Chapter 27 Macroeconomics- Recessions and Depressions

Macroeconomics Chapter 27: Recessions and Depressions The Great Recession • December 2007-June 2009 • early on there were significant problems in the financial markets • longer and deeper than typical recessions • For several years after the recession was officially over, unemployment remained high and real GDP grew slowly • For a typical recession, the unemployment rate climbed to around 7% and then declined after about 12 to 15 months. But for the Great Recession, the unemployment rate climbed to 10% in October 2009 • It took 4 years for GDP to recover • Using Agg Demand-Agg Supply Model o Both aggregate demand and short-run aggregate supply fell o Some economists say excessive economic expansion is the reason o Housing prices were rising rapidly, but many economists now believe that this was a result of monetary expansion. The monetary expansion then led to a “bubble” in housing prices that burst in 2008. o When real estate values fell, the US financial market suffered. Firms depend on each other so it spread throughout the country and the world o When the loanable funds market does not function properly, firms cannot get funding to produce output, and aggregate supply falls. o Why it had long-term effects: ▪ Misallocation of resources leading up to it: houses that were not needed were built, resulting in a decrease in LRAS ▪ Dodd-Frank Act: signed in 2010, primary regulatory response to the financial turmoil, established several new oversight bodies and regulations on financial institutions with the stated aim of reducing risk (permanently made it harder for firms to receive funding for investment) o Why aggregate demand was affected: ▪ Fall in wealth: people’s homes are the largest component of their wealth so when real estate values fell, so did people’s wealth ▪ US stocks lost 1/3 of their value ▪ Decline in expected future income • Indicated by the fact the Consumer Sentiment Index fell before and during the recession o housing prices fell, leading to financial market turmoil, lower real wealth, and then lower consumer confidence o ^ moved the equilibrium point, unemployment at 10% and real GDP shrunk by 9% o Unemployment rose partially because of cyclical unemployment and partially because of structural unemployment since the economy adjusted to new types of output o In 2012, real GDP was still expanding at less than 2%, and the unemployment rate remained at 8% (lasting effects) The Great Depression • real GDP fell from $1,057 billion in 1929 to $778 billion in 1933 (in 2009 dollars) • after four years the economy is producing almost 30% less than it was when the contraction started! • Real GDP fell by nearly 30% over the four years from 1929 to 1933 • In 1929, the unemployment rate was just 2.2%, but just three years later it had climbed to over 25% • Following the start of the Great Depression, unemployment remained above 10% for over a decade. • prices across the economy declined throughout the course of the decade • Primary cause = decrease in aggregate demand • Macroeconomic policy: government acts that influence the direction of the overall economy o Fiscal policy: the use of government’s budget tools, government spending, and taxes to influence the macroeconomy. o Monetary policy: adjusting the money supply to influence the economy. • When the stock market crashed, it also lowered future expectations, lowering aggregate demand • The government reduced the amount of money hoping it would lower stock prices BUT reduced money supply also lowers aggregate demand • Everyone pulled their money out of banks and the government didn’t lend to them (more declines in money supply) • Between 1929-1933, the money supply was 1/3 • Raises in taxes to balance the federal budget also had a role (Hawley-Smoot Tariff) Prices • If prices are assumed to be flexible, the implication is a generally stable macroeconomy without significant need for government help. • If prices are assumed to be sticky, the implication is an inherently unstable economy in need of government assistance. Classical Economics • Key tenets: o Seeing macroeconomics as an extension of microeconomics o Prices are flexible throughout the economy o stresses the importance of aggregate supply o adjustment can and should occur naturally (self-correcting economy) • When prices are completely flexible, the economy comes back to full-employment output and the natural rate of unemployment relatively quickly • Laissez-faire in recommendations since they figured the economy was self-correcting • Focused on promoting policies for long-run growth and shifting LRAS • savings is translated into investment, which increases capital and shifts the long-run aggregate supply curve to the right Keynesian Economics • Key tenets: o stresses the importance of aggregate demand o calls for the government to speed the process back to full employment o return to long-run equilibrium is an adjustment that occurs unpredictably o wages do not adjust downward quickly enough during recessions o high real wages prevent the labor market from reaching equilibrium and restoring full employment, leading to prolonged recessions o Nominal prices matter to the long-run economy o resource prices (like wages) are sticky downward • Recommended governments take action to increase aggregate demand with additional government spending, such as investing in social programs and additional infrastructure Bonus Notes: • Similarities between the GD and the GR o Stock market values declined. o The economic downturn was longer and more severe than in an average recession. o Problems existed in financial markets. • The aggregate expenditures model is essentially another way of viewing a country’s aggregate demand. In this model, the economy is viewed from a Keynesian economist’s perspective, and it assumes that in the short run, prices are sticky. • How the GR started: o U.S. home prices begin to fall. o The values of mortgage-backed securities fall. o The loanable-funds market stops functioning properly. o Aggregate supply decreases. o The Great Recession begins. • Random chronology: o the era in which the classical view dominated economic thought o beginning of the Great Depression o J. M. Keynes’s General Theory of Employment, Interest, and Money published o end of the Great Depression o F. A. Hayek’s Road to Serfdom published o beginning of the Great Recession • The wealth-effects school holds that when asset bubbles pop, people suddenly feel poorer. This causes them to cut spending, which sends demand crashing. The debtoverhang school believes that people have sudden shifts in their willingness to take on debt -- when they go into balance-sheet repair mode, they stop spending. • If the wealth effect causes financial crises to lead to recessions, then policy makers should concentrate on keeping asset bubbles from becoming too large • if debt overhang is the primary reason that financial disasters lead to recessions, then government policy makers should concentrate on stopping households from borrowing so much • A leftward shift of the AD reflects the fall in consumption that follows from a fall in expected future income. •