exam 3- chapter 16

business fluctuations are caused by

shocks to aggregate demand (AD) and aggregate supply (AS)

the advantage of using monetary policy is not the recovery itself but the

speed of the recovery

Which of the following explains why the Fed is able to have a dramatic effect on aggregate demand and real output in the short run?

sticky prices that slow the adjustment of the price level

The pitfalls of a strict money supply rule can be avoided if the Fed:

targets nominal GDP growth.

when faces with a negative shock to AD,

the central bank can restore AD through an expansionary monetary policy (the best case)

the disinflation process

is painful and results in a recession

monetary policy, however,

is subject to uncertainties in impact and timing (even in the best case)

If the Fed increases M too much,

it may find that it later has to contract M when inflation becomes too high

If the Fed overshoots when responding to a negative demand shock:

it will cause inflation, which the Fed will fight by reducing the growth rate of the money supply. -This disinflation will likely cause more unemployment.

the fed has some influence over the growth rate of GDP through

its influence over the money supply, and thus AD

The Fed tried to reduce unemployment in the years following the recession of 2001 by:

keeping the Federal funds rate very low.

it is not always possible to achieve both

low inflation and low unemployment (the negative real shock dilemma)

The Fed's actions leading up to the Great Recession:

may have contributed to the housing bubble and made the recession worse.

If economic data reveals that inflation is rising, the Fed:

may reduce the growth rate of the money supply without really knowing the state of real GDP growth. -This is because rising inflation will show up in the data before slowing growth will.

monetary policy is conducted to

mitigate business fluctuations by using the fed's control over the money supply and interest rates

central banking is a hard job!

-*even in the best case (AD shock), because of lags, uncertainty, and incomplete control of the money supply, the fed faces difficulty of getting the /timing/ and /amount/ just right* -overshoot or undershoot -in the case of a negative real shock, either they shoot to decrease inflation which decreases real GDP growth even further, or they shoot to increase real GDP growth, which increases inflation even further

Mortgage Backed Securities (MBSs)

-a type of bond representing an investment in a pool of real estate loans

Credit Default Swaps (CDSs)

-a type of insurance for investors against the possibility of people defaulting on the underlying loans that comprise a MBS or CDO -

Credit Rating Agencies (CRAs)

-assigned credit ratings to these different MBSs and CDOs -credit ratings were based on a debtor's ability to pay back debt by making timely interest payments and the likelihood of default

Fed's (partial) response

-during the financial crisis of 2007-2008, the fed went considerably beyond its traditional role in helping out financial institutions: -The *Term Auction Facility* was set up to inject reserves into the system -over the year, the fed lent over 2 trill to the banking system -the *Troubled Asset Relief Program* (TARP), gave up to $700 billion to banks

Asset price bubbles

-easy to say that the fed should have raised rates sooner or more quickly -several problems with this 1. few people expected that a fall in housing prices would wreak as much havoc as it did 2. its not always easy to identify when a bubble is present 3. monetary policy is a crude means of "popping" a bubble, as it affects the whole economy.

Rules vs Discretion

-ideally, monetary policy tried to adjust for shocks in AD, but it is often debated whether these adjustments are effective in reducing the volatility of output. -some believe the Fed should follow a consistent policy and not try to adjust to every AD shock -typical monetary ruse would set target ranges for the monetary aggregates like M1 or M2, or for the rate of inflation -a monetary rule works best only when v, monetary velocity, doesn't change rapidly. -If M is constant and v falls, then either P must fall, or Y must fall -since prices are sticky, the usual outcome is that both P and Y fall, and a fall in Y means a recession -others suggest a nominal GDP rule: keep Mv constant (or growing at a constant rate) -If Mv doesnt change or grows smoothly, then so does PY, and that would be ideal -*if the fed had followed a nominal GDP rule, the recession of 2008 would have been much milder.* -the fed did not increase M enough to make up for a fall in v, even though between August and December of 2008, the monetary base doubled.

when the fed does too much

-late 1990s, economic growth was strong and unemployment was low -The 2001 recession was short, but unemployment continued to increase after it ended -3 years later, unemployment rate remained the same -The fed kept pushing down the federal funds rate from about 6.5% in 2000 and held it at 1% until 2004 -the low federal funds rate helped to make credit cheap throughout the economy -it encouraged people to take out mortgages, bidding up the price of homes -this fueled speculative bubble in housing -housing prices peaked in 2006, and were in a free fall by 2007 real estate crash contributed to a freezing up of financial intermediation

Predatory Lending Practices

-making loans without verifying income or job status -offering absurd adjustable rate mortgages with payments that people could afford at first but quickly ballooned beyond their means -these has increased probabilities of defaulting

events leading up to the crisis- Subprime mortgages

-prices began to decline (fast) as people started defaulting on their loans that they could no longer afford -as prices fell, some borrowers suddenly had mortgages for way more than what their home was currently worth. -some people simply stopped paying their mortgages, which led to more defaults, pushing prices even lower. -as this was happening, big financial institutions stopped buying subprime mortgages and subprime lenders were getting stuck with bad loans -by 2007, some really big lenders had declared bankruptcy -this problem spread to investors who had invested in MBSs and CDOs which by now were saturates with these subprime mortgage loans

Collateralized Debt Obligations (CDOs)

-structured financial products backed by a pool of loans (not necessarily mortgages) -pools of loans partitioned according to quality (safe, moderate risk, high risk)

monetary policy- THE BEST CASE

-suppose that borrowers and lenders become pessimistic about the future state of the economy -borrowers will want to borrow less and banks will wish to lend less -as a result the rate of growth of the money supply (→M) falls -this causes a fall in AD and a decline in the growth rate of output -if the reduction in →M is permanent , eventually the economy will recover from the negative monetary shock -*The fed can use monetary policy to reduce the length and severity of a recession by either increasing the rate of growth of the money supply or reducing interest rates and encourage more borrowing (thereby increasing AD to its original position)*

asset price bubbles

-the fed does have the power to regulate banks -it probably could have restrained some of the "subprime", no questions asked mortgages that later went into default -that would have been the best way of limiting the bubble without taking down the broader economy -economists have not settled on what to do when assed prices boom

overshooting -1970s

-the fed over stimulated the economy resulting in an inflation rate of 13.5% -by 1983, tough monetary policy reduced it to 3% -consequence was very severe recession with 10% unemployment rate

events leading up to the crisis -Home Mortgages

-traditionally, it was pretty difficult to get a mortgage if you didn't have a steady job or had bad credit -lenders didn't want to risk you defaulting on your loan -early 2000s this began to change -investors began throwing their money at the housing market -normally, investors might purchase T bills, but as a result of the 2001 recession, interest rates had dropped considerably due to expansionary monetary policy

monetary policy- Real world example -9/11 terrorist attacks

-uncertainty increased after attacks -if enough people took the uncertainty as a signal to reduce investment, could've created severe recession -the fed tried to prevent this from happening by lending billions of dollars to banks -this helped stabilize expectations, reduce fear, and raise confidence

events leading up to the crisis- credit default swaps

-unregulated CDSs were being sold without the financial backing in case things went south -when the CDOs being insured defaulted, these companies that sold large amounts or CDSs simply didn't have the means to pay out the "insurance claims" -AIG for ex, sold tens of billions of these CDSs without money to back them up when things went wrong -these credit default swaps were also turned into other securities that essentially allowed traders to bet huge amounts of money on whether the values of mortgage securities would go up or down ("Synthetic CDOs")

Negative Real Shock Dilemma

-when there is a negative reak shock (shift in LRAS to the left), INFLATION INCREASES and REAL GDP GROWTH DECREASES -if the fed decreases the AD curve by decreasing the money supply, it leads to lower inflation BUT even lower real GDP growth -if the fed increases the AD curve by increasing the money supply, it leads to slightly higher GDP growht BUT much higher inflation. -conclusion: when there is a negative real shock, fed cant fufill low inflation AND high real GDP growth.

2 relevant points about home mortgages:

1. mortgages (or titles to the property) can be sold and re-sold -original lenders sell mortgages all the time 2. Default

monetary policy is difficult because

1. the federal reserve must operate in real time when much of the data about the state of the economy is unknown 2. the feds control of the money supply is incomplete and subject to uncertain lags.

Which of the following would create simultaneous high inflation and high unemployment?

A negative real shock -A negative real shock would shift the LRAS curve to the left, moving the economy up along the AD curve towards higher inflation and lower real GDP growth.

Why doesn't GDP change in the long run when the money supply changes?

Because in the long run, GDP is determined by the fundamental factors of growth, not the money supply.

In what way may the Fed have contributed to the housing bubble?

By making credit cheaper with a low Federal funds rate

Which of the following is true about monetary policy?

It is ineffective in the long run and difficult in the short run.

In the best case scenario, what is the Fed's response to a negative demand shock?

The Fed will increase the growth rate of the money supply to offset the negative demand shock.

What would happen if banks decided to stop lending altogether and instead held on to enormous amounts of cash?

The tools of monetary policy would become less effective in response to a recession. -If banks did not lend money, then the money creation process would not work as well.

High inflation may show up in economic data before sluggish growth, even if the two have the same cause.

This may cause the Fed to think it can reduce inflation without risking higher unemployment.

Most of the Fed's policy tools impact aggregate demand as a whole. Is there any way that the Fed could have targeted the housing market directly in the mid-2000s?

Yes, through its power to regulate banks.

subprime mortgage

a home loan issued to borrowers with poor credit histories

home mortgage

a loan given by a bank, mortgage company, or other financial institution for the purchase of a home -a borrower pays back a portion of the mortgage each month -some of the payment goes toward the principal (the amount borrowed), the rest goes to interest (calculated based on the principal) -owner of the property (borrower) transfers the title to the lender on the condition that the title will be transfered back to the owner once the payment has been made and other terms have been met.

The cost of stimulating the economy in the 1970s was:

a severe recession with high unemployment in the 1980s. -The Fed overstimulated the economy in the 1970s, and then had to reduce inflation in the 1980s.

when the fed does too much -The Great Recession

fed policy in 2001-2004 contributed to the housing boom and eventual bust that led to the financial crisis in 2007-2008

A bubble happens when:

asset prices rise higher and faster than can be explained by the fundamentals.

In order to fight high inflation the Fed should _______; in order to fight high unemployment the Fed should _______.

decrease the growth rate of the money supply; increase the growth rate of the money supply -

the new lax lending requirements and low interest rates

drove housing prices higher and higher -this only made the MBSs and CDOs seem like an even better investment

key prerequisite for the BEST CASE is that

the recession is caused by a DEMAND shock rather than a supply (real) shock

monetary policy difficulties

timing and amount -undershoot or overshoot

In addition to keeping interest rates too low for too long, the Fed also:

underestimated the impact of a decline in the housing sector on the whole economy.

Default

when a debtor is unable to meet the legal obligation of debt repayment -whoever owns the mortgage (title of property) at the time of default gets the house