Aggregate Demand II:

Applying the IS-LM Model

Chapter 12 of
Macroeconomics, 9th edition,
by N. Gregory Mankiw
ECO62 Udayan Roy
 Applying the IS-LM Model
Section 12-1 shows how the IS-LM model
that we studied in Chapter 11 can be
applied to understand how an economy
copes with disturbances (or, shocks) in the
short run
Section 12-3 extends section 12-1 by
looking closely at
The Great Depression of the 1930s, and
The Great recession of 2008-09
Warning: I will skip section 12-2! Very sorry!
 The IS-LM Model: Ch. 11
Assumptions
Y=C+I+G
C = Co + Cy (Y T)
I = I o I rr
G and T are exogenous
M = Md = L(i) P Y
L(i) = Lo Li i
i = r + E
M, P and E are exogenous
The IS-LM Model: Ch. 11 Summary

Y=C+I+G Y
1
(Co I o G )
Cy
T
Ir
r
1 Cy 1 Cy 1 Cy
C = Co + Cy (Y T)
I = I o I rr
G and T are exogenous
M = Md = L(i) P Y
L(i) = Lo Li i
i = r + E
M, P and E are exogenous
 The IS-LM Model: Ch. 11
Summary
Short-run equilibrium in the goods market is represented
by a downward-sloping IS curve linking Y and r.
Short-run equilibrium in the money market is represented
by an upward-sloping LM curve linking Y and r.
The intersection of the IS and LM curves determine the
short-run equilibrium values of Y and r.
The IS curve shifts right if there is: r
an increase in Co + Io + G, or L
a decrease in T. M
The LM curve shifts right if:
M/P or E increases, or
Lo decreases

IS
Y
 Equilibrium in the IS -LM model
The IS curve represents r
equilibrium in the goods LM
market.
Y C (Y T ) I (r ) G
r1
The LM curve represents
money market
equilibrium. IS
M L(r E ) P Y
Y1 Y
 Shifts of the IS curve
r
Recall from Chapter 11 that
LM
the consumption function is
C(Y T) = Co + Cy (Y T),
and
The investment function is I(r)
= Io Ir r r1
Recall also that the IS curve
shifts right if there is:
IS
an increase in Co + Io + G, or
a decrease in T. Y1 Y
As a result, both Y and r
increase
 Shifts of the IS curve
r
Similarly, the IS LM
curve shifts left if
there is:
a decrease in Co + r1
Io + G, or
an increase in T. IS
As a result, both Y Y1 Y
and r decrease
 Shifts of the IS curve
r
In other words, we LM
can make the
following predictions:
IS-LM Predictions r1
Y r

Co + I o + + IS
+G
T Y1 Y
Ch. 11: Comparing fiscal policy in the
Keynesian Cross and in the IS Curve
In the Keynesian Cross model, expansionary fiscal policy
boosts GDP by an amount dictated by the multipliers.
Keynesian
1 C y Cross
Y (Co I o G ) T
1 Cy 1 Cy
K.C. Spending K.C. Tax-Cut
Multiplier Multiplier

In the IS-LM model, expansionary fiscal policy also raises the

real interest rate, thereby weakening the effect of fiscal
1 Cy
policy on GDP. (Crowding-out effect)
Ir
Y (Co I o G ) T r
1 Cy 1 Cy 1 Cy
IS
Curve
 Fiscal Policy is Weakened by the
Crowding-Out Effect
We have just seen that, in the IS-LM model,
expansionary fiscal policy (G or T)
leads to higher interest rates, which
exerts downward pressure on investment spending, which
exerts downward pressure on GDP and jobs.
This negative aspect of expansionary fiscal policy is
called the crowding-out effect
This effect was absent in the Keynesian Cross model
Thus, fiscal policy is less effective in the IS-LM
model than in the Keynesian Cross model
 An increase in government
purchases: graph
1. IS curve shifts r
right 1
by G LM
1 MPC
causing GDP to r2
rise. 2.
r1
2. This raises money
demand, causing 1. IS2
the interest rate to IS1
3. rise
which reduces Y1 Y2
Y
investment, so the final
3.
increase in Y 1
is smaller than G
1 MPC
 A tax cut
Consumers save r
(1MPC) of the tax cut, LM
so the initial boost in
spending is smaller for
T than for an equal r
2.
G r21
and theIS
MPCcurve shifts 1. IS2
by 1. T IS1
1 MPC
Y1 Y2 Y
2. so the effects on r
2.
and Y are smaller for
T than for an equal
G.
 Shifts of the LM curve
r
Recall
from Chapter LM
11 that .
Recall also that the LM
curve shifts right if r1
there is:
an increase in M or E,
or IS
a decrease in Lo or P. Y1 Y
As a result, Y
increases and r
decreases
 Shifts of the LM curve
r
Similarly, the LM LM
curve shifts left if
there is:
a decrease in M/P r1
or E, or
an increase in Lo. IS
As a result, Y Y1 Y
decreases and r
increases
 Shifts of the LM curve
We
have just seen how a shift of the LM
curve affects real GDP (Y) and the real
interest rate (r).
But how is the nominal interest rate (i)
affected?
Recall that
Therefore, if expected inflation () is
unchanged, the effect on i would be
identical to the effect on r.
But if changes, things get complicated.
 Shifts of the LM curve
r
Recall from Ch. 11 that, LM
if expected inflation (E)
increases (decreases),
the LM curve shifts down
(up) by the exact same r1
amount!
Therefore, if E IS
decreases, r will
increase, but by a Y1 Y
smaller amount.
Therefore, i = r + E will
decrease.
 IS-LM Predictions
IS-LM Predictions
IS Curve LM Y r i
Curve
C o + Io + + + +
G
T
M/P +
E + +
Lo + +

At this point, you should

be able to do problems 1,
2, 3 (a) (f), 4, and 5 on
pages 352 353 of the
textbook. Please try them.
 Monetary Policy
The practice of changing the quantity
of money (M) in order to affect the
macroeconomic outcome is called
monetary policy
an increase in the quantity of money
(M) is called expansionary monetary
policy, and
A decrease in the quantity of money
(M) is called contractionary monetary
policy
 Shifts of the LM curve
r
When the central bank of a
LM
country makes changes to
the quantity of money (M),
only the LM curve changes,
and
the real interest rate (r)
r1
changes in the opposite
direction
As expected inflation (E) is IS
assumed exogenous in the IS-
LM model, when the real Y1 Y
interest rate (r) changes, the
nominal interest rate (i = r +
E) changes in the same
direction.
 Shifts of the LM curve
r
One can think of LM
the central bank as
targeting M and
affecting r and i in r1
the process, or as
targeting r and/or i IS
and adjusting M to Y
Y1
achieve the target
Monetary Policy Re-defined
Therefore, one can re-define
expansionary and contractionary
monetary policy as follows:
Monetary policy is expansionary when
the central bank attempts to reduce
interest rates (real and nominal), and
Monetary policy is contractionary when
the central bank attempts to increase
the interest rates (real and nominal)
 The Federal Funds Rate
In the United States, the central bank (the
Federal Reserve) formally describes its
monetary policy by periodically
announcing its desired or target level for a
nominal interest rate called the Federal
Funds Rate
Having announced its target level for the
FFR, the Fed then adjusts the money
supply to steer the actual FFR as close to
its target level as it can
 The Federal Funds Rate
The Federal Funds Rate is the
interest rate that banks charge each
other for overnight loans
If the Fed wishes the FFR to be 1.8%,
all it has to do is to announce that
it will lend money to any bank at 1.8%
interest and
will pay 1.8% interest on deposits
received from any bank
 The Federal Funds Rate
Given that the Fed expresses its monetary
policy in terms of the target value of the
Federal Funds Rate, we can re-define monetary
policy as follows:
Monetary policy is expansionary when the Fed
seeks to reduce the federal funds rate, and
Monetary policy is contractionary when the
Fed seeks to increase the federal funds rate
Keep in mind that, when expected inflation (E)
is exogenous, changes in nominal interest rates
(such as the FFR) lead to equal changes in real
interest rates
 The Zero Lower Bound on Nominal
Interest Rates
r
We have seen that, when
LM
faced with a recession, the
central bank can
Increase the money supply
(M)
r1
Thereby shifting the LM
curve right
Thereby reducing the real
IS
interest rate (r = i E )
and the nominal interest rate Y
(i = r + E) and increasing
Y1
GDP (Y) to drag the
economy out of the recession
 The Zero Lower Bound on Nominal
Interest Rates
r
The problem is that there is
a limit to how low the
LM
nominal interest rate can be
Nominal interest rates (such
as the federal funds rate)
cannot be negative r1
To deal with the 2008
economic crisis, the Fed
reduced the FFR to zero IS
But the recession persisted Y
Y1
Unfortunately, the Fed could
not reduce interest rates
below zero: monetary policy
had reached its limit
The Zero Lower Bound on Nominal
Interest Rates: Crisis 2008-09
 The Zero Lower Bound on Nominal
Interest Rates
r
r = i E LM
iminimum = 0
Therefore, rminimum =
iminimum E = 0 r1
E 2.1
%
Therefore, rminimum = IS
E Y1 Y
For example, if E =
3%, then rminimum =
E = 3%
 The Zero Lower Bound on Nominal
Interest Rates
r
For example, in the
LM
diagram, the central bank
will have to reduce the
real interest rate to r =
2.1% in order to end the r1
recession
But suppose expected 2.1
%
inflation is E = 3% IS
Then, the nominal interest
Y1 Y
rate would have to be
brought down to i = r + This example also shows
E = 2.1 3.0 = 0.9% how dangerous it can be if
we have deflation and
Which, alas, is impossible people begin to expect the
deflation to continue
 The Zero Lower Bound on Nominal
Interest Rates
If the nominal interest rate has been
reduced all the way down to zero,
and the economy is still stuck in a
recession, the economy is said to be
at the zero lower bound, or
in a liquidity trap
See page 350 of the textbook
 The Zero Lower Bound on Nominal
Interest Rates: Solutions
When an economy is in a liquidity trap,
monetary policy cannot be used to reduce
interest rates any further
But is there nothing else that can be done to
bring the economy back to life?
Yes, there is!
Expansionary fiscal policy can be used
And theres something else that the monetary
authorities (the central bank) can do: make a
credible promise to be irresponsible!
 The Zero Lower Bound on Nominal
Interest Rates: Solutions
In my example,
r
the central bank needs to reduce the LM
real interest rate to r = 2.1% to end
the recession
But expected inflation is E = 3%
So, the necessary nominal interest
rate is i = 0.9%, which is impossible r1
Recall that the LM curve shifts right
if either M or E increases 2.1
If the central bank promises to be %
irresponsible and to create rapid IS
inflation in the future, and if people
believe its promise, then E will Y1 Y
increase, say from 3% to +1%
Then the nominal interest rate
required for full-employment will The zero-lower-bound
be i = r + E = 2.1 + 1.0 = 3.1%, problem can be solved if
which is definitely attainable the central bank can
credibly promise to be
 The Zero Lower Bound on Nominal
Interest Rates: Solutions
Although this chapter assumes a closed
economy, in reality foreign trade does
matter.
So, the central bank can
print domestic currency, and
use it to buy foreign currency,
thereby making the domestic currency
cheaper relative to the foreign currency,
thereby stimulating exports,
thereby ending the recession!
 The Zero Lower Bound on Nominal
Interest Rates: Solutions
Even when short-term interest rates such as
the federal funds rate are at zero percent, the
central bank can print money and make long-
term loans to the government, to businesses,
to home-buyers who need mortgages, etc.
This would reduce long-term interest rates
directly, thereby stimulating spending by the
borrowers
This strategycalled quantitative easing
may also end a recession
 Interaction between
monetary and fiscal policy

IS-LM Model:
Monetary and fiscal policy variables
(M, G, and T ) are exogenous.
Real world:
Monetary policymakers may adjust M

in response to changes in fiscal

policy,
or vice versa.
Such responses by the central bank
 The Feds response to G > 0

Suppose the government

increases G.
Possible Fed responses:
1. hold M constant
2. hold r constant
3. hold Y constant
In each case, the effects of G on
Y
are different
 Response 1: Hold M constant

When G increases, r
the IS curve shifts LM
right.
If Fed holds M
r2
constant, then LM r1
curve does not shift.
IS2
As a result, interest
IS1
rates rise. This has a
crowding-out effect. Y1 Y2 Y
Consequently, GDP
increases, but not a
lot.
 Response 2: Hold r constant

If Congress raises G, r
the IS curve shifts LM
right. 1 LM
To keep r constant, 2
r2
Fed increases M r1
to shift LM curve
right. IS2
Results: IS1
Y Y3 Y1 Y1 Y2 Y3 Y

r 0
 Response 3: Hold Y constant

If Congress raises G, r LM
the IS curve shifts 2 LM
right. 1

To keep Y r3
r2
constant, Fed r1
reduces M
to shift LM curve IS2
Results:
left. IS1
Y 0 Y
Y1 Y2
r r3 r1
At this point, you should be
able to do problem 7 on
page 353 of the textbook.
 Estimates of fiscal policy multipliers
from the DRI macroeconometric model

Estimated Estimated
Assumption about value of value of
monetary policy Y / G Y / T

Fed holds
0.60 0.2
money supply
6
constant
Fed holds nominal
1.93 1.19
interest rate
constant
A macroeconometric model is a more elaborate version of our IS-
LM model, with the parameters given the numerical values that
they are estimated to have, based on historical data.
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
The U.S. Recession of 2001
3.9% on Unemployment

9/00 7.0

4.9% on
6.0

8/01 5.0

6.3%
4.0

on
6/03
3.0

2.0

5.0% on 1.0

7/05
0.0
 The U.S. Recession of 2001
Growth of GDP growth rate
GDP was 10.0

negative in 8.0

the 1st and 6.0

3rd quarters 4.0

of 2001
2.0

Thats
essentially
0.0

before 9/11 -2.0

 Recall: IS-LM Predictions
IS-LM Predictions
IS Curve LM Y r i
Curve
C o + Io + + + +
G
T
M/P +
E + +
Lo + +
 The U.S. Recession of 2001
r
Why?
Demand shocks moved the IS
LM
curve left
The tech bubble ended and
stocks fell 25% between 8/00 and
8/01 r1
9/11 attacks led to a 12% fall in
stock prices in one week and a
huge rise in uncertainty
Scandals at Enron, WorldCom IS
and other corporations led to
stock price declines and a decline Y1 Y
in trust and a rise in uncertainty
Lower household wealth reduced
Co and higher uncertainty
reduced Io
 CASE STUDY:
The U.S. recession of 2001
Causes: 1) Stock market decline C

1500
Standard & Poors
Index (1942 = 100)

1200 500

900

600

300
1995 1996 1997 1998 1999 2000 2001 2002 2003
 The U.S. Recession of 2001
r
Fiscal stimulus moved IS
LM
curve right
Major tax cuts were enacted in 1 LM
2001 and 2003 2
Government spending was
boosted
r1
to rebuild NYC, and
to bail out the airline industry IS2
Fed printed money and IS1
moved LM curve right
Y1 Y3 Y
Interest rate on 3-month
Treasury bills fell
6.4% in 11/00
3.3% in 8/01
All three toolsG, T and M
0.9% in 7/03
were used
01
/01

0
1
2
3
4
5
6
7
/20

right
04
/02 00
07 /200
/03 0
/20
10
/03 00
01 /200
/03 0
/20
04
/05 01
07 /200
/06 1
/20
10
/06 01
01 /200
/06 1
CASE STUDY:

T-Bill

/20
04
/08 02
07 /200
2
T-Bill Rate
Rate

/09
Three-month
Three-month

/20
10
/09 02
01 /200
/09 2
/20
04
/11 03
The U.S. recession of 2001

/20
Monetary policy response: shifted LM curve

03
 Skip!
I am skipping section 11-2
THE GREAT DEPRESSION
 The Great Depression
240 30
Unemployment
billions of 1958 dollars

percent of labor force

220 (right scale) 25

200 20

180 15

160 10

140 Real GNP 5

(left scale)
120 0
1929 1931 1933 1935 1937 1939
Table 12-1
Mankiw: Macroeconomics, Ninth
Edition
 Real Interest
Year
Rate
1929
1930 6.2
1931 12.7
1932 12
1933 3.9
1934 -6.4
1935 -0.1
1936 0.6
1937 -3.3
1938 2.1
1939 2.2
1940 -1

Table 12-1
Mankiw: Macroeconomics, Ninth
Edition
 Explaining the Great
Depression
The Spending Hypothesis: IS Shifted
Left
The Money Hypothesis: LM Shifted
Left
The Money Hypothesis: Debt-
Deflation
 THE SPENDING HYPOTHESIS:
Shocks to the IS curve
asserts that the Great r
Depression was largely LM
due to an exogenous fall
in the demand for goods
and services a
r1
leftward shift of the IS
curve.
evidence: output and IS
interest rates both fell in Y
Y1
early 1930s, 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%
Large drop in investment in housing
correction after overbuilding in the 1920s
widespread bank failures in early 1930s
made it harder to obtain financing for
investment
Contractionary fiscal policy
Politicians raised tax rates in 1932 and cut
spending to combat increasing deficits.
 THE MONEY HYPOTHESIS:
A shock to the LM curve
asserts that the Great 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

 THE MONEY HYPOTHESIS AGAIN:
The effects of falling prices
asserts that the severity of the Great
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?
 Deflation and the IS-LM
Theory
First, the good news about deflation:
Usual IS-LM Theory: Deflation may shift the
LM curve to the right (P)
Pigou Effect: Deflation may shift the IS
curve to the right
Next, the bad news:
Debt-Deflation Theory: Deflation may shift
the IS curve to the left
Usual IS-LM Theory: Deflation may shift the
LM curve to the left (E)
 THE MONEY HYPOTHESIS AGAIN:
The effects of falling prices
By the usual IS-LM theory, deflation
was thought to stabilize an economy:
P (M/P ) LM shifts right Y
 THE MONEY HYPOTHESIS AGAIN:
The effects of falling prices
Pigou effect:
P (M/P )
consumers wealth
C
IS shifts right
Y
 IS-LM Predictions
IS-LM Predictions
IS Curve LM Y r i
Curve
C o + Io + + + +
G
T
M/P +
E + +
Lo + +
 THE MONEY HYPOTHESIS AGAIN:
The effects of falling prices
Although traditionally, deflation was
thought to stabilize an economy,
after the Great Depression,
economists began to see the
negative effects of deflation:
When prices fall, expected inflation could fall.
This could have negative effects
When prices fall, lenders gain and borrowers
lose. This can reduce overall spending and
hurt the economy
 THE MONEY HYPOTHESIS AGAIN:
The effects of falling prices
P E r
E LM curve shifts LM
left
r and I (r )
planned expenditure r1
income and output
Also, the nominal IS
interest rate decreases
Y1 Y
(i):
see IS-LM predictions
grid
 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
 The evidence on output and
nominal interest rates
Note that, other than the money hypothesis, all the
other hypothesesthe spending hypothesis, the debt-
deflation hypothesis, and the deflationary expectations
hypothesispredict falling real GDP and falling
nominal interest rates
This is exactly what happened in the early stages of
the Great Depression
The spending hypothesis and the debt-deflation
hypothesis both predict falling real interest rates,
whereas the deflationary expectations hypothesis
predicts rising real interest rates
Therefore, evidence on real interest rates is crucial in
identifying suitable explanations for the Great
Depression
 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.
THE FINANCIAL CRISIS AND
ECONOMIC DOWNTURN OF 2008 AND
2009
 CASE STUDY
The 2008-09 Financial Crisis & Recession
2009: Real GDP fell, unemployment 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
 A Too-Brief and Too-Simple
Explanation
The price of housing had risen to
unsustainable levels.
When home prices inevitably
crashed, people suddenly felt poor
and cut back their spending plans.
This fall in planned expenditure
brought about the Great Recession of
2008-09.
 The Housing Bubble Inflates, then
Deflates
The S&P Case-Shiller 20-City Home
Price Index went from
100 in Jan 2000, to
206.54 in April 2006, to
140.95 in May 2009, to
142.16 in Dec 2010
Why did the housing bubble inflate?
 The Housing Bubble:
Reasons
The Fed kept the interest rates too
low for too long
Securitization technology got a lot
fancier in the mortgage bond market
The government regulators were
sleeping
Pretty much everybody believed that
home prices could never fall
 The Housing Bubble: Low
FFR
The Fed had reduced the Federal
Funds Rate to fight the Recession of
2001.
After that recession ended, the Fed
continued to keep interest rates low
until 2004
The Fed was watching inflation, which
remained tame. Consequently, the Fed
saw little reason to raise interest rates.
The Fed did not believe that housing
prices had formed a bubble until it
 The Housing Bubble:
Securitization
In the past, people with money did
not like to lend money to home
buyers because such loans were
risky and had unreliable returns
But the advent of new financial
technologies called securitization and
tranching made people with money
suddenly eager to lend to home
buyers
 The Housing Bubble: Weak
Regulators
The financial sector was regulated by
people who were ideologically
opposed to regulation
They turned a blind eye to even the
worst lending practices
The Housing Bubble Inflates
The Feds low-interest policy and financial
innovation made it easy for home buyers
to borrow money
Lax regulation allowed subprime lending
That is, lending to people who had few assets
and/or prospects that would make repayment
likely
The belief that home prices would keep
rising made it unnecessary to worry about
the credit worthiness of borrowers
 The Housing Bubble
Deflates
After mid-2006, home prices started
to fall
Home owners began to default on their
loans
Foreclosures increased
This flooded the market with more
homes for sale
Which led to further declines in home
prices
These cascading and self-reinforcing
home price declines made people feel
 The Housing Bubble
Deflates
After mid-2006, home prices started to fall
The financial institutions that had made mortgage
loans faced huge losses when borrowers began to
default
These institutions began to second guess their
ability to spot good borrowers. So, they reduced
lending
Even financial institutions that had not made bad
loans were scared to lend because they feared that
the borrower may have made bad investments and
would soon go bankrupt
Business investment spending collapsed
 The Housing Bubble
Deflates
After mid-2006, home prices started to fall
Financial institutions were revealed to have suffered
huge losses
Non-financial businesses were not getting loans and
were shutting down
But a lack of transparency meant that it was not
possible to figure out which companies would
collapse next
This caused great uncertainty
People with money sold off their stocks and bonds
The decline in stock prices made people feel poor
Consumption spending fell
 The Housing Bubble
Deflates
The collapse of the housing bubble
led, through a complex chain of
causation, to major declines in
consumption and investment
spending
One can think of all this as a shift of
the IS curve to the left
This brings about a recession, with
falling output and rising
unemployment
 The Feds Response
The Federal Reserve reduced the
Federal Funds Rate
from 5.25% in Sept 2007
to essentially zero in Dec 2008
The Fed had reached the zero lower bound
and could not go any further
The Fed is now trying less orthodox
measures, called quantitative easing,
to reduce long-term interest rates
The Federal Governments Response

In October 2008, the outgoing Bush

administration enacted the Troubled
Assets Recovery Program (TARP) that
spent $700 billion to revive Wall Street
In January 2009, the incoming Obama
administration enacted the American
Recovery and Reinvestment Act (ARRA),
which consisted of $800 billion in tax cuts
and spending initiatives to spread over
two years
 Slow Recovery
The Great Recession officially ended
in June 2009
But the recovery has been very slow
Real GDP grew at 3.1% in the fourth
quarter of 2010
The unemployment rate was at 8.9%
in February 2011
THE GREAT RECESSION
CHARTBOOK
Interest rates and house prices

Federal Funds rate

30-year mortgage rate
Case-Shiller 20-city composite house price index

House price index, 2000=100

interest rate (%)

 Change in U.S. house price index
and rate of new foreclosures, 1999-2009

US house price index

New foreclosures

Percent change in house prices (from 4 quarters earlier)

 House price change and new foreclosures,
2006:Q3 2009Q1
20%

18% Nevada
Florida Illinois
16%
Michigan Ohio
% of all mortgages
New foreclosures,

14%
California Georgia
12%
Arizona Colorado
10%
Rhode Island
8% Texas
New Jersey
6%
Hawaii S. Dakota
4%
Oregon
Wyoming
2% Alaska
N. Dakota
0%
-35% -30% -25% -20% -15% -10% -5% 0% 5% 10% 15%
Cumulative change in house price index
 U.S. bank failures by year, 2000-2009

70

60
Number of bank failures
50

40

30

20

10

0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009*

* as of July 24, 2009.

 Major U.S. stock indexes
(% change from 52 weeks earlier)
140%
DJIA
120%
S&P 500
100%
NASDAQ
80%

60%

40%

20%

0%

-20%

-40%

-60%

-80%
8/13/2000 12/28/2001 5/14/2003 9/27/2004 2/11/2006 6/28/2007 11/11/2008
12/6/1999 4/21/2001 9/5/2002 1/20/2004 6/5/2005 10/20/2006 3/5/2008 7/20/2009
Consumer sentiment and growth in consumer
durables and investment spending

% change from four quarters earlier Consumer Sentiment Index, 1966=100

Durables
Investment
UM Consumer Sentiment Index
Real GDP growth and Unemployment

Real GDP growth rate (left scale)

Unemployment rate (right scale)

% change from 4 quaters

% of
earlier
labor force
The Fed Tried: M/P Kept
Rising
But the Fed hit the zero lower bound
Falling mortgage rates
helped
Mortgage rates were very Note that there is a
low between 04 and 06. link between the
They may have contributed two rates, though
to the housing bubble weak

In hindsight, the
FFR should have
been higher in
2003-06. But
inflation was low.
Record low mortgage rates

Mortgage rates are

even lower now.
The unusually low But credit
mortgage rates may standards have
have helped to inflate been tightened. In
the housing bubble. any case, the
economy is still
weak. So, dont
expect another
housing bubble.
The Housing Bubble Inflates, and
then Deflates
The Stock Market Tanks

In 2007, it becomes
clear that banks
would get hit by the
collapse of the
housing bubble
The Fear Index Spikes
The Fear Index Spikes
Consumption Spending Falls

In 2007, the growth

rate of consumption
slowed faster than
GDP did. This was
unusual.
Business Investment Tanks

From 2007,
investment, which
includes new
housing, absolutely
crashed.
Unemployment Shot Up

Remember Okuns
Law?
Unemployment Shot Up

Remember Okuns Law?

Because GDP growth has
remained below 3%,
unemployment has
remained stubbornly high.
 Inflation Fell Sharply

The Fed pays more attention to the core

inflation rate, which ignores food and
energy. Now you see why. The downward
trend in core inflation is a worry: we dont
need deflation.
A Yawning Budget Deficit!

Has government spending risen at

an unusually rapid rate? Not really.

The main budgetary problem has

been caused by the crashing tax
revenues.
A Yawning Budget Deficit!

Has government spending

risen at an unusually rapid
rate? Not really.

The main budgetary problem has

been caused by the crashing tax
revenues.
A Yawning Budget Deficit!

Has government spending risen at an

unusually rapid rate? Not really.

The main budgetary problem has been

caused by the crashing tax revenues.
This recession was special: job
losses

Horizontal axis shows months. Vertical axis

shows the ratio of that months nonfarm payrolls
to the nonfarm payrolls at the start of recession.
And this doesnt even account for the fact that
the working-age population has continued to
grow, meaning that if the economy were healthy
we should have more jobs today than we had
before the recession.