Chapter 14 - 6/23/2011 1 Chapter 14 The Great Recession...

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Unformatted text preview: 6/23/2011 1 Chapter 14 The Great Recession Great Recession and the Short-Run Model Charles I. Jones 14.1 Introduction In this chapter, we: introduce financial considerationsa risk premiuminto our short-run model and use this framework to understand the financial crisis. study deflation, bubbles, and the Federal Reserves balance sheet as we deepen our understanding of the financial crisis. consider various actions that policymakers have taken in response to recent events. Contributors to a very large negative shock in AD The wedge between the fed funds rate and the prevailing interest rates a household balance-sheet crisis substantial uncertainty Having exhausted conventional monetary policies, the Fed has turned to unconventional actions. 14.2 Financial Considerations in the Short-Run Model A risk premium an extra amount of money charged to compensate for the probability that a loan will A Risk Premium compensate for the probability that a loan will not be repaid This was responsible for the spread in interest rates. interest rates moving in the wrong direction deepening instead of mitigating the downturn. We can incorporate the risk premium into our short run model Real Interest Rate Real Interest rate at which firms borrow in financial markets Risk Premium 6/23/2011 2 During normal times we assume p = 0 During a financial crisis p rises and interferes with the Feds ability to stimulate the economy. A Rising Risk Premium in the IS/MP Framework To stabilize the economy after the bursting of a housing bubble the Fed may lower the interest rate to stimulate the economy counteracting the negative aggregate demand shock. The Risk Premium in the AS/AD Framework Recall that the IS/MP structure feeds into the aggregate demand curve. The risk premium The risk premium works through investment in the IS curve it shifts the AD curve inward, just like a negative demand shock. The current situation has two related shocks that shift the AD curve down and to the left. A decline in housing and equity prices that reduces household wealth. A rise in the risk premium These shocks result in a deep recession These shocks result in a deep recession that lowers inflation below its target rate. Deflation a negative rate of inflation. the aggregate price level is declining over time. 6/23/2011 3 Case Study: Deriving the New AD Curve Recall Combining the risk premium equation and the monetary policy rule gives Substituting this into the IS curve yields the new AD curve In situations where monetary policy rules are functioning the AS/AD model is preferable it tracks the dynamics of the economy in a single graph....
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Chapter 14 - 6/23/2011 1 Chapter 14 The Great Recession...

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