Transcript Mankiw 5/e Chapter 1: The Science of Macroeconomics

macro
Macroeconomics of
Business Cycles
Growth rates of real GDP, consumption
Percent
change
from 4
quarters
earlier
10
Real GDP
growth rate
8
Consumption
growth rate
6
Average
growth
rate
4
2
0
-2
-4
1970
1975
1980
1985
1990
1995
2000
2005
2010
Growth rates of real GDP, consumption,
investment
Percent
change
from 4
quarters
earlier
Investment
growth rate
40
30
20
Real GDP
growth rate
10
0
Consumption
growth rate
-10
-20
-30
1970
1975
1980
1985
1990
1995
2000
2005
2010
Unemployment
Percent
of labor
force
12
10
8
6
4
2
0
1970
1975
1980
1985
1990
1995
2000
2005
2010
Okun’s Law
Percentage 10
change in
real GDP 8
1951
Y
 3  2 u
Y
1966
1984
6
2003
4
1971
1987
2008
2
0
1975
2001
-2
1991
1982
-4
-3
-2
-1
0
1
2
3
4
Change in unemployment rate
Facts about the business cycle
 GDP growth averages 3–3.5 percent per year over
the long run with large fluctuations in the short run.
 Consumption and investment fluctuate with GDP,
but consumption tends to be less volatile and
investment more volatile than GDP.
 Unemployment rises during recessions and falls
during expansions.
 Okun’s Law: the negative relationship between
GDP and unemployment.
Index of Leading Economic
Indicators
 Published monthly by the Conference Board.
 Aims to forecast changes in economic activity
6-9 months into the future.
 Used in planning by businesses and govt,
despite not being a perfect predictor.
Components of the LEI index










Average workweek in manufacturing
Initial weekly claims for unemployment insurance
New orders for consumer goods and materials
New orders, nondefense capital goods
Vendor performance
New building permits issued
Index of stock prices
M2
Yield spread (10-year minus 3-month) on Treasuries
Index of consumer expectations
Index of Leading Economic Indicators
120
110
2004 = 100
100
90
80
70
60
50
40
Source: 30
Conference 1970
Board
1975
1980
1985
1990
1995
2000
2005
2010
Time horizons in macroeconomics
 Long run
Prices are flexible, respond to changes in
supply or demand.
 Short run
Many prices are “sticky” at a
predetermined level.
The economy behaves much
differently when prices are sticky.
Recap of classical macro theory
 Output is determined by the supply side:
– supplies of capital, labor
– technology
 Changes in demand for goods & services
(C, I, G ) only affect prices, not quantities.
 Assumes complete price flexibility.
 Applies to the long run.
When prices are sticky…
…output and employment also depend on
demand, which is affected by:
– fiscal policy (G and T )
– monetary policy (M )
– other factors, like exogenous changes in
C or I
AD/AS Model
 The paradigm most mainstream economists
and policymakers use to think about economic
fluctuations and policies to stabilize the
economy
 Shows how the price level and aggregate
output are determined
 Shows how the economy’s behavior is different
in the short run and long run
Aggregate demand
 The aggregate demand curve shows the
relationship between the price level and the
quantity of output demanded.
 we use a simple theory of AD based on the
quantity theory of money.
 Recall the quantity equation
MV = PY
 For given values of M and V,
this equation implies an inverse relationship
between P and Y :
Y= MV/P
The downward-sloping AD curve
An increase in the
price level causes a
fall in real money
balances (M/P ),
P
causing a decrease
in the demand for
goods & services.
AD
Y
Shifting the AD curve
P
An increase in
the money
supply shifts the
AD curve to the
right.
AD2
AD1
Y
Aggregate supply in the long run
 Recall from Chapter 3:
In the long run, output is determined by
factor supplies and technology
Y  F (K , L )
Y is the full-employment or natural level of
output, at which the economy’s resources are
fully employed.
“Full employment” means that
unemployment equals its natural rate (not zero).
The long-run aggregate supply curve
P
LRAS
Y does not
depend on P,
so LRAS is
vertical.
Y
 F (K , L )
Y
Long-run effects of an increase in M
P
In the long run,
this raises the
price level…
LRAS
P2
An increase
in M shifts
AD to the
right.
P1
AD2
AD1
…but leaves
output the same.
Y
Y
Aggregate supply in the short run
 Many prices are sticky in the short run.
 For now we assume
– all prices are stuck at a predetermined level in
the short run.
– firms are willing to sell as much at that price
level as their customers are willing to buy.
 Therefore, the short-run aggregate supply
(SRAS) curve is horizontal:
The short-run aggregate supply curve
The SRAS curve
is horizontal:
The price level
is fixed at a
predetermined
level, and firms
sell as much as
buyers demand.
P
P
SRAS
Y
Short-run effects of an increase in M
In the short run
when prices are
sticky,…
P
…an increase in
aggregate demand…
SRAS
AD2
AD1
P
…causes output
to rise.
Y1
Y2
Y
From the short run to the long run
Over time, prices gradually become “unstuck.”
When they do, will they rise or fall?
In the short-run
equilibrium, if
then over time,
P will…
Y Y
rise
Y Y
fall
Y Y
remain constant
The adjustment of prices is what moves
the economy to its long-run equilibrium.
The SR & LR effects of M > 0
A = initial
equilibrium
B = new shortrun eq’m
after Fed
increases M
C = long-run
equilibrium
P
LRAS
C
P2
P
B
A
Y
Y2
SRAS
AD2
AD1
Y
How shocking!!!
 shocks: exogenous changes in agg. supply or
demand
 Shocks temporarily push the economy away
from full employment.
 Example: exogenous decrease in velocity
If the money supply is held constant, a
decrease in V means people will be using their
money in fewer transactions, causing a
decrease in demand for goods and services.
The effects of a negative demand shock
AD shifts left,
depressing output
and employment
in the short run.
Over time,
prices fall and
the economy
moves down its
demand curve
toward fullemployment.
P
P
LRAS
B
P2
A
SRAS
C
AD1
AD2
Y2
Y
Y
Supply shocks
 A supply shock alters production costs, affects the
prices that firms charge. (also called price shocks)
 Examples of adverse supply shocks:
– Bad weather reduces crop yields, pushing up
food prices.
– Workers unionize, negotiate wage increases.
– New environmental regulations require firms to
reduce emissions. Firms charge higher prices to
help cover the costs of compliance.
 Favorable supply shocks lower costs and prices.
CASE STUDY:
The 1970s oil shocks
 Early 1970s: OPEC coordinates a
reduction in the supply of oil.
 Oil prices rose
11% in 1973
68% in 1974
16% in 1975
 Such sharp oil price increases are supply
shocks because they significantly impact
production costs and prices.
CASE STUDY:
The 1970s oil shocks
The oil price shock
shifts SRAS up,
causing output and
employment to fall.
In absence of
further price
shocks, prices will
fall over time and
economy moves
back toward full
employment.
P
P2
LRAS
B
SRAS2
A
P1
SRAS1
AD
Y2
Y
Y
CASE STUDY:
The 1970s oil shocks
70%
Predicted effects
of the oil shock:
• inflation 
• output 
• unemployment 
…and then a
gradual recovery.
12%
60%
50%
10%
40%
8%
30%
20%
6%
10%
0%
1973
1974
1975
1976
Change in oil prices (left scale)
Inflation rate-CPI (right scale)
Unemployment rate (right scale)
4%
1977
CASE STUDY:
The 1970s oil shocks
60%
Late 1970s:
As economy
was recovering,
oil prices shot up
again, causing
another huge
supply shock!!!
14%
50%
12%
40%
10%
30%
8%
20%
6%
10%
0%
1977
4%
1978
1979
1980
Change in oil prices (left scale)
Inflation rate-CPI (right scale)
Unemployment rate (right scale)
1981
CASE STUDY:
The 1980s oil shocks
40%
1980s:
A favorable
supply shock-a significant fall
in oil prices.
As the model
predicts,
inflation and
unemployment
fell:
10%
30%
8%
20%
10%
6%
0%
-10%
4%
-20%
-30%
2%
-40%
-50%
1982
0%
1983
1984
1985
1986
Change in oil prices (left scale)
Inflation rate-CPI (right scale)
Unemployment rate (right scale)
1987
Stabilization policy
 def: policy actions aimed at reducing the
severity of short-run economic
fluctuations.
 Example: Using monetary policy to
combat the effects of adverse supply
shocks…
Stabilizing output with
monetary policy
P
The adverse
supply shock
moves the
economy to
point B.
P2
LRAS
B
SRAS2
A
P1
SRAS1
AD1
Y2
Y
Y
Stabilizing output with
monetary policy
But the Fed
accommodates
the shock by
raising agg.
demand.
results:
P is permanently
higher, but Y
remains at its fullemployment level.
P
P2
LRAS
B
C
SRAS2
A
P1
AD1
Y2
Y
AD2
Y
Aggregate Demand I:
The IS-LM Model
The IS-LM model determines
income and the interest rate in
the short run when P is fixed
The Big Picture
Keynesian
Cross
Theory of
Liquidity
Preference
IS
curve
LM
curve
IS-LM
model
Agg.
demand
curve
Agg.
supply
curve
Explanation
of short-run
fluctuations
Model of
Agg.
Demand
and Agg.
Supply
The Keynesian Cross
 A simple closed economy model in which
income is determined by expenditure.
(due to J.M. Keynes)
 Notation:
I = planned investment
PE = C + I + G = planned expenditure
Y = real GDP = actual expenditure
 Difference between actual & planned
expenditure = unplanned inventory
investment
Elements of the Keynesian Cross
consumption function:
C  C (Y T )
govt policy variables:
G  G , T T
for now, planned
investment is exogenous:
planned expenditure:
I I
PE  C (Y  T )  I  G
equilibrium condition:
actual expenditure = planned expenditure
Y  PE
Graphing planned expenditure
PE
planned
expenditure
PE =C +I +G
MPC
1
income, output, Y
Graphing the equilibrium condition
PE
PE =Y
planned
expenditure
45º
income, output, Y
The equilibrium value of income
PE
PE =Y
planned
expenditure
PE =C +I +G
income, output, Y
Equilibrium
income
An increase in government purchases
PE
At Y1,
there is now an
unplanned drop
in inventory…
PE =C +I +G2
PE =C +I +G1
G
…so firms
increase output,
and income
rises toward a
new equilibrium.
Y
PE1 = Y1
Y
PE2 = Y2
Solving for Y
Y  C  I  G
equilibrium condition
Y  C  I  G
in changes

C
 G
 MPC  Y  G
Collect terms with Y
on the left side of the
equals sign:
(1  MPC)  Y  G
because I exogenous
because C = MPC Y
Solve for Y :


1
Y  
  G
 1  MPC 
The government purchases multiplier
Definition: the increase in income resulting
from a $1 increase in G.
In this model, the govt
purchases multiplier equals
Y
1

G
1  MPC
Example: If MPC = 0.8, then
Y
1

 5
G
1  0.8
An increase in G
causes income to
increase 5 times
as much!
Why the multiplier is greater than 1
 Initially, the increase in G causes an equal
increase in Y:
 Y =  G.
 But Y  C
 further Y
 further C
 further Y
 So the final impact on income is much
bigger than the initial G.
An increase in taxes
PE
Initially, the tax
increase reduces
consumption, and
therefore PE:
PE =C1 +I +G
PE =C2 +I +G
At Y1, there is now
an unplanned
inventory buildup…
C = MPC T
…so firms
reduce output,
and income falls
toward a new
equilibrium
Y
PE2 = Y2
Y
PE1 = Y1
Solving for Y
eq’m condition in
changes
Y  C  I  G
I and G exogenous
 C
 MPC   Y  T
Solving for Y :
Final result:

(1  MPC)  Y   MPC  T
  MPC 
Y  
  T
 1  MPC 
The tax multiplier
def: the change in income resulting from
a $1 increase in T :
Y
 MPC

T
1  MPC
If MPC = 0.8, then the tax multiplier equals
Y
T
 0.8
 0.8


 4
1  0.8
0.2
The tax multiplier
…is negative:
A tax increase reduces C,
which reduces income.
…is greater than one
(in absolute value):
A change in taxes has a
multiplier effect on income.
…is smaller than the govt spending multiplier:
Consumers save the fraction (1 – MPC) of a tax cut,
so the initial boost in spending from a tax cut is
smaller than from an equal increase in G.
The IS curve
def: a graph of all combinations of r and
Y that result in goods market equilibrium
i.e. actual output = planned expenditure
The equation for the IS curve is:
Y  C (Y  T )  I (r )  G
J.R. Hicks
Deriving the IS curve
PE =Y PE =C +I (r )+G
2
PE
PE =C +I (r1 )+G
r  I
 PE
 Y
I
r
Y1
Y
Y2
r1
r2
IS
Y1
Y2
Y
Fiscal Policy and the IS curve
 We can use the IS-LM model to see
how fiscal policy (G and T ) affects
aggregate demand and output.
 Let’s start by using the Keynesian cross
to see how fiscal policy shifts the IS
curve…
Shifting the IS curve: G
At any value of r,
PE =Y PE =C +I (r )+G
1
2
PE
PE =C +I (r1 )+G1
G  PE  Y
…so the IS curve
shifts to the right.
The horizontal
distance of the
IS shift equals
r
Y1
Y
Y2
r1
1
Y 
G
1 MPC
Y
Y1
IS1
Y2
IS2
Y
NOW YOU TRY:
Shifting the IS curve: T
 Use the diagram of the Keynesian cross or
loanable funds model to show how an
increase in taxes shifts the IS curve.
The Theory of Liquidity Preference
 Due to John Maynard Keynes.
 A simple theory in which the interest rate
is determined by money supply and
money demand.
Equilibrium
The interest
rate adjusts
to equate
the supply
and demand
for money:
r
interest
rate
M
P
s
r1
L (r )
M P  L (r )
M P
M/P
real money
balances
How the Fed raises the interest rate
r
To increase r,
Fed reduces M
interest
rate
r2
r1
L (r )
M2
P
M1
P
M/P
real money
balances
The LM curve
Now let’s put Y back into the money demand
function:
d
M
P
 L (r ,Y )
The LM curve is a graph of all combinations of
r and Y that equate the supply and demand for
real money balances.
The equation for the LM curve is:
M P  L (r ,Y )
Deriving the LM curve
(a) The market for
r
real money balances
(b) The LM curve
r
LM
r2
r2
L (r , Y2 )
r1
r1
L (r , Y1 )
M1
P
M/P
Y1
Y2
Y
How M shifts the LM curve
(a) The market for
r
real money balances
(b) The LM curve
r
LM2
LM1
r2
r2
r1
r1
L ( r , Y1 )
M2
P
M1
P
M/P
Y1
Y
The short-run equilibrium
The short-run equilibrium is
the combination of r and Y
that simultaneously satisfies
the equilibrium conditions in
the goods & money markets:
Y  C (Y  T )  I (r )  G
r
LM
IS
Y
M P  L (r ,Y )
Equilibrium
interest
rate
Equilibrium
level of
income
Policy analysis with the IS -LM model
Y  C (Y  T )  I (r )  G
r
LM
M P  L (r ,Y )
We can use the IS-LM
model to analyze the
effects of
• fiscal policy: G and/or T
• monetary policy: M
r1
IS
Y1
Y
An increase in government purchases
1. IS curve shifts right
by
r
LM
1
G
1 MPC
causing output &
income to rise.
2. This raises money
demand, causing the
interest rate to rise…
2.
r2
r1
3. …which reduces investment,
so the final increase in Y
1
is smaller than
G
1 MPC
IS2
1.
IS1
Y1 Y2
3.
Y
A tax cut
Consumers save
r
(1MPC) of the tax cut,
so the initial boost in
spending is smaller for T
r2
than for an equal G…
2.
r1
and the IS curve shifts by
1.
LM
1.
MPC
T
1 MPC
2. …so the effects on r
and Y are smaller for T
than for an equal G.
IS2
IS1
Y1 Y2
2.
Y
Monetary policy: An increase in M
1. M > 0 shifts
the LM curve down
(or to the right)
2. …causing the
interest rate to fall
3. …which increases
investment, causing
output & income to
rise.
r
LM1
LM2
r1
r2
IS
Y1 Y2
Y
The Fed’s response to G > 0
 Suppose Congress increases G.
 Possible Fed responses:
1. hold M constant
2. hold r constant
3. hold Y constant
 In each case, the effects of the G
are different…
Response 1: Hold M constant
If Congress raises G,
the IS curve shifts right.
r
If Fed holds M constant,
then LM curve doesn’t
shift.
r2
r1
LM1
IS2
IS1
Results:
Y  Y 2  Y1
r  r2  r1
Y1 Y2
Y
Response 2: Hold r constant
If Congress raises G,
the IS curve shifts right.
To keep r constant,
Fed increases M
to shift LM curve right.
r
LM1
r2
r1
IS2
IS1
Results:
Y  Y 3  Y1
r  0
LM2
Y1 Y2 Y3
Y
Response 3: Hold Y constant
If Congress raises G,
the IS curve shifts right.
To keep Y constant,
Fed reduces M
to shift LM curve left.
LM2
LM1
r
r3
r2
r1
IS2
IS1
Results:
Y  0
r  r3  r1
Y1 Y2
Y
Estimates of fiscal policy multipliers
from the DRI macroeconometric model
Assumption about
monetary policy
Estimated
value of
Y / G
Estimated
value of
Y / T
Fed holds money
supply constant
0.60
0.26
Fed holds nominal
interest rate constant
1.93
1.19
Shocks in the IS -LM model
IS shocks: exogenous changes in the
demand for goods & services.
Examples:
– stock market boom or crash
 change in households’ wealth
 C
– change in business or consumer
confidence or expectations
 I and/or C
Shocks in the IS -LM model
LM shocks: exogenous changes in
the demand for money.
Examples:
– a wave of credit card fraud increases
demand for money.
– more ATMs or the Internet reduce
money demand.
NOW YOU TRY:
Analyze shocks with the IS-LM Model
Use the IS-LM model to analyze the effects of
1. a boom in the stock market that makes
consumers wealthier.
2. after a wave of credit card fraud, consumers
using cash more frequently in transactions.
For each shock,
a. use the IS-LM diagram to show the effects of
the shock on Y and r.
b. determine what happens to C, I, and the
unemployment rate.
CASE STUDY:
The U.S. recession of 2001
 During 2001,
– 2.1 million jobs lost,
unemployment rose from 3.9% to 5.8%.
– GDP growth slowed to 0.8%
(compared to 3.9% average annual
growth during 1994-2000).
CASE STUDY:
The U.S. recession of 2001
Index (1942 = 100)
Causes: 1) Stock market decline  C
1500
S&P 500
1200
900
600
300
1995
1996
1997
1998
1999
2000
2001
2002
2003
CASE STUDY:
The U.S. recession of 2001
Causes: 2) 9/11
– increased uncertainty
– fall in consumer & business confidence
– result: lower spending, IS curve shifted
left
Causes: 3) Corporate accounting scandals
– Enron, WorldCom, etc.
– reduced stock prices, discouraged
investment
CASE STUDY:
The U.S. recession of 2001
 Fiscal policy response: shifted IS curve
right
– tax cuts in 2001 and 2003
– spending increases
• airline industry bailout
• NYC reconstruction
• Afghanistan war
CASE STUDY:
The U.S. recession of 2001
 Monetary policy response: shifted LM curve right
7
6
5
4
3
2
1
0
Three-month
T-Bill Rate
IS-LM and aggregate demand
 So far, we’ve been using the IS-LM
model to analyze the short run, when
the price level is assumed fixed.
 However, a change in P would shift LM
and therefore affect Y.
 The aggregate demand curve
(introduced in Chap. 9) captures this
relationship between P and Y.
Deriving the AD curve
r
Intuition for slope
of AD curve:
P  (M/P )
 LM shifts left
 r
 I
 Y
LM(P2)
LM(P1)
r2
r1
IS
P
Y2
Y1
Y
P2
P1
AD
Y2
Y1
Y
Monetary policy and the AD curve
The Fed can increase
aggregate demand:
M  LM shifts right
r
LM(M1/P1)
LM(M2/P1)
r1
r2
IS
 r
 I
P
 Y at each
value of P
P1
Y1
Y1
Y2
Y2
Y
AD2
AD1
Y
Fiscal policy and the AD curve
Expansionary fiscal
policy (G and/or T )
increases agg. demand:
r
LM
r2
r1
IS2
T  C
IS1
 IS shifts right
P
 Y at each
value of P
P1
Y1
Y1
Y2
Y2
Y
AD2
AD1
Y
IS-LM and AD-AS
in the short run & long run
Recall from Chapter 9:
The force that moves
the economy from the short run to the long run
is the gradual adjustment of prices.
In the short-run
equilibrium, if
then over time, the
price level will
Y Y
rise
Y Y
fall
Y Y
remain constant
The SR and LR effects of an IS shock
r
A negative IS
shock shifts IS
and AD left,
causing Y to fall.
LRAS LM(P )
1
IS2
Y
P
IS1
Y
LRAS
P1
SRAS1
Y
AD1
AD2
Y
The SR and LR effects of an IS shock
r
LRAS LM(P )
1
In the new short-run
equilibrium, Y  Y
IS2
Y
P
IS1
Y
LRAS
P1
SRAS1
Y
AD1
AD2
Y
The SR and LR effects of an IS shock
r
LRAS LM(P )
1
In the new short-run
equilibrium, Y  Y
IS2
Over time, P gradually
falls, causing
• SRAS to move down
• M/P to increase,
Y
P
IS1
Y
LRAS
P1
SRAS1
which causes LM
to move down
Y
AD1
AD2
Y
The SR and LR effects of an IS shock
r
LRAS LM(P )
1
LM(P2)
IS2
Over time, P gradually
falls, causing
• SRAS to move down
• M/P to increase,
Y
P
IS1
Y
LRAS
P1
SRAS1
P2
SRAS2
which causes LM
to move down
Y
AD1
AD2
Y
The SR and LR effects of an IS shock
r
LRAS LM(P )
1
LM(P2)
This process continues
until economy reaches a
long-run equilibrium with
Y Y
IS2
Y
P
IS1
Y
LRAS
P1
SRAS1
P2
SRAS2
Y
AD1
AD2
Y
NOW YOU TRY:
Analyze SR & LR effects of M
a. Draw the IS-LM and AD-AS
r
diagrams as shown here.
LRAS LM(M /P )
1
1
b. Suppose Fed increases M.
Show the short-run effects
on your graphs.
IS
c. Show what happens in the
transition from the short run
to the long run.
d. How do the new long-run
equilibrium values of the
endogenous variables
compare to their initial
values?
Y
P
Y
LRAS
P1
SRAS1
AD1
Y
Y
The Great Depression
30
Unemployment
(right scale)
220
25
200
20
180
15
160
10
Real GNP
(left scale)
140
120
1929
5
0
1931
1933
1935
1937
1939
percent of labor force
billions of 1958 dollars
240
THE SPENDING HYPOTHESIS:
Shocks to the IS curve
 asserts that the Depression was largely due
to an exogenous fall in the demand for goods
& services – a leftward shift of the IS curve.
 evidence:
output and interest rates both fell, which is
what a leftward IS shift would cause.
THE SPENDING HYPOTHESIS:
Reasons for the IS shift
 Stock market crash  exogenous C
– Oct-Dec 1929: S&P 500 fell 17%
– Oct 1929-Dec 1933: S&P 500 fell 71%
 Drop in investment
– “correction” after overbuilding in the 1920s
– widespread bank failures made it harder to obtain
financing for investment
 Contractionary fiscal policy
– Politicians raised tax rates and cut spending to
combat increasing deficits.
THE MONEY HYPOTHESIS:
A shock to the LM curve
 asserts that the Depression was largely due
to huge fall in the money supply.
 evidence:
M1 fell 25% during 1929-33.
 But, two problems with this hypothesis:
– P fell even more, so M/P actually rose
slightly during 1929-31.
– nominal interest rates fell, which is the
opposite of what a leftward LM shift would
cause.
THE MONEY HYPOTHESIS AGAIN:
The effects of falling prices
 asserts that the severity of the Depression
was due to a huge deflation:
P fell 25% during 1929-33.
 This deflation was probably caused by the fall
in M, so perhaps money played an important
role after all.
 In what ways does a deflation affect the
economy?
THE MONEY HYPOTHESIS AGAIN:
The effects of falling prices
 The stabilizing effects of deflation:
 P  (M/P )  LM shifts right  Y
 Pigou effect:
P





(M/P )
consumers’ wealth 
C
IS shifts right
Y
THE MONEY HYPOTHESIS AGAIN:
The effects of falling prices
 The destabilizing effects of expected
deflation:
E




r  for each value of i
I  because I = I (r )
planned expenditure & agg. demand 
income & output 
THE MONEY HYPOTHESIS AGAIN:
The effects of falling prices
 The destabilizing effects of unexpected
deflation: debt-deflation theory
P (if unexpected)
 transfers purchasing power from borrowers
to lenders
 borrowers spend less,
lenders spend more
 if borrowers’ propensity to spend is larger
than lenders’, then aggregate spending falls,
the IS curve shifts left, and Y falls
Why another Depression is unlikely
 Policymakers (or their advisors) now know
much more about macroeconomics:
– The Fed knows better than to let M fall
so much, especially during a contraction.
– Fiscal policymakers know better than to raise
taxes or cut spending during a contraction.
 Federal deposit insurance makes widespread
bank failures very unlikely.
 Automatic stabilizers make fiscal policy
expansionary during an economic downturn.
CASE STUDY
The 2008-09 Financial Crisis &
Recession
 2009: Real GDP fell, u-rate approached 10%
 Important factors in the crisis:
– early 2000s Federal Reserve interest rate policy
– sub-prime mortgage crisis
– bursting of house price bubble,
rising foreclosure rates
– falling stock prices
– failing financial institutions
– declining consumer confidence, drop in
spending on consumer durables and investment
goods
Interest rates and house prices
9
8
170
interest rate (%)
7
6
150
5
130
4
110
3
90
2
70
1
0
2000
2001
2002
2003
2004
50
2005
House price index, 2000=100
Federal Funds rate
30-year mortgage rate
190
Case-Shiller 20-city composite house price index
Change in U.S. house price index
and rate of new foreclosures, 1999-2009
14%
1.4
10%
1.2
8%
1.0
6%
0.8
4%
2%
0.6
0%
0.4
-2%
0.2
-4%
-6%
1999
0.0
2001
2003
2005
2007
2009
New foreclosure starts
(% of total mortgages)
Percent change in house prices
(from 4 quarters earlier)
12%
US house price index
New foreclosures
House price change and new
foreclosures, 2006:Q3 – 2009Q1
20%
18%
Nevada
Florida
Illinois
New foreclosures,
% of all mortgages
16%
14%
Michigan
Ohio
California
Georgia
12%
10%
8%
Colorado
Arizona
Rhode Island
New Jersey
Texas
6%
S. Dakota
Hawaii
4%
Oregon
Alaska
2%
0%
-40%
-30%
-20%
-10%
0%
Wyoming
N. Dakota
10%
Cumulative change in house price index
20%
U.S. bank failures by year, 2000-2009
Number of bank failures
70
60
50
40
30
20
10
0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009*
* as of July 24, 2009.
7/20/2009
100%
11/11/2008
120%
3/5/2008
(% change from 52 weeks earlier)
6/28/2007
10/20/2006
2/11/2006
6/5/2005
9/27/2004
1/20/2004
5/14/2003
9/5/2002
12/28/2001
4/21/2001
140%
8/13/2000
12/6/1999
Major U.S. stock indexes
DJIA
S&P 500
NASDAQ
80%
60%
40%
20%
0%
-20%
-40%
-60%
-80%
Consumer sentiment and growth in consumer
durables and investment spending
110
15%
10%
100
5%
90
0%
80
-5%
-10%
70
-15%
Durables
-20%
Investment
60
UM Consumer Sentiment Index
-25%
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
50
Consumer Sentiment Index, 1966=100
% change from four quarters earlier
20%
Real GDP growth and Unemployment
10%
10
Real GDP growth rate (left scale)
Unemployment rate (right scale)
8
6%
7
6
4%
5
2%
4
3
0%
2
-2%
1
-4%
1995
0
1997
1999
2001
2003
2005
2007
2009
% of labor force
% change from 4 quaters earlier
8%
9