Chapter 14 - 1 Chapter 14 The Great Recession Great...

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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 considerations—a risk premium—into our short-run model and use this framework to understand the financial crisis. – study deflation, bubbles, and the Federal Reserve’s 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 Fed’s 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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This note was uploaded on 08/23/2011 for the course ECON 3203 taught by Professor Robertpennington during the Summer '11 term at University of Central Florida.

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Chapter 14 - 1 Chapter 14 The Great Recession Great...

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