Econ 202 Problem Set 7 Solutions Macroeconomic shocks of the 20 th and 21 st Centuries Reading: The Economy 1.0 Unit 17 Intro, 17.2, 17.3, 17.8 17.10, 17.11 1) Causes of the Great Depression (1929 to 1933) a) What must h ave caused the Great Depression (dramatic drops in output and prices and a dramatic increase in unemployment over four years) according to the Multiplier Model and Phillips Curve model? Give a “list of suspect ” causes. Falling output and prices and rising unemployment could only occur due to decreases in aggregate demand. The of “list of suspects” is anything which decrease aggregate demand namely, decreases in autonomous consumption, decreases in autonomous investment, higher real interest rates, lower government spending, lower exports, higher tax rates. The first five of these shifts the AD curve down and the last one makes the slope of the AD cur ve flatter. b) As discussed in class and in the lecture notes, what five causes are typically given for the cause of the Great Depression? The initial cause was the Fed increasing interest rates in 1928 which decreased investment spending ↓ I →↓ AD The stock market crash of 1929 reduced household wealth and increased uncertainty thus decreasing autonomous consumption ↓ c o →↓ AD the four ways of bank runs from 1931 to 1933 reduced bank lending and thus decreased autonomous consumption and autonomous investment: ↓ c o ↓ a o →↓ AD In 1932 the government increased income tax rates to try to reduce the government budget deficit. The higher income tax rates reduced disposable income and thus decreased aggregate demand. ↑ t →↓ (1 - t)Y → ↓C →↓AD In 1932 the Fed increased interest rates to maintain the convertibility of the US dollar to gold. Higher interest rates reduced investment spending: ↑r→↓I →↓AD c) Given your answer part b) d raw the multiplier model graph and Phillips Curve graphs. Show in your graph w hich curve would shift and which way due to the five events you discussed in part b). Assume expected inflation initially equals zero and then eventually becomes unanchored. Once expected inflation becomes unanchored the Phillips Curve shifts down as ↓ inflation →↓ expected inflation → further decreases in inflation and so on in a deflationary spiral. PC ( 𝜋 𝑒 = 0% ) Q of inflation Q of Employment PC ( 𝜋 𝑡 𝐸 = 𝜋 𝑡 − 1 ) 0% Q of Output (Y) Q of AD AD curve 1929 Y=AD AD curve year 1933 d) Given your answer to part c), u se flow diagrams for the multiplier model graph and the Phillips Curve graph to give the intuition for the changes in output, unemployment and prices (inflation). Flow diagram for the multiplier model causes of the Great Depression. Plus in 1932 ↑ t →↓ (1 - t)Y → ↓C →↓AD Flow diagram for the Phillips curve causes of the Great Depression deflation HR can ↓ W and still get workers to not shirk Given ↓ W the marketing dept ↓ P to maintain the profit margin. ↓P → lower inflation. Negative inflation, the price level falling is called “deflation” “Wage Price Spiral” Decreases in AD → firms ↓production ↓Y and fire workers: ↓ employment & ↑unemployment→ bargaining gap < 0 → ↓COJL Once expected inflation becomes unanchored, ↓inflation → ↓expected inflation (PC curve shifts down) 2) Recovery from the Great Depression (1933 to 1941) a) What must have caused the recovery from Great Depression (increase s in output and prices and a decrease in unemployment over four years) according to the Multiplier Model and Phillips Curve model? Give a “list of suspect” causes. To increase output and prices (positive inflation aggregate demand must have increased. The of “list of suspects” is anything which in crease aggregate demand namely, in creases in autonomous consumption, in creases in autonomous investment, lower real interest rates, higher government spending, higher exports, lower rates. The first five of these shifts the AD curve up and the last one makes the slope of the AD curve steeper b) As discussed in class and in the lecture notes, what three causes are typically given for the cause of the recovery from the Great Depression? Three Causes of the Recovery from the Great Depression i) Creation of deposit insurance and US government guaranteeing the safety of banks resorted trust in banking. Banks started lending again. Stock market boomed. This implies an increase in autonomous consumption and autonomous investment : ↑ c o ↑ a o → ↑ AD ii) US government left the gold standard which increased expected inflation ↑ 𝝅 𝑬 → ↓real interest rates since 𝒓 = 𝒊 − 𝝅 𝑬 →↑I → ↑AD iii) The US government increased defense spending in anticipation of getting into WWII : ↑ G → ↑ AD c) Given your answer part b) d raw the multiplier model graph and Phillips Curve graphs. Show in your graph w hich curve s would shift and which way due to the three events you discussed in part b). PC ( ℎ 𝑖𝑔 ℎ 𝑒𝑟 𝜋 𝐸 ) Q of inflation Q of Employment PC ( 𝐿𝑜𝑤𝑒𝑟 𝜋 𝑡 𝐸 ) 0% Q of Output (Y) Q of AD AD curve 1940 Y=AD AD curve 1933 d) Given your answer to part c), u se flow diagrams for the multiplier model graph and the Phillips Curve graph to give the intuition for the changes in output, unemployment and prices (inflation). Flow diagram for the multiplier model Flow diagram for the Phillips curve causes of the Great Depression inflation after 1933 3) The Great Moderation (1986 to 2006) to Global Financial Crisis and Great Recession (2007 to 2009) . See the lecture notes. a) What happened to output and inflation during the “Great Moderation? What was true about recessions and expansions during the Great Moderation? The Great Moderation is the period from mid 1980s to 2006. This period is characterized by: Decreased volatility of inflation Decreased volatility of Real GDP growth meant long economic expansions and mild recessions. ↑Q of AD = C+I+G+X - M Firms ↑ production ( ↑ Y) → ↑employment so ↓ unemployment ↑ income ( ↑ Y) ↑C ↑ c o → ↑ C ↑ a o → ↑ I ↑ 𝜋 𝐸 → ↓ 𝑟 = 𝑖 − 𝜋 𝐸 →↑I ↑G ↑ tax revenue = tY ↑iMports = mY ↓ NX = X - M HR can ↑ W and to recruit retain and get workers to not shirk . Also ↑ 𝜋 𝐸 → ↑ W Given ↑ W the marketing dept ↑ P to maintain the profit margin. ↑P → higher inflation. “Wage Price Spiral” increases in AD → firms ↑production ↑Y and hire more workers: ↑ employment & ↓ unemployment → ↓COJL If expected inflation is unanchored then ↑inflation → ↑expected inflation (PC curve shifts up) b) How did the Great Moderation contribute to causing credit boom that preceded the Global Financial Crisis and Great Recession (2007 to 2009) ? Less volatile Real GDP and inflation along with long expansions and mild recessions → decreased perceived risk of lending The decreased perceived risk of lending supported arguments for bank deregulation result ed in increased bank lending to households (a credit boom) to buy houses and increased leverage ratios for banks. The credit boom led to an increased demand for housing and higher housing prices. 4 ) Housing Booms and Busts a) What is collateral? Use a pawn shop as an example. What is the relationship between the value of a household’s collateral and the amount a household can borrow? What is the collateral for a mortgage? Collateral is something that a borrower owns that becomes the property of the lender if the borrower defaults on a loan. For example, if I get a loan of $200 from a pawn shop by letting the pawn shop hold my Martin guitar as collateral. If I fail to pay ba ck the pawn shop in time, so I default on the loan, then the pawn shop now owns the guitar. The pawn shop puts the guitar in the pawn shop window and attempts to sell the guitar. An increase in the value of a household’s collateral increases the amount a h ousehold can borrow. The collateral for a mortgage is the house the borrower buys with the mortgage. b) Explain in words and in a flow diagram the housing boom cycle and the housing bust cycle as discussed in the lecture notes 5 ) Housing boom to bust example: (record each event on the balance sheet below) Katrin’s b/s Assets Liabilities Cash a) $10,000 b) - $10,000 Value of House b) +$300,000 c) +$150,000 d) +$50,000 e) - $300,000 Mortgages + Home equity loans b) +$290,000 d) +$50,000 Net Worth a) $10,000 b) No change c) +$150,000 d) No change e) - $300,000 a) Suppose initially Katrin has $10,000 in “cash” for example funds in a checking account. This is Katrin’s only financial asset, and she initially has no debts. What is Katrin’s financial net worth? what is Katrin’s leverage ratio? Katrin’s leverage ratio = assets/net worth = $10,000/$10,000 = 1 b) Then Katrin buys a $300,000 house with $290,000 mortgage and a $10,000 down payment. What happens to Katrin’s net worth and leverage ratio? Katrin’s net worth = $10,000 so no change. Leverage ratio = $300,000/$10,000 = 30 c) Time passes and the value of Katrin’s house increases to $450,000. What happens to Katrin’s net worth? What is Katrin’s return on her $10,000 down payment? What happens to Katrin’s leverage ratio? Katrin’s net worth = $160,000 so it has increased by $150,000 Return on down payment = ($160,000 - $10,000)/$10,000 = 15 or 1500% Leverage ratio = $450,000/$160,000 = 2.8 d) Katrin takes out a home equity loan of $50,000 to redo her kitchen. Katrin figures that her house increases in value by $50,000. What happens to Katrin’s net worth? What happens to Katrin’s leverage ratio? Katrin’s net worth = $160,000 so no change from part c) Leverage ratio = $500,000/$160,000 = 3.1 e) More time passes, and the housing boom turns into a bust. The value of Katrin’s house falls to $200,000. What happens to Katrin’s net worth? Could it make financial sense for Katrin to default on her mortgage and home equity loan? Katrin’s net worth = - $140,000 so it has increased by - $300,000 Yes it could make financial sense for Katrin to default on her mortgage and home equity loan. After the housing bust the house is worth $200,000 and the mortgage and home equity loan equals $340,000. If Katrin defaults her net worth increases by $140,000 t o a net worth of zero. 6 ) Housing bust to financial crisis Suppose ABC Bank borrowed funds partly from uninsured depositors (large cash pools too large to covered by deposit insurance) and partly from “insured” depositors (with accounts small enough to be backed by deposit insurance) in order to finance its mortga ge lending to 655 people like Katrin. ABC b/s Assets Liabilities Reserves = $10 million Mortgages = $190 million Interbank loans to other banks = $0 insured deposits = $50 million Uninsured deposits = $140 million Discount loans from the Fed = $0 Interbank loans from other banks = $0 Net Worth $10 million a) What is ABC initial leverage ratio? ABC leverage ratio = $200 million/$10 million = 10 Now suppose that the “Katrins” start defaulting on ABC mortgages. b) What happens to the value of mortgages and the net worth of ABC bank? What change in the value of mortgages would make ABS bank insolvent? ↑defaults → ↓value of mortgages → ↓ABC net worth. If the value of mortgages falls by more than $10 million, then ABC bank is “insolvent”. c) What is the “collateral” for $140 million the uninsured depositors have lent to ABC Bank? How will the uninsured depositors respond to the change in the net worth of ABC bank? The assets of ABC bank are the collateral for $140 million the uninsured depositors have lent to ABC Bank. If the value of mortgages decreases the uninsured depositor will not be willing to lend as much to ABC bank. ABC bank will have to pay the uninsured depositors whatever they demand up to $140 million. d) What are three ways ABC Bank can attempt to obtain reserves to pay the uninsured depositors? First ABC will use its $10 million in reserves to pay the uninsured depositors. Then ABC will attempt to borrow reserves from other banks. If ABC is unable to obtain enough reserves from other banks, then ABC will try to sell its’ assets. ABC could try to borrow reserves, in the form of “discount loans” from the central bank. e) If there is a run on ABC bank what could happen to other banks, thus causing a financial crisis? If there is run on ABC bank and the uninsured depositors of ABC take losses, then this could cause a run by uninsured depositors on other banks. Other banks would attempt to obtain reserves by borrowing from other banks and by selling assets. f) If many banks are selling MBS (“fire sales”) what happens to the net worth of banks? If many banks are selling assets, then the value of assets falls potentially making banks insolvent. g) What can The Fed (the US central bank) do to stop the fire sales and stop the bank runs? The Fed can create and lend reserves to banks in the form of discount loans. This would stop the need for fire sales of assets since the reserves could be used to pay the uninsured depositors. The mere announcement that the Fed is willing to lend of reserv es to banks might be enough to stop the bank run without banks actually having to pay out reserves to the uninsured depositors. h) Your answers to question 6), what values for leverage ratios for households would make mortgage defaults less likely? Given your answers to a) to g) above what values for leverage ratios for banks would make bank runs and financial panics less likely? Lower leverage ratios for households, and hence higher “down payments”, when purchasing homes would make households less likely to default on mortgages. Lower leverage ratios for banks, would make bank runs (financial panic) less likely. 7 ) The impact of the financial crisis on the real economy: The Great Recession 2007 - 2009 a) Declines in wealth due to the fall in housing prices decreased “autonomous consumption”. In addition, financial crisis (bank runs) induced banks to decrease lending which decreased investment spending. Analyze these events using the Multiplier graph alo ng with a flow diagram for the intuition. Decrease in autonomous consumption and investment causes the AD curve to shift down: b) What is the argument that fiscal policy and monetary policy made the Great Recession less severe thus avoiding another Great Depression? According to the Multiplier Model, the Great Recession was made less severe, since the government used both fiscal and monetary policy to increase aggregate demand. The Fiscal policies were tax cuts ↓t → ↑C and increases in government spending ↑G. The mone tary policy was cuts in real interest rates ↓r → ↑I. Hence both fiscal policy and monetary policy shifted up the AD Curve: ↓ 𝑐 0 ↓I ↓ Q of AD i.e. ↓AD= C+I+G+X Firms ↓ production ( ↓ Y) ↓ income ( ↓ Y) ↓ consumption ( ↓ C) Y=AD on the 45 degree line Q of AD Q of Y New AD curve 𝑐 0 + 𝐼 + 𝐺 + 𝑋 𝑠𝑙𝑜𝑝𝑒 𝑜𝑓 𝐴𝐷 = 𝑐 1 ሺ 1 − 𝑡 ) Y=AD on the 45 degree line Q of AD Q of Y New AD curve 𝑐 0 + 𝐼 + 𝐺 + 𝑋 𝑠𝑙𝑜𝑝𝑒 𝑜𝑓 𝐴𝐷 = 𝑐 1 ሺ 1 − 𝑡 ) ↓t →↑C ↑G ↓r → ↑I ↑ Q of AD i.e. ↑AD= C+I+G+X Firms ↑ production ( ↑ Y) ↑ income ( ↑ Y) ↑ consumption ( ↑ C)