The Great RecessionECON 30020: Intermediate Macroeconomics

Prof. Eric Sims

University of Notre Dame

Fall 2016

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Overview

I Worst economic contraction since Great Depression (by mostmeasures)

I Could do entire course on the subjectI We will do a very brief overview:

I FactsI Underlying causes: mapping into our model(s)I Policy responses: mapping into our model(s)I Lingering questions

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Facts

I “Official” dating: December 2007 - June 2009

I Real GDP declined relative to trend by as much as 10 percent(or more). Has not been a robust recovery

I Unemployment rose from 5 percent to 10 percent. Laborhours fell by 10 percent

I House prices fell by 30 percent. Stock prices by 60 percent

I US government debt increased substantially to 100 percent ofGDP

I Unprecedented policy responses: Fed Funds rate at zero foreight years. Financial bailouts

I Important international dimension

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Output DeclineI Decline in real GDP relative to linear trend of more than 10

percent

9.2

9.3

9.4

9.5

9.6

9.7

9.8

9.9

10.0

96 98 00 02 04 06 08 10 12 14 16

Real GDPConstant growth trend (average growth 1995-2006)

log

re

al G

DP

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1980-1982 RecessionI Compared to last big recession, recovery very weak

8.4

8.5

8.6

8.7

8.8

8.9

9.0

9.1

9.2

1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990

Real GDPConstant growth trend (average growth 1970-1980)

log

re

al G

DP

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Big Decline in Labor Market Variables

I Unemployment rate doubled, has since come back down. Notso with hours worked

0.80

0.84

0.88

0.92

0.96

1.00

1.04

1.08

96 98 00 02 04 06 08 10 12 14 16

Hours per Capita

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Labor Force Participation Has Continued Secular Trend

62

63

64

65

66

67

68

96 98 00 02 04 06 08 10 12 14 16

Labor Force Participation Rate

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Inflation has been low (or negative)

-1

0

1

2

3

4

5

96 98 00 02 04 06 08 10 12 14 16

Inflation rate

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Phase I: Housing Crisis

I Enormous and unprecedented housing price increasesthroughout early and mid-2000s

I Not completely clear why:I “Bubble”?I Mortgage finance innovation: people previously unable to get

loans were getting themI Excessively easy monetary policy?I Role of GSEs (government sponsored entities), Fannie and

Freddie

I Higher home prices: higher consumer spending (wealth effectand easing of liquidity constraints)

I Higher home prices: more home-building

I House prices level off in 2006 and begin to collapse in 2007

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Home Price Run-Up and Decline

60

80

100

120

140

160

180

200

220

240

96 98 00 02 04 06 08 10 12 14 16

Case-Shiller 10 City Home Price Index

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Enormous Decline in Housing Construction

400

800

1,200

1,600

2,000

2,400

96 98 00 02 04 06 08 10 12 14 16

Housing Starts

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Phase 2: Financial Crisis

I After the decline in house prices (2006-2007), the US and therest of the world experienced a financial crisis (2007-2009)

I Temporally followed the decline in house prices

I Most think that the housing market collapse also caused thefinancial crisis

I Why? Over-exposure to previously thought safemortgage-related assets (mortgage backed securities, MBS)combined with increasing interconnectedness of financialinstitutions (things like CDOs, REPOs, etc)

I Signs of financial distress:I Qualitative financial stress indexI Stock pricesI Bond spreads

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Financial Distress Index

-2

-1

0

1

2

3

4

5

96 98 00 02 04 06 08 10 12 14 16

St. Louis Fed Financial Stress Index

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Stock Prices

400

800

1,200

1,600

2,000

2,400

96 98 00 02 04 06 08 10 12 14 16

S&P 500 Stock Price Index

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Bond Spreads

-1

0

1

2

3

4

5

6

96 98 00 02 04 06 08 10 12 14 16

AAA - 3 Month T-Bill SpreadBAA - AAA Spread30 Yr Treasury - 3 Month T-Bill Spread

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Phase 3: Policy Responses and Weak Recovery

I Nominal interest rates went to zero and the Fed triedextraordinary “non-standard” policy responses

I Large scale financial market intervention: TARP, etc

I Large fiscal “recovery package” (American Recovery andReinvestment Act)

I Output and other real variables began to recovery in themiddle of 2009

I Housing market quit collapsing, and indicators of financialdistress dissipated

I Nevertheless, recovery has been weaker than most hoped

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Tying the Facts into our Model

I Phase I:I Housing wealth shock reduces consumption demand; negative

IS/AD shockI Fed responds by aggressively lowering interest rates

I Phase II:I A large negative financial shock (reduction in qt) leads to

negative IS/AD shockI By the time this hit (mid-2008), the ZLB was essentially

bindingI Output reduction much larger than it otherwise would have

been

I Phase III:I Financial market intervention (trying to reverse declines in qt

and housing prices)I Non-standard monetary policy (trying to raise expected

inflation)I Fiscal expansion: IS shift

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Housing Market Collapse and Policy Easing

𝐴𝐴𝐴𝐴

𝐴𝐴𝐴𝐴06

= 𝐴𝐴𝐴𝐴08

𝐴𝐴𝐴𝐴07

𝐼𝐼𝐴𝐴06 𝐼𝐼𝐴𝐴07

𝐿𝐿𝐿𝐿(𝐿𝐿06)

𝐿𝐿𝐿𝐿(𝐿𝐿08)

𝑟𝑟06

𝑟𝑟07

𝑟𝑟08 = −𝜋𝜋𝑡𝑡+1𝑒𝑒

𝑟𝑟𝑡𝑡

𝑌𝑌𝑡𝑡

𝑌𝑌𝑡𝑡

𝑃𝑃𝑡𝑡

𝑃𝑃�0,𝑡𝑡

2006 equilibrium

2007 IS shock due to decline in house prices

2007-2008 monetary policy response

𝑌𝑌06= 𝑌𝑌08

𝑌𝑌07

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Binding ZLB

0

1

2

3

4

5

6

7

96 98 00 02 04 06 08 10 12 14 16

Effective Federal Funds Rate

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Financial Shock

𝑟𝑟𝑡𝑡

𝑌𝑌𝑡𝑡

𝑟𝑟08 = 𝑟𝑟09 = −𝜋𝜋𝑡𝑡+1𝑒𝑒 𝐿𝐿𝐿𝐿

𝑌𝑌𝑡𝑡

𝑃𝑃𝑡𝑡 𝐴𝐴𝐴𝐴08

𝐼𝐼𝐼𝐼08

𝐴𝐴𝐼𝐼

𝐴𝐴𝐴𝐴09

𝑌𝑌09 𝑌𝑌08

𝑃𝑃�0,𝑡𝑡

2008 equilibrium, binding ZLB

2008-2009 financial shock (large ↓ 𝑞𝑞𝑡𝑡)

𝐼𝐼𝐼𝐼09

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Weak Recovery

𝑟𝑟𝑡𝑡

𝑌𝑌𝑡𝑡

𝑟𝑟09 = 𝑟𝑟10 = −𝜋𝜋𝑡𝑡+1𝑒𝑒 𝐿𝐿𝐿𝐿

𝑌𝑌𝑡𝑡

𝑃𝑃𝑡𝑡

𝐴𝐴𝐴𝐴09

𝐴𝐴𝐴𝐴09

𝑌𝑌09= 𝑌𝑌10

𝑌𝑌09𝑓𝑓

𝑃𝑃�09

2009 equilibrium, binding ZLB

AS adjustment in 2009-2010 doesn’t close gap

𝐼𝐼𝐴𝐴09

𝐴𝐴𝐴𝐴10 𝑃𝑃�10

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Policy Response: Financial Market Interventions

I Bailouts and Troubled Asset Relief Program (TARP)

I Involved purchasing “troubled assets” from large financialinstitutions

I Cause of the financial crisis was break down in lendingbecause of fears of insolvency

I Buy up the bad assets leading to insolvency: get rid of theunderlying problem

I Can think about this angle of policy response as trying toreverse course on the decline in qt

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Policy Response: TARP

𝑟𝑟𝑡𝑡

𝑌𝑌𝑡𝑡

𝑟𝑟09 = −𝜋𝜋𝑡𝑡+1𝑒𝑒 𝐿𝐿𝐿𝐿

𝑌𝑌𝑡𝑡

𝑃𝑃𝑡𝑡 𝐴𝐴𝐴𝐴𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇

𝐼𝐼𝐼𝐼(𝑇𝑇𝐴𝐴𝑇𝑇𝑃𝑃)

𝐴𝐴𝐼𝐼

𝐴𝐴𝐴𝐴09

𝑌𝑌09 𝑌𝑌09′

𝑃𝑃�0,𝑡𝑡

2009 equilibrium, binding ZLB

Financial market intervention (e.g. TARP): attempt to ↑ 𝑞𝑞𝑡𝑡

𝐼𝐼𝐼𝐼09

I Basically, trying to reverse decrease in qt buy taking “troubledassets” out of the system

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Quantitative Easing

I We’ve written down model with one interest rate, rtI In reality, many interest rates, which differ according to risk

and time to maturity

I Normal monetary policy: buy and sell government bonds,affecting money supply and short term, riskless interest rate

I Quantitative easing: buy and sell longer maturity or higherrisk bonds, affecting risky longer term interest rates

I Call τ the risk/term premium. Relevant interest rate forconsumption and investment is rt + τt

I QE: trying to lower τt

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Quantitative Easing

𝑟𝑟𝑡𝑡

𝑌𝑌𝑡𝑡

𝑟𝑟09 = −𝜋𝜋𝑡𝑡+1𝑒𝑒 𝐿𝐿𝐿𝐿

𝑌𝑌𝑡𝑡

𝑃𝑃𝑡𝑡 𝐴𝐴𝐴𝐴𝑄𝑄𝑄𝑄

𝐼𝐼𝐼𝐼(↓ 𝜏𝜏𝑡𝑡)

𝐴𝐴𝐼𝐼

𝐴𝐴𝐴𝐴09

𝑌𝑌09 𝑌𝑌09′

𝑃𝑃�0,𝑡𝑡

2009 equilibrium, binding ZLB

Non-standard monetary policy: quantitative easing (QE) to lower risk/term premium, 𝜏𝜏𝑡𝑡

𝐼𝐼𝐼𝐼09

I Lower τt raises consumption/investment demand for a givenrt , which shifts IS curve

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Forward Guidance

I What matters for investment and saving decisions are longerterm interest rates

I Normal monetary policy: affect short term rates, which affectslonger term rates

I Forward guidance: promise to keep short term rates low far offin to the future. Idea: get longer term rates to dropimmediately

I Based on “expectations hypothesis” of interest rates: longermaturity rates are product of sequence of short maturity rates

I Hence, can think of forward guidance as also trying to impactτt

I Two other channels of forward guidance:I Raise expectations of future incomeI Raise expectations of future inflation

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Forward Guidance: Yt+1 channel

𝑟𝑟𝑡𝑡

𝑌𝑌𝑡𝑡

𝑟𝑟09 = −𝜋𝜋𝑡𝑡+1𝑒𝑒 𝐿𝐿𝐿𝐿

𝑌𝑌𝑡𝑡

𝑃𝑃𝑡𝑡 𝐴𝐴𝐴𝐴𝐹𝐹𝐹𝐹

𝐼𝐼𝐼𝐼(↑ 𝑌𝑌𝑡𝑡+1)

𝐴𝐴𝐼𝐼

𝐴𝐴𝐴𝐴09

𝑌𝑌09 𝑌𝑌09′

𝑃𝑃�0,𝑡𝑡

2009 equilibrium, binding ZLB

Non-standard monetary policy: forward guidance, promise to lower future interest rates to raise 𝑌𝑌𝑡𝑡+1

𝐼𝐼𝐼𝐼09

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Forward Guidance: πet+1 channel

𝑟𝑟𝑡𝑡

𝑌𝑌𝑡𝑡

𝑟𝑟09 = −𝜋𝜋0,𝑡𝑡+1𝑒𝑒 𝐿𝐿𝐿𝐿

𝑌𝑌𝑡𝑡

𝑃𝑃𝑡𝑡 𝐴𝐴𝐴𝐴𝐹𝐹𝐹𝐹

𝐴𝐴𝐴𝐴

𝐴𝐴𝐴𝐴09

𝑌𝑌09 𝑌𝑌09′

𝑃𝑃�0,𝑡𝑡

2009 equilibrium, binding ZLB

Non-standard monetary policy: forward guidance, implicit promise to raise future inflation, and hence expected inflation, 𝜋𝜋𝑡𝑡+1𝑒𝑒

𝐼𝐼𝐴𝐴09

𝑟𝑟09′ = −𝜋𝜋1,𝑡𝑡+1𝑒𝑒

𝐿𝐿𝐿𝐿(↑ 𝜋𝜋𝑡𝑡+1𝑒𝑒 )

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Fiscal Expansion

I As noted earlier, when ZLB binds, IS shocks have biggeroutput effects

I Hence, fiscal expansion makes more sense in such periodsI American Recovery and Reinvestment Act:

I Spending increases and tax cutes totaling about $800 billion tospread over 10 years

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Fiscal Stimulus

𝑟𝑟𝑡𝑡

𝑌𝑌𝑡𝑡

𝑟𝑟09 = −𝜋𝜋𝑡𝑡+1𝑒𝑒 𝐿𝐿𝐿𝐿

𝑌𝑌𝑡𝑡

𝑃𝑃𝑡𝑡 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴

𝐼𝐼𝐼𝐼(𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴)

𝐴𝐴𝐼𝐼

𝐴𝐴𝐴𝐴09

𝑌𝑌09 𝑌𝑌09′

𝑃𝑃�0,𝑡𝑡

2009 equilibrium, binding ZLB

Fiscal stimulus (e.g. ARRA): ↑ 𝐺𝐺𝑡𝑡 and ↓ 𝑇𝑇𝑡𝑡

𝐼𝐼𝐼𝐼09

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Policy Angles: Summary

I Three different modes of policy response: financialintervention, non-standard monetary policy, fiscal stimulus

I Within context of our SR NK model, all make some degree ofsense given widely accepted view of underlying cause of GreatRecession

I Did the policy changes work?

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Did it Work?

I Financial market intervention:I Indicators of financial stress went back to normal levels in 2009I Stock prices and risky bond spreads are basically back to

where they wereI Financial system didn’t blow up

I Non-standard monetary policy:I Haven’t had deflation, but inflation expectations haven’t risenI Commercial banks sitting on lots of cashI Longer maturity bond spreads are still fairly high

I Fiscal stimulus:I Probably wasn’t big enough to do an enormous amount anywayI Raised government debt and policy related uncertaintyI Little consensus within empirical literature on effects of

stimulus

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US Debt-GDP Ratio

50

60

70

80

90

100

110

96 98 00 02 04 06 08 10 12 14 16

US Debt-GDP

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Long Run Growth Forecasts: Lots of Pessimism

2.2

2.4

2.6

2.8

3.0

3.2

3.4

96 98 00 02 04 06 08 10 12 14 16

10 Year Expected Real GDP Growth Rate

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