Aggregate Demand II: Applying
the IS-LM Model
Chapter 12 of Macroeconomics, 8th
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 = Io − Irr
– G and T are exogenous
• M = Md = L(i) ✕ P ✕ Y
• L(i) = Lo – Li ✕ i
– i = r + Eπ
– M, P and Eπ are exogenous
The IS-LM Model: Ch. 11 Summary
• Y=C+I+G
Cy
1
Ir
Y
 (Co  I o  G ) 
T 
r
1 Cy
1 Cy
1 Cy
– C = Co + Cy ✕ (Y – T)
– I = Io − Irr
– G and T are exogenous
• M = Md = L(i) ✕ P ✕ Y
• L(i) = Lo – Li ✕ i
– i = r + Eπ
– M, P and Eπ 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
LM
– a decrease in T.
• The LM curve shifts right if:
– M/P or Eπ increases, or
– Lo decreases
IS
Y
Equilibrium in the IS-LM model
The IS curve represents
equilibrium in the goods
market.
r
LM
Y  C (Y  T )  I (r )  G
The LM curve represents
money market equilibrium.
r1
IS
M  L(r  E )  P  Y
Y1
Y
Shifts of the IS curve
• Recall from Chapter 11 that
r
LM
– the consumption function is
C(Y – T) = Co + Cy ✕ (Y – T),
and
– The investment function is r1
I(r) = Io – Ir ✕ r
• Recall also that the IS curve
shifts right if there is:
– an increase in Co + Io + G, or
– a decrease in T.
• As a result, both Y and r
increase
IS
Y1
Y
Shifts of the IS curve
• Similarly, the IS curve
shifts left if there is:
r
LM
– a decrease in Co + Io + G,
r1
or
– an increase in T.
• As a result, both Y and r
decrease
IS
Y1
Y
Shifts of the IS curve
• In other words, we can
make the following
predictions:
r
LM
r1
IS-LM Predictions
Y
r
Co + Io + G
+
+
T
−
−
IS
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 Cross
Cy
1
Y
 (Co  I o  G ) 
T
1 Cy
1 Cy
K.C. Spending Multiplier
K.C. Tax-Cut Multiplier
In the IS-LM model, expansionary fiscal policy also raises the real interest rate,
thereby weakening the effect of fiscal policy on GDP. (Crowding-out effect)
Cy
1
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 right
1
by
G
1 MPC
causing GDP to rise.
r
LM
r2
2.
2. This raises money
demand, causing the
interest rate to rise…
3. …which reduces investment, so
the final increase in Y
1
is smaller than
G
1 MPC
r1
1.
IS2
IS1
Y1
Y2
3.
Y
A tax cut
Consumers save (1MPC) of
r
the tax cut, so the initial
boost in spending is smaller
for T than for an equal
r2
G…
2.
r1
and the IS curve shifts by
1.
LM
1.
MPC
T
1 MPC
2. …so the effects on r
and Y are smaller for T
than for an equal G.
IS2
IS1
Y1 Y2
2.
Y
Shifts of the LM curve
r
LM
r1
IS
Y1
Y
Shifts of the LM curve
• Similarly, the LM curve
shifts left if there is:
r
LM
– a decrease in M/P or Eπ,
r1
or
– an increase in Lo.
• As a result, Y decreases
and r increases
IS
Y1
Y
Shifts of the LM curve
Shifts of the LM curve
r
• Recall from Ch. 11 that, if
expected inflation (Eπ)
increases (decreases),
the LM curve shifts down
(up) by the exact same r1
amount!
• Therefore, if Eπ
decreases, r will increase,
but by a smaller amount.
• Therefore, i = r + Eπ will
decrease.
LM
IS
Y1
Y
IS-LM Predictions
IS-LM Predictions
IS Curve
LM Curve
Y
r
i
Co + Io + G
→
+
+
+
T
←
−
−
−
M/P
→
+
−
−
Eπ
→
+
−
+
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
• When the central bank of a
country makes changes to
the quantity of money (M),
r
– only the LM curve changes,
and
r1
– the real interest rate (r)
changes in the opposite
direction
– As expected inflation (Eπ) is
assumed exogenous in the
IS-LM model, when the real
interest rate (r) changes, the
nominal interest rate (i = r +
Eπ) changes in the same
direction.
LM
IS
Y1
Y
Shifts of the LM curve
• One can think of the
central bank as
r
– targeting M and
affecting r and i in the r1
process, or as
– targeting r and/or i and
adjusting M to achieve
the target
LM
IS
Y1
Y
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 (Eπ) 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
• We have seen that, when
faced with a recession, the
central bank can
r
– Increase the money supply
(M↑)
r1
– Thereby shifting the LM
curve right
– Thereby reducing the real
interest rate (r = i − Eπ ↓)
and the nominal interest
rate (i = r + Eπ↓) and
increasing GDP (Y↑) to drag
the economy out of the
recession
LM
IS
Y1
Y
The Zero Lower Bound on Nominal
Interest Rates
r
• The problem is that there is a
limit to how low the nominal
interest rate can be
• Nominal interest rates (such
as the federal funds rate)
r1
cannot be negative
• To deal with the 2008
economic crisis, the Fed
reduced the FFR to zero
• But the recession persisted
• Unfortunately, the Fed could
not reduce interest rates
below zero: monetary policy
had reached its limit
LM
IS
Y1
Y
The Zero Lower Bound on Nominal
Interest Rates: Crisis 2008-09
The Zero Lower Bound on Nominal
Interest Rates
r
• r = i − Eπ
• iminimum = 0
• Therefore, rminimum =
r1
iminimum − Eπ = 0 − Eπ
2.1%
• Therefore, rminimum = −
Eπ
• For example, if Eπ =
−3%, then rminimum = −
Eπ = 3%
LM
IS
Y1
Y
The Zero Lower Bound on Nominal
Interest Rates
r
• For example, in the
diagram, the central bank
will have to reduce the real
interest rate to r = 2.1% in
order to end the recession r1
• But suppose expected
2.1%
inflation is Eπ = − 3%
• Then, the nominal interest
rate would have to be
brought down to i = r + Eπ
= 2.1 – 3.0 = – 0.9%
• Which, alas, is impossible
LM
IS
Y1
Y
This example also shows how
dangerous it can be if we have
deflation and 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 there’s 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,
– the central bank needs to reduce
the real interest rate to r = 2.1% to
end the recession
– But expected inflation is Eπ = − 3%
– So, the nominal interest rate would
have to be brought down to i = –
0.9%, which, alas, is impossible
r
LM
r1
• Recall that the LM curve shifts right2.1%
if either M or Eπ increases
• If the central bank promises to be
IS
irresponsible and to create rapid
inflation in the future, and if people
Y
Y1
believe its promise, then Eπ will
increase, say from − 3% to +1%
• Then the nominal interest rate
The zero-lower-bound problem can be
required for full-employment will be
solved if the central bank can credibly
i = r + Eπ = 2.1 + 1.0 = 3.1%, which is
promise to be irresponsible!
definitely attainable
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 homebuyers who need mortgages, etc.
• This would reduce long-term interest rates
directly, thereby stimulating spending by the
borrowers
• This strategy—called 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 may affect
the effectiveness of fiscal policy
The Fed’s 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,
the IS curve shifts right.
If Fed holds M constant,
then LM curve does not
shift.
As a result, interest rates
rise. This has a crowdingout effect. Consequently,
GDP increases, but not a
lot.
r
LM
r2
r1
IS2
IS1
Y1 Y2
Y
Response 2: Hold r constant
If Congress raises G,
the IS curve shifts right.
To keep r constant, Fed
increases M
to shift LM curve right.
r
LM1
LM2
r2
r1
IS2
Results:
Y  Y 3  Y1
r  0
IS1
Y1 Y2 Y3
Y
Response 3: Hold Y constant
If Congress raises G,
the IS curve shifts right.
To keep Y constant, Fed
reduces M
to shift LM curve left.
LM2
LM1
r
r3
r2
r1
IS2
Results:
Y  0
IS1
Y1 Y2
Y
r  r3  r1
At this point, you should be able to do
problem 7 on page 353 of the
textbook. Please try it.
Estimates of fiscal policy multipliers
from the DRI macroeconometric model
Assumption about
monetary policy
Estimated
value of
Y/G
Estimated
value of
Y/T
Fed holds money
supply constant
0.60
0.26
Fed holds nominal
interest rate constant
1.93
1.19
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 9/00
4.9% on 8/01
6.3% on 6/03
5.0% on 7/05
Unemployment
7.0
6.0
5.0
4.0
3.0
2.0
1.0
0.0
The U.S. Recession of 2001
• Growth of
GDP was
negative in
the 1st and
3rd quarters
of 2001
• That’s
essentially
before 9/11
GDP growth rate
10.0
8.0
6.0
4.0
2.0
0.0
-2.0
Recall: IS-LM Predictions
IS-LM Predictions
IS Curve
LM Curve
Y
r
i
Co + Io + G
→
+
+
+
T
←
−
−
−
M/P
→
+
−
−
Eπ
→
+
−
+
Lo
←
−
+
+
The U.S. Recession of 2001
• Why?
• Demand shocks moved the IS
curve left
– The “tech bubble” ended and
stocks fell 25% between 8/00
and 8/01
– 9/11 attacks led to a 12% fall in
stock prices in one week and a
huge rise in uncertainty
– Scandals at Enron, WorldCom
and other corporations led to
stock price declines and a
decline in trust and a rise in
uncertainty
– Lower household wealth
reduced Co and higher
uncertainty reduced Io
r
LM
r1
IS
Y1
Y
CASE STUDY:
The U.S. recession of 2001
Index (1942 = 100)
Causes: 1) Stock market decline  C
1500
1200
Standard & Poor’s
500
900
600
300
1995
1996
1997
1998
1999
2000
2001
2002
2003
The U.S. Recession of 2001
• Fiscal stimulus moved IS curve
right
r
LM1
LM2
– Major tax cuts were enacted in
2001 and 2003
– Government spending was
r1
boosted
• to rebuild NYC, and
• to bail out the airline industry
• Fed printed money and
moved LM curve right
– Interest rate on 3-month
Treasury bills fell
• 6.4% in 11/00
• 3.3% in 8/01
• 0.9% in 7/03
IS2
IS1
Y1
Y3
Y
All three tools—G, T and M—were used
CASE STUDY:
The U.S. recession of 2001
• Monetary policy response: shifted LM curve right
7
6
5
4
3
2
1
0
Three-month
T-Bill Rate
Skip!
• I am skipping section 11-2
THE GREAT DEPRESSION
The Great Depression
30
Unemployment
(right scale)
220
25
200
20
180
15
160
10
Real GNP
(left scale)
140
120
1929
5
0
1931
1933
1935
1937
1939
percent of labor force
billions of 1958 dollars
240
THE SPENDING HYPOTHESIS:
Shocks to the IS curve
r
• asserts that the
Depression was largely
due to an exogenous fall
in the demand for goods
and services – a leftward r1
shift of the IS curve.
• evidence: output and
interest rates both fell in
early 1930s, which is
what a leftward IS shift
would cause.
LM
IS
Y1
Y
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%
• Drop in investment
– “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 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 opposite
of what a leftward LM shift would cause.
THE MONEY HYPOTHESIS AGAIN:
The effects of falling prices
• asserts that the severity of the 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?
THE MONEY HYPOTHESIS AGAIN:
The effects of falling prices
• The stabilizing effects of deflation:
• P  (M/P)  LM shifts right  Y
• Pigou effect:
P
 (M/P)
 consumers’ wealth 
 C
 IS shifts right
 Y
IS-LM Predictions
IS-LM Predictions
IS Curve
LM Curve
Y
r
i
Co + Io + G
→
+
+
+
T
←
−
−
−
M/P
→
+
−
−
Eπ
→
+
−
+
Lo
←
−
+
+
THE MONEY HYPOTHESIS AGAIN:
The effects of falling prices
• The destabilizing effects
of expected deflation: E
• LM curve shifts left
r  and I (r ) 
 planned expenditure 
income and output 
• Also, the nominal interest
rate decreases (i↓):
– see IS-LM predictions grid
r
LM
r1
IS
Y1
Y
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 hypotheses—the spending hypothesis, the debtdeflation hypothesis, and the deflationary expectations
hypothesis—predict 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 was blindingly obvious
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 Fed’s 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 poor
– Consumption spending fell
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 Fed’s 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 longterm interest rates
The Federal Government’s 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
9
8
170
interest rate (%)
7
6
150
5
130
4
110
3
90
2
70
1
0
2000
2001
2002
2003
2004
50
2005
House price index, 2000=100
Federal Funds rate
30-year mortgage rate
190
Case-Shiller 20-city composite house price index
Change in U.S. house price index
and rate of new foreclosures, 1999-2009
14%
1.4
10%
1.2
8%
1.0
6%
0.8
4%
2%
0.6
0%
0.4
-2%
0.2
-4%
-6%
1999
0.0
2001
2003
2005
2007
2009
New foreclosure starts
(% of total mortgages)
Percent change in house prices
(from 4 quarters earlier)
12%
US house price index
New foreclosures
House price change and new foreclosures, 2006:Q3 – 2009Q1
20%
18%
Nevada
Florida
Illinois
New foreclosures,
% of all mortgages
16%
14%
Michigan
Ohio
California
Georgia
12%
10%
8%
Colorado
Arizona
Rhode Island
New Jersey
Texas
6%
S. Dakota
Hawaii
4%
Oregon
Alaska
2%
0%
-40%
-30%
-20%
-10%
0%
Wyoming
N. Dakota
10%
Cumulative change in house price index
20%
U.S. bank failures by year, 2000-2009
Number of bank failures
70
60
50
40
30
20
10
0
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009*
* as of July 24, 2009.
100%
7/20/2009
120%
11/11/2008
140%
3/5/2008
(% change from 52 weeks earlier)
6/28/2007
10/20/2006
2/11/2006
6/5/2005
9/27/2004
1/20/2004
5/14/2003
9/5/2002
12/28/2001
4/21/2001
8/13/2000
12/6/1999
Major U.S. stock indexes
DJIA
S&P 500
NASDAQ
80%
60%
40%
20%
0%
-20%
-40%
-60%
-80%
Consumer sentiment and growth in consumer durables and
investment spending
110
15%
10%
100
5%
90
0%
80
-5%
-10%
70
-15%
Durables
-20%
Investment
60
UM Consumer Sentiment Index
-25%
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
50
Consumer Sentiment Index, 1966=100
% change from four quarters earlier
20%
Real GDP growth and Unemployment
10%
10
Real GDP growth rate (left scale)
Unemployment rate (right scale)
8
6%
7
6
4%
5
2%
4
3
0%
2
-2%
1
-4%
1995
0
1997
1999
2001
2003
2005
2007
2009
% of labor force
% change from 4 quaters earlier
8%
9
The Fed Tried: M/P Kept Rising
But the Fed hit the zero lower bound
Falling mortgage rates helped
Mortgage rates were very low
between ‘04 and ‘06. They
may have contributed to the
housing bubble
In hindsight, the FFR
should have been
higher in 2003-06.
But inflation was low.
Note that there is a
link between the two
rates, though weak
Record low mortgage rates
The unusually low
mortgage rates may have
helped to inflate the
housing bubble.
Mortgage rates are
even lower now. But
credit standards have
been tightened. In
any case, the
economy is still
weak. So, don’t
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 Okun’s Law?
Unemployment Shot Up
Remember Okun’s 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 don’t 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 month’s nonfarm payrolls to the
nonfarm payrolls at the start of recession. And this
doesn’t even account for the fact that the workingage population has continued to grow, meaning that
if the economy were healthy we should have more
jobs today than we had before the recession.