Background for Prof. Brad Delong s April 17 Lecture: Fiscal Policy in a Depressed Economy Econ 191: Background Lecture 6 April 10, 2012
Outline 1 Announcements 2 3 4 5
Announcements Graded revised research topic comments will be available in Issi s office hours this Friday, April 13. Graded preliminary results will be available in lecture next Tuesday, April 17. Visit Professor Delong s website to preview next week s slides: http://delong.typepad.com/sdj/2012/04/econ-191-spring- 2012-uc-berkeley-fiscal-policy-in-the-great-recession-april-17-2012.html Lit reviews not previously collected are available tonight.
Next Week s Topic Fiscal Policy in a Depressed Economy Next week, Professor Delong will discuss: Lloyd Metzler (1951). "Wealth, Saving, and the Rate of Interest." Gauti Eggertson and Michael Woodford (2002). "The Zero Bound on Interest Rates and Optimal Monetary Policy." Gabriel Chodorow-Reich, Laura Feiveson, Zachary Liscow, and William Gui Woolston (2011). "Does State Fiscal Relief During Recessions Increase Employment? Evidence from the American Recovery and Reinvestment Act." Jan Hazius and Sven Jari Stehn (2011). "The Case for a Nominal GDP Level Target." Christina D. Romer (2011). "What Do We Know About the Effects of Fiscal Policy? Separating Evidence from Ideology."
Next Week s Topic Fiscal Policy in a Depressed Economy Visit Professor Delong s website to preview other topics he will discuss: http://delong.typepad.com/sdj/2012/04/econ-191-spring- 2012-uc-berkeley-fiscal-policy-in-the-great-recession-april-17-2012.html (Or, Google Brad Delong Econ 191, and click on the first search result.
Next Week s Topic Fiscal Policy in a Depressed Economy This week, Dawn will discuss How an economy can become depressed: The 2007-2009 financial crisis Potential policy responses to depressed economies How different policy responses theoretically affect macroeconomic variables IS/LM, AD/AS models Resources used in building today s lecture include Mishkin (2012), various posts from Brad Delong s blog, Grasping Reality with the Invisible Hand, and lecture notes from Brad Delong s 2009 Econ 202B Macroeconomics class.
The 2007-2009 Financial Crisis How can an economy become depressed? Several types of financial crises are possible: Bank runs: 1 Depositors suddenly withdraw a significant amount of their deposits. 2 Because banks lend out most of its deposits, they may have insufficient funds to repay a large amount of these deposits immediately, and so go bankrupt. E.g.: Bank of U.S. (1931), Northern Rock PLC (2007) (Note: A less severe form of bank runs are credit crunches, whereby banks are reluctant to lend because they worry that they have insufficient funds available.)
The 2007-2009 Financial Crisis How can an economy become depressed? Several types of financial crises are possible: Asset bubbles and crashes: 1 Bubble: The price of a financial asset (e.g. stocks) exceeds the present value of its expected future income. However, it continues to be purchased not because of a perceived increase in its intuitive value, but because speculators in the market hope to sell the asset to someone else at an even higher price. 2 Crash: Many asset holders decide to sell the asset, causing the price to fall quickly. E.g. 1929 U.S. stock market crash, U.S. tech bubble (2000), U.S. housing bubble (2007)
The 2007-2009 Financial Crisis How can an economy become depressed? Several types of financial crises are possible: Currency (balance of payments) crises: 1 Investors quickly sell a country s currency when its value is high in order to cause devaluation of the currency, so that investors can re-purchase the currency at a much lower price. 2 Countries with fixed exchange rates often do not have the large amount of reserves necessary to maintain the exchange rate, and must often devalue the currency or risk financial collapse. 3 Currency crises are often coupled with a country s defaulting on foreign debt. E.g. Asian financial crisis (1997), Argentina financial crisis (1999)
The 2007-2009 Financial Crisis The 2007-2009 financial crisis: Three main factors: 1 Unregulated financial innovation in mortgage markets 2 Agency problems in mortgage markets 3 Asymmetric information in the credit rating process.
The 2007-2009 Financial Crisis Three main factors: Unregulated financial innovation in mortgage markets Before 2000, only the most credit-worthy borrowers could obtain residential mortgages (bank loans for large real estate purchases using the real estate as collateral).
The 2007-2009 Financial Crisis Three main factors: Unregulated financial innovation in mortgage markets Technological advances: 1 Allowed numerical credit scores to be assigned to households, predicting the likelihood of mortgage default 2 Enabled smaller loans (like mortgages) to be bundled together easily into securitized debt: mortgage-backed securities => Lower transaction costs + ability to spread risk across many individuals/institutions => Banks became able to offer subprime mortgages, and more eagerly approved less solvent borrowers for loans
The 2007-2009 Financial Crisis Three main factors: Agency problems in mortgage markets The mortgage brokers who originated the loans had lesser incentive to evaluate whether the borrower would default on the loan, since the buyers of mortgage-backed securities would soon take on the risk Risk-loving investors invested in housing, since they could default on the loan at any time Mortgage brokers, because they made profit from transaction commissions, were incentivized to sign up as many mortgage loans as possible. This sometimes lead to mortgage application fraud by brokers.
The 2007-2009 Financial Crisis Three main factors: Agency problems in mortgage markets Commercial and investment banks earned large fees from underwriting mortgage-backed securities, and so had weak incentives to make sure the ultimate holders of the securities were paid off. Insurance companies like AIG earned large fees from writing financial insurance contracts, and so also had weak incentives to make sure the ultimate holders of the securities were paid off.
The 2007-2009 Financial Crisis Three main factors: Asymmetric information in the credit rating process Credit rating agencies rate debt securities by their probability of default, but also make money advising clients on how to structure their financial instruments. => Conflict of interest may have produced inaccurate ratings of clients debt instruments.
The 2007-2009 Financial Crisis Impacts: U.S. residential housing market Financial institutions balance sheets Shadow banking system Global financial markets Failures of major financial firms
The 2007-2009 Financial Crisis Impacts: U.S. residential housing market: The growth of the subprime lending market increased the demand for housing and thus housing prices Rising housing prices caused subprime borrowers to expect a lower probability of default, and thus take larger and more loans The growing distance between housing prices and housing fundamentals (purchase/renting cost, housing cost relative to median income) eventually caused the housing price bubble to burst. Many home prices fell below the amount of the mortgage, greatly incentivizing struggling homeowners to walk away from their mortgages and give the house to the lender.
The 2007-2009 Financial Crisis Impacts: Financial institutions balance sheets: Rising defaults on mortgages caused the value of mortgage-backed securities to collapse, leading banks and other financial institutions holding securities to have less net worth. In order to improve their asset/liability ratio, these institutions sold off assets and restricted credit to HHs and businesses. Less credit to HHs and businesses lead to decreases in C and I, and thus aggregate demand (more later).
The 2007-2009 Financial Crisis Impacts: Shadow banking system: Shadow banking system: Hedge funds, investment banks, and other non-depository financial firms, which are not as tightly regulated as banks, but who help fund elements of the financial system such as low interest-rate mortgages and auto loans. Financial institutions borrow from the shadow banking system through repurchase agreements, where assets like mortgage-backed securities are used as collateral. With the value of mortgage-backed securities falling, the amount of collateral required to borrow from the shadow banking system increased as much as 50%.
The 2007-2009 Financial Crisis Impacts: Shadow banking system: In order to raise funds for collateral, financial institutions had to sell off their assets very quickly, and did so by engaging in fire sales, whereby they offered these assets at a lower price. These fire sales lead to further decreases in value for mortgage-backed securities, and thus higher collateral requirements, and thus more fire sales, etc.
The 2007-2009 Financial Crisis Impacts: Global financial markets: BNP Paribas suspended redeeming of money market fund shares in funds which had sustained large losses European banks also began to hoard cash Northern Rock and other European financial institutions collapsed in 2007 European countries actually experienced a more severe downturn than in the US, especially where banks had high exposure to mortgage markets and high short-term borrowing in the repurchase market.
The 2007-2009 Financial Crisis Impacts: Failures of major financial firms: March 2008: Bear Stearns, the fifth-largest investment bank in the United States, which had invested heavily in subprime related securities, had a run on its repurchase funding and was forced to sell itself to J.P. Morgan for less than 5% of its 2007 value July 2008: U.S. Treasury and the Federal Reserve bails out and then assumes governance of Fannie Mae and Freddie Mac, two privately owned government-sponsored enterprises that together insured over $5 trillion of mortgages or mortgage-backed assets, after suffering substantial losses from their holdings of subprime securities.
The 2007-2009 Financial Crisis Impacts: Failures of major financial firms: Sept. 2008: 1 Merrill Lynch, the third-largest investment bank who also suffered large losses on its holding of subprime securities, announced its sale to Bank of America for a price 60% below its 2007 value. 2 Lehman Brothers, the fourth-largest investment bank by asset size with over $600 billion in assets and 25,000 employees, filed for bankruptcy the largest in U.S. history. 3 AIG, an insurance firm with assets over $1 trillion, had to make payouts on possible losses in over $400 billion worth of insurance contracts. The Federal Reserve lent AIG $85 billion when it suffered an extreme liquidity crisis due to a credit rating downgrade.
The 2007-2009 Financial Crisis Worsening and height of the crisis: Sept. 2008: U.S. House of Representatives, fearing voter backlash for bailing out Wall Street, votes down a $700 billion dollar bailout package proposed by the Bush administration A week later, the bill passes, but... Oct. 2008: Worst weekly stock market decline in US history.
Governments affect the macroeconomy primary through two policy channels: Fiscal policy: Government spending and taxing behavior In order to stimulate the economy, a government may increase spending and decrease taxation. E.g. The 2008 U.S. Emergency Economic Stabilization Act
Governments affect the macroeconomy primary through two policy channels: Monetary policy: Actions of a country s central bank with respect to money supply In order to stimulate the economy, a government s central bank may increase the money supply in order to lower the interest rate, which (A) decreases the cost of investment and (B) increase consumers opportunity cost of holding money (versus spending it). E.g. In the US, the Federal Reserve sells U.S. Treasury bonds.
What, in theory, is the causal chain between fiscal or monetary policy and improvements in macroeconomic indicators? We will use IS/LM, AD/AS models to answer this question.
The IS curve Recall from intermediate macroeconomics that the IS curve tells us, for each given level of the real interest rate r, what aggregate output Y must be for the goods market to be in equilibrium (Y = AE = C + I + G + NX ):
The IS curve Source: Mishkin (2012)
The IS curve Intuition for the IS curve s (downward sloping) shape: r increases => C, I, NX decrease => AE decreases => Y must be lower for it to equal AE (and thus satisfy the goods market equilibrium).
The IS curve Note that a change in the real interest rate that affects equilibrium aggregate output Y causes only a movement along the IS curve. A shift in the IS curve, by contrast, occurs when equilibrium output changes at each given real interest rate.
The IS curve Factors that shift the IS curve: Source: Mishkin (2012) Note: Autonomous here means that the relevant variable is unrelated to other variables in the IS model, such as output or interest rates.
The MP curve Recall that the monetary policy (MP) curve indicates the relationship between the real interest rate the central bank sets and the inflation rate: r = r + λπ where r is the component of the real interest rate set by the central bank, λ is the responsiveness of the interest rate to the inflation rate, and π is the inflation rate.
The MP curve
The MP curve Intuition for the MP curve s upward slope: Y increases => π increases π increases => r increases => r increases r increases => Y decreases => π decreases
The MP curve Note that a change in the real interest rate r that affects inflation π causes only a movement along the MP curve. (I.e. An automatic adjustment, such as that caused by the Taylor Rule) A shift in the MP curve, by contrast, occurs when the central bank changes r, the autonomous (and discretionary) changes to monetary policy. 1 The MP curve shifts up if autonomous monetary policy is tightened ( r increases => r increases). 2 The MP curve shifts down if autonomous monetary policy is loosened ( r decreases => r decreases).
The MP curve
The AD curve Recall that the aggregate demand (AD) curve indicates the relationship between the aggregate output Y and the inflation rate π when the goods market is in equilibrium: 1 Y =[C +I +G +NX mpc T ] 1 mpc c+d+e 1 mpc (r +λπ) where mpc is the marginal propensity to consume, T is tax revenue, and c, d, e, andλ are (constant) parameters of the model.
The AD curve Recall that the aggregate demand (AD) curve indicates the relationship between the aggregate output Y and the inflation rate π when the goods market is in equilibrium. The AD curve uses the shared vertical variable of the IS and MP curves, r, to link the two horizontal variables of the IS and MP curves, (1) aggregate output Y and (2) the inflation rate π:
The AD curve Source: Mishkin (2012)
The AD curve Note that a change in the inflation rate π causes only a movement along the AD curve. A shift in the AD curve, by contrast, occurs for the same five reasons the IS curve shifts, and shifts the AD curve in the same direction:
The AD curve A shift in the AD curve can also occur through autonomous changes in monetary policy r: An autonomous tightening of monetary policy ( r increases => r increases) shifts the MP curve up, causes upward movement along the IS curve, and thus shifts the AD curve to the left:
The AD curve Source: Mishkin (2012)
The AD curve Source: Mishkin (2012)
The AD curve Source: Mishkin (2012)
The AD curve Similarly, an autonomous easing of monetary policy ( r decreases => r decreases) shifts the AD curve to the right.
The AS curves Recall that the aggregate supply (AS) curve represents the relationship between the total quantity of output that firms are willing to produce, Y, and the inflation rate π: π = π e + γ(y Y P )+ρ where π is current inflation, π e is expected inflation, Y P is potential output, and ρ is any price shock (shift in inflation independent of labor markets or expected inflation).
The AS curves There are 2 AS curves: The long run AS (LRAS) curve and the short-run AS (SRAS) curve.
The AS curves 1 LRAS: In the long run, wages and prices are fully flexible, and the LRAS is determined by labor, capital, technology, and the natural rate of unemployment. As a result, the LRAS curve is vertical at the level of potential output, Y P. 2 SRAS: In the short run, wages and prices take time to adjust to economic conditions. As a result, the SRAS curve is upward sloping, but not vertical; as output rises relative to potential, inflation rises from its current level.
The AS curves Source: Mishkin (2012)
The AS curves Factors shifting the LRAS: Shocks to the natural rate of unemployment and technology Long-run changes in the amounts of labor or capital that affect the amount of output the economy can produce
The AS curves Factors shifting the SRAS: Expected Inflation. When expected inflation rises, workers and firms will want to raise wages and prices more, causing inflation to rise. => SRAS shifts up- and leftward. Price Shocks. Supply restrictions or workers pushing for higher wages can cause firms to raise prices, causing inflation to rise. => SRAS shifts up- and leftward.
The AS curves Factors shifting the SRAS: Persistent Output Gap. When output remains high relative to potential output, the output gap is persistently positive. Labor and product markets remain tight, increasing current and expected inflation => SRAS shifts up- and leftward. (The reverse is true when output remains low relative to potential output.)
The AS curves Factors shifting the SRAS: Source: Mishkin (2012)
Policy responses to a negative AD shock: If there is a negative shock to AD, the government can choose to affect no fiscal or monetary policy, causing a negative output gap and thus a downward shift of the SRAS curve as the economy moves back to long-run equilibrium:
Negative shock to AD + No fiscal or monetary policy: Source: Mishkin (2012)
Policy responses to a negative AD shock: If there is a negative shock to AD, Congress can enact expansionary fiscal policy to shift the IS curve and thus the AD curve back out and avoid an output gap that causes the SRAS to shift down:
Negative shock to AD + Expansionary fiscal policy: Source: Mishkin (2012)
Negative shock to AD + Expansionary fiscal policy: Source: Mishkin (2012)
Policy responses to a negative AD shock: If there is a negative shock to AD, an autonomous easing of monetary policy can shift the AD curve back out and avoid an output gap that causes the SRAS to shift down:
Negative shock to AD + Expansionary monetary policy:
Negative shock to AD + Expansionary monetary policy: Source: Mishkin (2012)
Policy responses to a negative (temporary) AS shock: If there is a negative shock to AS (e.g. from a temporary supply shock, such as a spike in the price of oil), the government can choose to affect no fiscal or monetary policy, causing a negative output gap and thus an upward shift of the SRAS curve:
Negative (temporary) AS shock + No fiscal or monetary response:
Policy responses to a negative (temporary) AS shock: If there is a negative (temporary) shock to AS, the Fed can enact contractionary monetary policy to shift the MP curve up, and thus the AD curve left. The resulting output gap causes the SRAS curve to shift back downward. When the monetary policy is no longer needed because inflation has subsided, the MP curve is shifted back downward, which shifts the AD curve back out:
Negative shock to AS + Contractionary monetary policy: Source: Mishkin (2012)
Negative shock to AS + Contractionary monetary policy:
Hand Out Attendance Sheet Hand Out Attendance Sheet
Several types of economic crises exist, including bank runs, asset bubble crashes, and currency (balance of payments) crises. Three interrelated problems contributed to the 2007-2009 financial crisis: 1 Unregulated financial innovation in mortgage markets 2 Agency problems in mortgage markets 3 Asymmetric information in the credit rating process.
Governments affect the macroeconomy primary through two policy channels: fiscal and monetary policy. can help us understand the channels through which fiscal and monetary policy can affect macroeconomic variables in depressed economies.
Finish reading papers for Prof. Delong s lecture next week. Check out Prof. Delong s posted slides for next week. Pick up revised research q s in OH Friday Preliminary results (and remaining revised research q s) will be returned next Tuesday in lecture. Reminder: Deadline for final paper is May 1 at 5pm. Drop a hard copy in Issi Romem s mailbox, and email the paper to myself and Issi: kdpowers.gsi@gmail.com and iromem@econ.berkeley.edu