard William Jennings Bryan America Free Silver Movement Ounce of Gold Originally silver slippers

25 The Great Recession Linus Yamane

26 NASDAQ Composite Index Dot Com Bubble

27 250 Case Shiller Real Housing Price Index Year

28 Time Line 2006 Housing prices peak 2007 Subprime mortgage industry collapses 2008 Stock market crashes 2009 Recession bottoms out Recovery

29 Growth Rate 9 8 GDP Growth Rate Year

30 Percent of Labor Force 12 Unemployment Rate Year

31 Mortgages A mortgage is the pledging of a property to a lender as a security for a mortgage loan Historically we had fixed interest rate mortgages with a down payment of 20% and income verification These are extremely safe assets to hold

32 Conventional Mortgages 20% DOWN PAYMENT Down payment $60,000 Mortgage $240,000 Price $300,000 Unless the price of the home falls below $240,000, the lender is unlikely to lose any money. Very little risk for the lender.

33 Mortgages Financial institutions will bundle mortgages together and sell them in the secondary market A mortgage-backed security (MBS) is an asset-backed security whose cash flows are backed by the principal and interest payments of a set of mortgage loans MBSs are even safer because of the pooled risk

34 Unconventional Mortgages We eventually move to adjustable interest rate mortgages with no down payment and no income verification. 0% DOWN PAYMENT Down payment $0 Mortgage $300,000 Price $300,000 If the price of the house falls, the lender can lose some money.

35 Risks If interest rates increase, homeowners may not be able to afford the mortgage payments If home prices fall, homeowners may have negative equity Some homeowners choose to walk away from a home with negative equity If there is negative equity, the bank does not get all its money back with a foreclosure Foreclosure when the borrower defaults on the mortgage, the bank repossesses the property

36 Unconventional Mortgages There is a lot of risk here for the borrower and for the lender Financial institutions are okay as long as home prices do not fall If home prices fall, financial institutions can lose some of the money they loaned out

37 Case Shiller Index 200 US Home Prices Year

38 Housing Bubble 1990 Home Prices 1890 Home Prices Home prices increase by 3x from January 1994 to June 2006 (mostly after 1997) Home prices peak in June 2006 Home prices drop 32.9% to May 2009 During the Great Depression home prices fell 30%

39 Case Shiller Index 300 LA Home Price Index Mar-86 Dec-88 Sep-91 Jun-94 Mar-97 Dec-99 Sep-02 May-05 Feb-08 Nov-10 Aug-13 Month/Year

40 Los Angeles Market Peak in June 1990 Prices fall 27% until March 1996 Prices increase by a factor of 3.75 between 1996 and 2006 Peak in Sept 2006 Prices fall 41% to May 2009

41 March 2007 Subprime mortgage industry collapses 25 subprime lenders declare bankruptcy, announce significant losses, or put themselves up for sale New Century Financial, the largest subprime lender, files for Chapter 11 with liabilities exceeding $100 million

42 Commercial Bank Balance Sheet ASSETS Reserves (cash) Loans outstanding (mortgages) US gov securities LIABILITIES Checking account deposits Savings and time deposits Other liabilities Other securities (MBS) Other assets TOTAL $1,234,567 TOTAL $1,234,567

43 Credit Default Swaps Invented in 1997 Contract between two parties The buyer makes periodic payments to the seller The buyer receives a payoff if the underlying financial instrument defaults Like an insurance policy except The seller need not be regulated The buyer need not own the underlying financial instrument Uses include speculation, hedging, & arbitrage Notional value of $62 trillion world-wide

44 November 2007 Chuck Prince, CEO and Chairman of Citigroup, retires due to poor 3 rd quarter performance resulting from losses on mortgage backed securities (MBS) and collateralized debt obligations (CDO)

45 May 2008 Bear Stearns, one of the world s largest investment banks and securities trading and brokerage firms, was bought out by JP Morgan Chase.

46 Federal Reserve NY Lance Auer, Vice President of the Bank Supervision Group after He joined the FED in Sept 1991 as a financial analyst and was named an officer of the New York Fed in Dec Graduated from Pitzer College and Kennedy School of Government (Harvard).

47 July 2008 IndyMac Bank experiences bank runs, and is seized by FDIC. Largest savings and loan in the Los Angeles area Fourth largest bank failure in US history

48 September 2008 The US government, through the Federal Housing Finance Agency, takes control of Fannie Mae and Freddie Mac by placing them into conservatorship. Fannie Mae and Freddie Mac are private firms which compete in the secondary mortgage market.

49 September 2008 Lehman Brothers, a global financial services firm, files for Chapter 11 and marks the largest bankruptcy in US history. Lehman Brothers was partially purchased by Barclays. Washington Mutual, the nation s largest savings and loan, is seized by regulators, and purchased by JP Morgan for $1.9 billion. With $307 billion in assets, it is the largest bank failure in history.

50 September 2008 Federal Reserve extends credit line of $85 billion (eventually $170 billion) to AIG (American Insurance Group), the largest government bailout of a private company in US history. Bank of America agrees to acquire Merrill Lynch.

51 September 2008 Goldman Sachs and Morgan Stanley change its status from investment bank to bank holding, accepting more regulation in exchange for liquidities from the Federal Reserve Mitsubishi UFJ buys 21% stake in Morgan Stanley.

52 December 2008 Wachovia bites the dust 4 th largest banking chain in the US Banking operations bought out by Wells Fargo Deal brokered by FDIC Had acquired mortgage lender Golden West in 2006

53 Mortgage Delinquencies Delinquency rates peak (2009 III) mortgages more than 30 days past due 9.64% seasonally adjusted Foreclosure proceedings increased 1.3 mil (2007), 2.3 mil (2008), 2.8 mil (2009) Record number of homes repossessed 465,000 properties ,000 properties ,000 properties 2009

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55 Percent 14 Delinquency Rates real estate mortgage commercial Year

56 Problem When housing prices were falling, no one knew the value of these MBSs No one knew the value of another firm s assets No one wanted to lend Everyone was hoarding cash Credit markets froze up No loans for housing, college, cars, business

57 Credit Freeze McDonald's says Bank of America won't boost franchisee loans Credit freeze plunges Detroit 3 into cash crisis In a Credit Freeze, Farmers' Loans Could Dry Up Credit Crunch Squeezes Small-Business Owners Municipalities Also Find Credit Is Scarce

58 Black Monday 2008 September 29, 2008 Dow Jones suffers largest point drop in US history DJ falls 778 points after House fails to pass rescue package Markets are down about 9% in one day Loss of $1.2 trillion in market value Worst single day since October 1987

59 Dow Jones Index Dow Jones Industrials Index Year

60 S&P 500 Index 1800 S&P 500 Index Year

61 Stock Market Dow Jones peaked October 2007 Loses 49.3% to February 2009 S&P peaked October 2007 Loses 52.6% to February 2009 So Americans lost about 50% of their stock market wealth, and 30% of their housing wealth. Total loss of about $16 trillion in wealth.

62 Trillions Dollars 90 Household Net Worth Household net worth fell $16 trillion from 2007III to 2009I nominal real Year

63 Hard Hit Sectors Private domestic investment (15% of GDP) was down about 28% into 2009 II Personal consumption expenditures (69% of GDP) were down about 1.7% into 2009 II Durables were down 8.8% Nondurables were down 2.7% Services were down 0.2% Government expenditures (18.8% of GDP) were up 2.5% Net exports were up (deficit down 30%)

64 President Obama US Dept of the Treasury Tim Geithner Council of Economic Advisors Christina Romer National Economic Council Larry Summers Economic Recovery Advisory Board Paul Volcker

65 Fiscal Stimulus Federal fiscal policy needs to be expansionary enough to Offset the decline in housing and stock market wealth Offset most state governments which are raising taxes and cutting spending President and Congress Run a $1.75 trillion deficit Debt held by the public increases by $2.56 trillion in 2009 (direct loan accounts, TARP, financing accounts) Gross federal debt jumps from 70% of GDP to 90% of GDP in 2009 and 100% of GDP by 2011

66 Percent of GDP 30 Federal Government Spending, Taxes, and Deficit taxes exp deficit Year

67 Ben Bernanke Chair, Federal Reserve PhD Economics, MIT World s foremost expert on the Great Depression

68 Percent 18 3 Month Treasury Bill Rates Nominal interest rates are now as low as they can go Year

69 Percent Inflation No longer deflationary Year

70 Percent 8 Real Interest Rates 6 So real interest rates are negative Year

71 Multiplier 14 Money Multiplier (M2) 12 You can t push on a string! Year

72 Millions of Dollars Credit Easing Policy Tools Fed Agency Debt Mortgage-Backed Securities Purch Liquidity to Key Credit Markets Lending to Financial Institutions Long Term Treasury Purchases Traditional Security Holdings /3/2007 1/3/2008 1/3/2009 1/3/2010 1/3/2011 1/3/2012 1/3/2013 Year

73 Historical Comparisons JOBS LOST 21% 2.0% 5.9% UNEMPLOY MENT 25.2% 10.8% 10.1% REAL GDP 30% 2.9% 3.8%

74 Final Thoughts 1. Be Aware of Historical Norms - PE ratios 16 - Home Price / Household Income 3 2. Don t Put All Your Eggs in One Basket - Hold a broadly diversified portfolio - Buy Index funds 3. Relationship between Risk and Return Rate of return are higher if you bear more risk

75 Final Thoughts 4. How much risk should you bear? - More risk when you are younger - Less risk when you are older - How well do you sleep at night? 5. Much of Life Outcomes are due to Chance - Don t confuse luck and skill - Warren Buffett has been extremely lucky

76 Money Demand People hold money to buy goods and services and to carry out transactions The cost of holding money is the nominal interest rate M d = k o P T k o constant P price of transactions T # of transactions

77 Money Demand Assume # of transactions is proportional to income Y (k is constant) M d = k P Y Real money demand M P d = k Y M P d is proportional to income Money supply = Money demand M P = k Y

78 Quantity Equation MV=PY (this is an identity) M: nominal money supply V: velocity of money P: price level Y: real GDP Velocity of money is the number of times the stock of money is turned over in a year to purchase GDP

79 Velocity of Money Velocity of M1 PY M 1 = nominal GDP M 1 = $19,500.6 $3,614.6 = Velocity of M2 PY M 2 = $19,500.6 $13,844.5 = 1.408

80 Money Demand We have M P = ky and MV = PY k = 1 or V = 1 V k We have assumed that the velocity of money is constant. This may not be a good assumption But let us begin from here

81 Money, Prices & Inflation Quantity Equation MV=PY ln(m) + ln(v) = ln(p) + ln(y) M M + V V = P P + Y Y g M + g V = g P + g Y If V is constant, then g V = 0 g P = π = inflation g M = π + g Y

82 Friedman s Monetary Rule g Y depends on exogenous factors (labor, capital, technology) π = g M g Y Since g Y 3%, set g M = 3% in order to get π = 0 Or set g M = 5% in order to get π = 2% Inflation depends on the growth rate of money inflation is a purely monetary phenomenon Milton Friedman