Transcript Chapter X - McGraw Hill Higher Education

The Severe
Contraction:
An October 2008
through March 2009
Update
McGraw-Hill/Irwin
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
Overview
• U.S. recession began in
December 2007 due in part to:
–Steep decline in housing prices
–Mortgage loan crisis
–Financial market collapse
• GDP fell 6.3% from 2007 to 2008
• Unemployment rose to 8.1%
Banks and Other Financial
Institutions
• In the 2007-2009 period, the
banking system failed to promote
economic growth and stability.
–Bank lending collapsed
–The Fed and the U.S. Treasury
infused money to promote liquidity
Uncertainty, Expectations,
and Shocks
• The Severe Contraction is a good
example of an economy exposed
to a negative demand shock.
–Sticky prices from December 2007
to February 2009
–Decrease in total demand resulted
in declining real output
GDP = C + Ig + G + Xn
• Real GDP during the fourth
quarter of 2008 dropped by 6.3%
on an annual basis.
–Gross investment expenditures fell
by 23%
–Net exports fell by 6.1%
–Personal consumption
expenditures fell by 4.3%
The Circular Flow Revisited
• The recent recession has
dampened the major spending
and income flows.
• GDP, NDP, NI, and PI all
declined.
Production Possibilities Analysis
• Real GDP declined during the
Severe Contraction but not the
economy’s production capacity.
–The economy moved to a point
inside the PPC
• Prolonged recessions can
adversely affect the supply
factors of economic growth.
Productivity Acceleration
• The recession had not altered the
recent long-run productivity trend.
• The rate of productivity growth in
2008 matched the 2.7% annual
trend-line growth of productivity
since 1995.
Phases of the Business Cycle
• The economy peaked in
December 2007 and entered the
recession phase.
• The latest recession is the
sharpest and longest recession
since 1982, but is not likely to be
a depression.
U.S. Recessions since 1950
• Table 26.1 can be updated by
adding “2007” at the bottom of
column 1 and question marks at
the bottom of columns 2 and 3.
• The NBER declared the start of
the current recession as
December 2007.
Causation: A First Glance
• The view that business cycles
can result from unexpected
financial bubbles and bursts is
the most likely cause of the
current recession.
Cyclical Impacts
• In the latest recession, the
outputs of capital goods and
consumer durables were hit the
hardest, having fallen 22% and
22.1% respectively, on an annual
basis by fourth quarter 2008.
Unemployment
• The type of unemployment that
increases during recession is
cyclical unemployment.
• This helps to explain the higher
unemployment rates during the
current recession.
The Labor Force, Employment,
and Unemployment
• Between November 2008 and
February 2009, unemployment rose
by more than 5 million people and the
unemployment rate rose from 4.7%
to 8.1%.
• Unemployment numbers will likely
worsen before improving.
Actual and Potential GDP
• The latest recession has caused
a negative GDP gap.
• Actual GDP was well below
potential GDP from late 2007
through March 2009.
Unequal Burdens
• Between 2007 and 2008, the
unemployment rates for some
groups of workers, including
construction, manufacturing, and
retail workers, and AfricanAmericans and Hispanics, rose
more rapidly than for other
groups.
Facts of Inflation
• The current recession has
removed the demand-pull
inflation that began in 2007.
• Inflation has declined to near
zero, prompting concerns of
deflation which can worsen a
recession.
Last Word: The Stock Market and
the Economy
• The decline in stock prices from
late 2008 through early 2009:
–produced a huge negative wealth
effect that reduced consumer
spending
–constrained the ability of firms to
expand their operations by selling
stock
The Income-Consumption and
Income-Saving Relationship
• The Severe Contraction has
temporarily changed the current
consumption and saving behavior
in the economy.
–Households have increased
savings and reduced consumption,
illustrating a paradox of thrift
The Interest-Rate—Investment
Relationship
• Although interest rates declined
to near zero, investment
spending actually declined 23%
in the fourth quarter of 2008.
–The investment demand curve
shifted inward by more than the
investment-increasing effects of the
decline of real interest rates
The Volatility of Investment
• The recent recession reinforces
the central point that economic
investment (in real terms) is
extremely volatile relative to real
GDP.
The Multiplier Effect
• During a recession, the multiplier
effect runs in the opposite
direction.
–A decrease in spending creates a
multiple decrease in GDP
• However, the size of the multiplier
in the U.S. economy is not
known.
Recessionary Expenditure Gap
• Figure 28.7a can be used to
portray the current recession.
• During the Severe Contraction,
both after-tax consumption and
investment expenditures
declined, and the AE line shifts
downward, producing a negative
gap.
Recessionary Expenditure Gap
• The U.S. government followed
Keynes’ solution by:
–Providing tax rebate checks in
2008
–Enacting a $787 billion stimulus
package
• Both policies target closing a
recessionary expenditure gap.
International Economic Linkages
• The U.S. downturn reduced U.S.
imports which further lowered
U.S. real GDP.
• The World Trade Organization
has projected that world trade will
shrink by 9% 2009, the largest
collapse since World War II.
Recession and Cyclical
Unemployment
• The Severe Contraction can be
depicted in Figure 29.9
–Decrease in aggregate demand
stems from declining consumer
spending and investment spending.
–With sticky prices, a full-strength
multiplier occurred and real GDP
declined sharply.
Aggregate Demand and Aggregate
Supply
• It is now known that a recession
actually began in December 2007
and worsened in the last quarter
of 2008.
• Furthermore, the stabilization
policies used in 2008 to try to
prevent recession were
unsuccessful.
Last Word: Has the Impact of Oil
Prices Diminished?
• The rise in oil prices during the
summer of 2008 turned out to be a
speculative bubble that burst when
world economies slowed.
• Changes in oil prices—even
spectacular ones—seem to have less
of an effect on aggregate supply than
they once did.
Expansionary Fiscal Policy
• The Economic Stimulus Act of
2009 was not as expansionary or
long-lasting as anticipated.
• More current legislation seeks to
try to boost aggregate demand
through low and middle-income
tax-cuts and large increases in
government expenditures.
Automatic or Built-In Stabilizers
• Automatic stabilizers have not
had sufficient force to offset the
overall drop in aggregate
demand.
• The size of the Federal budget
deficit has increased due to the
decline in taxes resulting from the
reduction of GDP.
Federal Deficits and Surpluses as
Percentages of GDP
• As a percentage of GDP, the
Federal budget deficit was -3.2% in
2008.
• As a percentage of potential GDP,
the standardized budget deficit
rose from -1.4% in 2007 to -2.5% in
2008.
–Fiscal policy was expansionary in
2008
Budget Deficits and Projections
• Updated projected deficits and
surpluses in millions of nominal
dollars
2009 = -1,390
2012 = -264
2010 = -703
2013 = -257
2011 = -498
2014 = -250
Offsetting State and Local Finance
• Although state and local fiscal
policies are often pro-cyclical, the
$787 billion fiscal package of
2009 sought to reduce this
problem by giving aid dollars to
state governments.
The Public Debt
• Public debt is projected to rise
$11.5 trillion dollars in 2009.
• As a percentage of GDP, the
portion of the public debt that
is held by the public will also
rise.
The Investment Demand Curve
• Critics fear the deficit and debt
created by the stimulus package
of 2009 will raise interest rates
and crowd-out private investment.
• Proponents believe the
infrastructure spending will
expand private investment.
Last Word: The Leading Economic
Indicators
• The LEI index provided some
forewarning of the recession.
• The LEI index plummeted rapidly
from June 2008 through
November 2008, correctly
forecasting the severe decline in
fourth quarter real GDP of 2008.
Money and Banking
• Widespread securitization, rising
adjustable-rate mortgage interest
rates, plummeting housing
prices, growing mortgage loan
defaults and failing financial
banks pushed Congress to pass
the Troubled Asset Relief
Program (TARP) in late 2008.
Fed Functions and
the Money Supply
• The Fed’s role as lender-of-last
resort is critical to the U.S.
financial industry.
• The Fed has been highly active
in lending money to the financial
industry during the Severe
Contraction.
Major U.S. Financial Institutions
• Changes to “Examples” in the Table
– Wachovia was acquired by Wells Fargo
– Washington Mutual was acquired by Chase
– Remove Golden West
– Note: Merrill Lynch is now part of Bank of
America
– Remove Lehman Brothers
– Goldman Sachs and Morgan Stanley are
bank holding companies (commercial
banks)
Last Word: The Bank Panics of
1930 to 1933
• No major run on banks have
occurred due to FDIC.
• Insurance coverage increased to
$250,000 per account.
• The increase in bank reserves in
February 2009 resulted in more
reserves than checkable deposits!
The Demand for Money
• During the Severe Contraction,
transaction demand for money
decreased but asset demand for
money increased.
• The Fed greatly increased the
money supply.
–This shift in supply overpowered
the shift in demand
The Consolidated Balance Sheet of
the Federal Reserve Banks
• During the Severe Contraction:
–Assets rose due to huge a rise in
Fed owned securities and loans to
financial institutions
–Liabilities rose as commercial
bank reserves jumped when the
Fed began paying interest on
these reserves
Targeting the Federal Funds Rate
• By December 2008, the federal
funds rate target ranged from zero
to a quarter percent.
• The increase in the supply of
federal funds was achieved through
the term auction facility and openmarket operations.
The Prime Interest Rate and the
Federal Funds in the U.S.
• The decline in the Federal funds
rate to near zero lowered the
prime interest rate to 3.25
percent by February 2009.
Recent U.S. Monetary Policy
• A number of new lender-of-lastresort facilities were created to
ensure and maintain liquidity.
• The facilities are designed to
help banks, households, and
businesses in various ways.
Cyclical Asymmetry
• The Fed has created billions of
dollars of excess reserves.
• Yet, lending by banks was
sluggish throughout the first 15
months of the recession.
• This exemplifies a liquidity trap.
Risk
• Systemic risk has affected
almost all financial investments
in 2007 and 2008, including real
estate.
• Only a few assets such as U.S.
securities and gold were spared.
The Securities Market Line
• The Fed lowered the risk-free
interest rate resulting in a much
lower intercept of the SML.
• Although interest rates fell, stock
market prices did not rise in 2007
and 2008 as expected; the SML
became steeper.
Recession and the
Extended AD-AS Model
• In theory, a lower price level shifts
AS to the right and real GDP “selfcorrects” back to potential output
and full employment.
– Process is too slow and too costly
• Target active monetary and fiscal
policy to shift AD to the right.
The Phillips Curve
• The current recession follows
the general pattern of the
Phillips Curve:
–rising unemployment rate
–declining inflation rate
Taxation and Aggregate Supply
• Tax rebates of 2008 and tax
cuts in 2009 stimulus package
are mainly demand-side tax
cuts.
What Causes Macro Instability?
• Bursting of the housing bubble
initiated forces that led to the
recession.
• Housing bubble fueled by:
–A too-loose monetary policy
–Large international capital inflows
–“Pass the risk” lending practices
–Poor financial regulations
Some Key Facts
• The Severe Contraction has
diminished world trade.
• In 2008, Japanese exports fell
35%; German exports fell 21%.
• Gains from specialization based
on comparative advantage have
waned.
Increased Domestic Employment
Argument
• Recessions amplify arguments
for trade protections to stem
domestic job losses.
• Such policies may provoke
retaliation by other nations, thus
dampening exports.
The World Trade Organization
• Doha Round of international
trade negotiations have stalled
during the Severe Contraction.
• Recessions are not generally
conducive for achieving trade
deals.
Flexible Exchange Rates
• The value of the U.S. dollar has
appreciated since Dec. 2007.
–Lower demand for imports has
depreciated the value of other
currencies relative to the dollar
–“Flight to safety” by foreign investors
to U.S. securities also increased the
demand for dollars
Recent U.S. Trade Deficits
• From 2007 to 2008, the goods
deficit remained roughly
unchanged.
• However, the goods and
services deficit and the current
account deficit fell.