Week11 Lecture Essay

GFC and the Short Run Model

Week 11

Readings
Jones, 3rd Edition chapters 10 & 14
This lecture’s objectives
◦ Analyze the Great Financial Crisis (or Great Recession) by amending our models for financial frictions

Economics 2102 Week 11

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1. Prelmiinary

◦ Credit relationships play an integral part in modern economies and are interdependent
E.g trade credit, inter-bank lending, bank commercial lending, mortgage lending, bond markets ◦ When credit markets, the ‘financial economy’, seize up, the real economy is affected.
◦ In 2008, credit markets in the United States unravelled, very quickly, primarily due to bad lending by many banks relying on securitized mortgages.
◦ An immediate implication of the financial crisis was a dramatic rise in interest rates for all sorts of credit due to wide-spread concerns within financial markets about liquidity and solvency of financial firms.

Economics 2102 Week 11

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◦ In response to the crisis, central banks including the Federal Reserve lowered policy interest rates to (effectively) zero. And some central banks undertook unusual monetary policy actions (quantitative easing).
◦ We will look at components of the financial crisis using our short run models, specifically
– introduce financial considerations in our model in a simple manner — a spread between policy and market interest rates
– consider the implications of the zero lower bound for interest rates

Economics 2102 Week 11

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TED Spread
5

(Percent)

4

3

TED is an interbank lending rate less 3mo US Treasury Bill rate

2

1

0
2006

2008

2010

2012

Source: Federal Reserve Bank of St. Louis
Shaded areas indicate US recessions - 2015 research.stlouisfed.org

2014

Economics 2102 Week 11

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2. Financial Frictions & Economic Fluctuations
To model financial frictions and the loss of control policy makers experienced with general interest rates, we introduce a risk premium into our basic models:
Rt = Rtff + f where Rff is the policy interest rate and f is the risk premium term.
For what follows, we will first work with our simple assumption that the nominal policy interest rate can be set to achieve a desired policy real rate. In particular, assume for the moment that π e = 0 so that Rff = i.
Ordinarily, we have f = 0; but in times of financial distress we have f > 0.

Economics 2102 Week 11

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The IS-MP Model
The (simple) IS curve is
Y˜t = a − b(Rt − r)
Using the interest rate equation above,
Y˜t = a − b(Rtff + f − r)
We can analyze the financial crisis very simply; two shocks hit the economy:
(1) contraction in aggregate demand by households due to falling house prices reducing wealth; a = ac < 0.
(2) increase in risk premium as credit markets seize up, f > 0
One difference in analysis here — Rtff on vertical axis for IS curve and MP.

Economics 2102 Week 11

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ff

i t = Rt

ff
Rt ∆π
= rt

MP

a

IS(a = 0; f = 0)
IS(a < 0; f = 0)
0

0

IS(a < 0; f > 0)

Y˜t

IS(a < 0; f > 0) ff In order to close output gap, Rt must be lowered by a large amount in response to the two shocks. ff Possible that Rt would need to go below zero to achieve a zero output gap but this is not possible due to the zero lower bound (dashed IS curve with f ). Recall i = Rff and nominal interest rates must be positive. Economics 2102 Week 11

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Now, let’s make this a bit more realistic. From our Fisher relationship we have,
Rtff = ifft − πte
Where ifft is the Federal Funds rate (policy rate) in nominal terms.
The market real interest rate is,
Rt = Rtff + f = ifft − πte + f
The IS curve is now,
Y˜t = a − b(ifft − πte + f − r)
We now have a relationship between the nominal policy interest rate and the output gap.
It depends upon expected inflation as well as the financial premium (in addition to a and
r).

Economics 2102 Week 11

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ff
IS: Y˜t = a − b(it − πte + f − r)

ff

it

ff

it = r + π

MP

a

IS(a = 0; f = 0; πte = π)

0

b

0

Y˜t
IS(a < 0; f > 0; πte = π)

The effect of the two shocks, a < 0 and f > 0, shifts IS curve significantly to

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