Income, Inflation, and Unemployment

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1 Income, Inflation, and Unemployment Builds on the course with the same name using the textbook of Blanchard. We use the same book. But with 3 differences: 1. Topics covered: focus on chapters not discussed during the course 2. Method: intensive course, so with interaction and active participation 3. Focus on math exercises and applying the intuition to real world issues

2 Topics Covered Start with a refresher of IS/LM and AS/AD Model Add expectations to the basic model Discuss selected topics with a focus on banking and financial crisis

3 Week1 week2 week3 week4 week5 week6 Chapter Introduction+review chapter 5 review chapter 7 Chapter 8 Chapter 9 Chapter 14 Chapter 15 Topic Review of IS-LM Model AS/AD Model Philips Curve Inflation and Money Growth Expectations Financial Markets and Expectations week7 week8 week9 week10 week11 week12 week13 week14 Mid term exam Chapter 16 Chapter 17 Chapter 22 Chapter 24 Chapter 25 Articles Articles Expectations: Consumption and Investment Expectations: output Depressions and Slumps Credibility of Policy Monetary and Fiscal Policy Financial Crisis Financial Crisis week 15 Final exam

4 Method: Participation Participation is formalized Every week an assignment has to be handed in Assignments have to be made in groups of 3 or 4. Use the break to create groups Classes are organized as follows: before the break a lecture and after the break discussion of the assignment through presentations by the groups Assignments have to be handed in at the beginning of the lecture

5 Focus on Math and Intuition Assignments typically consist of a (math) exercise where you have to calculate an IS/LM or AS/AD equilibrium and do some experiments with it And an exercise focusing on the intuition, sometimes using newspaper articles or newsblogs Assignments are always available online immediately after the lecture at

6 Grade 30% assignments (each assignment counts for 1/11th) 30% midterm exam 40% final exam If you are ill at the midterm exam or absent for another valid reason, you can get 70% in the final exam

7 My Coordinates Eddy Bekkers Office: K126A Telephone: Office hours: Tuesday Wednesday

8 Motivating Story From the website of Nouriel Roubini on the Fed s policy move of yesterday,8/10/2008: On October 7 The Federal Reserve announces it will create a Commercial Paper Funding Facility (CPFF) to purchase U.S. commercial paper after the credit crunch threatened to cut off a key source of funding for corporations.

9 Motivating Story So, banks hardly lend money anymore to each other or at very high interest rates. Firms also have got increasing problems to finance their short-term liabilities. Can we somehow express this policy move of the Fed to deal with this problem in the framework familiar to us, the IS/LM Model? Let s first review the IS/LM Model

10 Accounting for the Fed s policy move The interest rate has already been decreased by the Fed to 2%. Why does the Fed buy commercial paper from firms? Why is a reduction in the federal funds rate not sufficient?

11 Accounting for the Fed s policy move Because banks are reluctant to lend money to each other and to firms: The spread between the interest rate on interbank loans and on short-term US government debt, the TED, has increased to 4%, from less than 1% in the beginning of this year Hence, a reduction of the Fed s interest rate does not affect the interest rate facing firms So, the Fed intervenes directly now in the credit market by buying commercial paper, that is giving loans to firms until this market is restored again

12 Accounting for the Fed s policy move How can we see this intervention in the IS/LM framework? The drying up of credit (credit crunch) to firms happening over the last weeks can be seen as: a sharp upward shift of the LM-curve

13 The LM curve shifted up because of the credit crunch, despite a low official interest rate, and the economy to point B for example. LM By the direct intervention in the LM market for commercial paper, the Fed tries to shift B the LM-curve back A down Interest rate IS Y Output

14 More on The Financial Crisis We saw that banks hardly lend anymore to each other Therefore, banks face direct payment problems, because they cannot finance their short-term liabilities Firms are starting to get problems to finance their activities, because the market for commercial paper dries up Bank customers are getting scared and threaten to withdraw their deposits. This would lead to a bank run

15 Causes Mortgages were sold in the US to people with insufficient income and/or assets: subprime mortgages The rising housing prices would enable the people to finance their mortgage These mortgages were combined with other safer mortgages, creditcard credits, student loans, etc. and packaged into a new instrument. Works as follows:

16

17 Causes Financial institutions, banks, pension funds invest in these unclear financial instruments Then the housing market in the US starts to decline. People have to sell their houses and cannot pay their mortgage anymore The value of the instruments based on the mortgages declines as well

18 Causes The investors are now uncertain about the value of their instruments Uncertainty derives from: Uncertainty about development of housing market Insufficient information about exact value of instruments you own

19 Effects on Real Economy Banks have problems to finance their liabilities and the next step is that firms will face these problems as well. This would lead to a huge impact on the real economy. Economists have different opinions on the likeliness of this: Nouriel Roubini, NYU: We are indeed at the cardiac arrest stage and at risk of the mother of all bank and non-bank runs Ken Rogoff, Harvard: Isn t it possible, then, that rather than causing a Great Depression, significant shrinkage of the financial sector, particularly if facilitated by an improved regulatory structure, might actually enhance efficiency and growth?

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