Chapter 14 - Great Recession

Chapter 14: The Great Recession and the Short Run
Ryan W. Herzog
Spring 2021
Ryan W. Herzog (GU) AD/AS Spring 2021 1 / 39

1 Introduction
2 Financial Considerations in the Short-Run Model
3 Policy Responses to the Financial Crisis

Introduction
Learning Objectives
Introduce financial considerations - a risk premium - into our short-run
model and use this framework to understand the financial crisis.
Study deflation, bubbles, and the Federal Reserve’s balance sheet as
we deepen our understanding of the financial crisis.
Consider various actions that policymakers have taken in response to
recent events.

Introduction
Financial Crises
Contributors to a very large negative shock in AD
The wedge between the fed funds rate and the prevailing interest rates
A household balance-sheet crisis
Substantial uncertainty
Having exhausted conventional monetary policies, the Fed has turned
to unconventional actions.

Financial Considerations in the Short-Run Model
A risk premium is the 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

Risk Premium

Risk Premium
We can incorporate the risk premium into our short-run model.
R = Rff
+ f (1)
where:
R is the real interest rate
Rff
is the real interest rate at which firms borrow in financial markets.
f is the risk premium
During normal times we assume f = 0.
During a financial crisis f rises and interferes with the Fed’s 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.

Financial Shock

Rising Risk Premium

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.

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.
Deflation could result as the aggregate price level that declines over
time.

Financial Crisis

Deriving the New AD Curve
Incorporate the risk premium into the MP curve:
IS curve: Ỹ = a − b(Rt − r)
MP rule: Rt − r = m(πt − π)
RP equation: Rt = Rff
t + f
Combining the risk premium equation and the monetary policy rule
gives
Rt − r = f + m(πt − π) (2)
Substituting this into the IS curve yields the new AD curve
Ỹ = a − bf − bm(πt − π) (3)

In situations where monetary policy rules are functioning:
The AS/AD model is preferable
It tracks the dynamics of the economy in a single graph.
When policy rules break down
The IS/MP-Phillips curve is superior.

Dangers of Deflation
Deflation was essentially responsible for the Great Depression.
Recall the Fisher equation (it = Rt + πt)
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.

Periods of Deflation
The Great Depression:
The Fed would not lower the nominal interest rate because of inflation
concerns.
This caused a serious recession.
The more insidious situation:
The nominal interest rate is already low.
Nominal interest rates have a zero lower bound, i.e. can’t be negative.
Fed “runs out of room” with monetary policy.

Deflation: Liquidity Trap
A liquidity trap is a situation in which the volume of transactions in
some financial markets falls sharply (extremely high quantity demand
for money).
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 and lead to 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.

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.

The Taylor Rule and Monetary Policy
Recall our simple policy rule. Which is the fed funds rate as a function
of the gap between the current inflation rate and some target rate
The Taylor rule goes further by allowing the current level of short-run
output to influence the fed funds rate.

Taylor Rule Prediction

Short-run Output

Core Inflation

Money Supply
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.

Growth Rate of Money Supply Measures

Should Monetary Policy Response to Asset Prices?
With the benefit of hindsight it appears that there was a bubble in
the housing market in the mid-2000s.
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 including capital
requirements and the regulation of lending standards

Asset Bubbles - Stock Prices

Asset Bubbles - Home Prices

The Fed’s Balance Sheet
When conventional monetary policy failed, the Federal Reserve and
the Treasury created new policies.
Goal: provide liquidity and capital to financial institutions.
The Fed has dramatically reshaped its balance sheet.
The size of the balance sheet more than doubled, growing by more
than $2 trillion.
The composition of assets and liabilities also changed significantly.

On the asset side:
Lending was expanded to the rest of the economy.
This included financial institutions and nonfinancial corporations.
On the liability side
The Fed has not financed additional lending by printing money.
The funds have come from borrowing from the U.S. Treasury and bank
excess reserves.

The Fed’s Balance Sheet

The Troubled Asset Relief Program (TARP)
Economists agree that restoring the financial system is crucial, but
there is debate over what policy is best.
Purchases of ‘toxic’ assets because banks possess bad assets, which
limits lending.
Capital injections into financial institutions (the original TARP included
$25 billion in each large financial institution
Complete reorganizations of financial institutions as government steps
in and reorganizes debt into new equity claims for the former debt
holders

The Fiscal Stimulus
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 over types of spending and relative weight on tax
cuts vs. new spending

The Ricardian equivalence argument
Suggests that high spending today must be financed by higher future
taxes
Reduces the current impact of the stimulus package
The CBO estimates that
Short-run output would reach -7.4 percent without a stimulus package
However, even with the stimulus packageÕs best-case scenario, the
recession will still be long and deep.

Financial Reform
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
which suggests that the government had no choice but to step in and
provide liquidity and capital when the banks were in trouble.

Squam Lake Group suggested guidelines for financial reform.
Create a systemic regulator
Enhance capital requirements
Link executive compensation to long-term performance
Require convertible debt
Require “living wills”
Main cost of bailouts:
Borne by people outside of the finance industry
Measured by lost jobs and forgone GDP

Macroeconomic Research after the Financial Crisis
Did macroeconomists fail the country?
No research was available to provide rules for what to do in this
situation.
Research has been limited by technology.

New models are more advanced and include
Frictions such as sticky inflation and limited financial markets
Heterogeneous consumers
Imperfect financial markets
Allowing for more roles of government
Generally, a large increase in macroeconomic research since the
recession

Chapter 14 - Great Recession

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Chapter 14 - Great Recession