ECON204 - UNIT 17
Golden Age ended with:
a crisis of profitability, investment, and productivity, followed by stagflation.
Figure 17.5b A cross-national comparison of the Great Depression, the golden age, and the financial crisis: Distinctive features of the US.
summarizes important differences between the US and other rich countries.
Great Moderation
Period of low volatility in aggregate output in advanced economies between the 1980s and the 2008 financial crisis. The name was suggested by James Stock and Mark Watson, the economists, and popularized by Ben Bernanke, then chairman of the Federal Reserve. ** At the onset of the crisis, government and central bank stabilization policies, notably including bank bailouts, avoided a repeat of the Great Depression. ** Nevertheless, there followed a sustained global fall in aggregate output, popularly known as the great recession.
stagflation
Persistent high inflation combined with high unemployment in a country's economy.
zero lower bound
This refers to the fact that the nominal interest rate cannot be negative, thus setting a floor on the nominal interest rate that can be set by the central bank at zero.
Baltic Dry Index (BDI)
a measure of shipping prices for commodities like iron, coal, and grain.
demand side (aggregate economy)
How spending decisions generate demand for goods and services, and as a result, employment and output. It uses the multiplier model.
Lessons from Economists
1) Economists have learned from the successes and the failures of the three epochs: 2) Successful policies in each epoch did not prevent positive feedback processes that contributed to subsequent crises: 3) No school of thought has policy advice that would have been good in every epoch: .
Governments rescue banks
Banks are rescued because the failure of a bank is different from the failure of a typical firm or household in a capitalist economy. Banks play a central role in the payments system of the economy and in providing loans to households and to firms. Chains of assets and liabilities link banks, and those chains had extended across the world in the years before the crisis.
Figure 17.9 The Great Depression and recovery: Households cut consumption to restore target wealth in the depression; and increased consumption from 1933.
Column C shows the household's perspective from late 1933. By that time, output and employment were growing.
QUESTION 17.4 CHOOSE THE CORRECT ANSWER(S) Figure 17.12 describes the movements in employment, profits and wages in the 1950s to 1960s using the labour market model. Which of the following statements is correct regarding this period? a) The rise in the wage-setting curve due to stronger trade unions and higher unemployment benefits led to postwar innovation. This shifted the price-setting curve up. b) A rise in the wage-setting curve depresses profits and reduces investment. This conflict of interest between workers and employers means that low unemployment, high profits, and high investment would not have been sustainable. c) The substantial increase in the bargaining power of trade unions and political movements allied with workers meant that they could demand the highest possible wages, pushing the wage-setting curve to its highest possible level. d) Continuing technological progress owing to widespread expectations of sustained high profits, together with high wages resulting from the strong bargaining power of trade unions, created a virtuous circle of high investment, rapid productivity growth, rising wages, and low unemployment.
Continuing technological progress owing to widespread expectations of sustained high profits, together with high wages resulting from the strong bargaining power of trade unions, created a virtuous circle of high investment, rapid productivity growth, rising wages, and low unemployment. ** This virtuous cycle led to a rapidly rising price-setting curve, and a wage-setting curve that rose with it, but not faster.
Alan Greenspan
Economist who served as head of Federal Reserve. Deeply opposed regulation 1987- 2006 - had the authority to prevent irresponsible lending practices that led to the subprime mortgage crisis
Figure 17.14 The end of the golden age: Strikes and wages relative to share prices in advanced economies (1950-2002).
Figure 17.14 plots the days on strike per 1,000 industrial workers in advanced economies from 1950 to 2002. As strike activity peaked, wages measured relative to share prices increased rapidly. The postwar accords that helped create the golden age collapsed.
supply side (aggregate economy)
How labour and capital are used to produce goods and services. It uses the labour market model (also referred to as the wage-setting curve and price-setting curve model).
Bank liquidity and the credit crunch
In many cases, banks or others operating in the money markets simply refused to lend at all. Newspapers called it the 'credit crunch'.
Figure 17.21 Leverage ratio of banks in the UK and US (1960-2014).
In the US, the leverage ratio of investment banks was between 12 and 14 in the late 1970s, rising to more than 30 in the early 1990s. It hit 40 in 1996 and peaked at 43 just before the financial crisis. By contrast, the leverage of the median UK bank remained at the level of around 20 until 2000. Leverage then increased very rapidly to a peak of 48 in 2007. In the 2000s, British and European global banks, including firms called shadow banks, increased borrowing to buy CDOs and other financial assets that originated in the US housing market. ** Leverage increased because of financial deregulation and the business model of banks.
Financial deregulation and bank leverage
In the context of the deregulated financial system, banks increased their borrowing: 1) to extend more loans for housing 2) to extend more loans for consumer durables like cars and furnishings 3) to buy more financial assets based on bundles of home loans
QUESTION 17.11 CHOOSE THE CORRECT ANSWER(S) Figure 17.26 depicts the US aggregate demand between 2006 Q2 and 2010 Q4. Based on this information, which of the following statements is correct? a) The fall in residential investment was the sole cause of the financial crisis. b) In the recession, not only did households stop purchasing new houses and other consumption goods, but also firms stopped investing. c) Government consumption and investment have been supporting economic growth throughout the period considered. d) Household consumption in housing and other goods recovered promptly since the end of the crisis.
In the recession, not only did households stop purchasing new houses and other consumption goods, but also firms stopped investing. ** Non-residential investment was the single greatest contributor, as indicated by the orange column in the crisis period.
Figure 17.13 shows both the growth of the government and the historically high level of trade union membership in the US. As we have seen, larger government partly reflected the new entitlements to unemployment benefits.
In the wage- and price-setting curve model, higher unemployment benefits and stronger trade unions shift the wage-setting curve upwards, but when unions are inclusive and when there is a strong union voice effect, then this upwards shift is restrained.
Three (3) simultaneous positive feedback mechanisms brought the American economy down in the 1930s:
Pessimism about the future: The impact of a decline in investment on unemployment and of the stock market crash of 1929 on future prospects spread fear among households. They prepared for the worst by saving more, bringing about a further decline in consumption demand. Failure of the banking system: The resulting decline in income meant that loans could not be repaid. By 1933, almost half of the banks in the US had failed, and access to credit shrank. The banks that did not fail raised interest rates as a hedge against risk, further discouraging firms from investing and curbing household spending on automobiles, refrigerators, and other durable goods. Deflation: Prices fell as unsold goods piled up on store shelves.
financial deregulation
Policies allowing banks and other financial institutions greater freedom in the types of financial assets they can sell, as well as other practices.
Financial deregulation and subprime borrowers
Shown in Figure 17.19. The financial accelerator mechanism is an example of positive feedback: from higher collateral, to more borrowing, to further increases in house prices.
Figure 17.2 - Unemployment, productivity growth, and inequality in the US (1914-2015)
Shows: Productivity growth Unemployment Inequality
QUESTION 17.7 CHOOSE THE CORRECT ANSWER(S) Figure 17.16 is a graph of the unemployment rate and consumer price inflation in advanced economies between 1960 and 2013. Based on this information, which of the following statements is correct? a) As predicted by the Phillips curve, the unemployment rate rises whenever inflation falls and vice versa throughout the period depicted. b) The unemployment rate and the inflation rate were consistently positively correlated during the stagflation period of the 1970s. c) Stagflation was caused by the shifting up of the Phillips curve, propelled by higher inflation expectations. d) The end of stagflation was characterized by falls in both the unemployment rate and the inflation rate.
Stagflation was caused by the shifting up of the Phillips curve, propelled by higher inflation expectations. ** The shifting up of the Phillips curve means a higher rate of inflation for any unemployment level, which is what happened during the stagflation period.
QUESTION 17.8 CHOOSE THE CORRECT ANSWER(S) Figure 17.19 shows the household debt-to-income ratio and the house prices in the US between 1950 and 2014. Based on this information, which of the following statements is correct? a) The real value of household debt more than doubled from the end of the golden age to the peak on the eve of the financial crisis. b) The causality is from the house price to household debt, that is, higher house prices encourage higher debt, but not the other way round. c) A household debt-to-income ratio of over 100 means that the household is bankrupt. d) Subprime mortgages partly explain the rise in debt in the US prior to the financial crisis.
Subprime mortgages partly explain the rise in debt in the US prior to the financial crisis. ** Some of the rise in household debt in the US was lent as mortgages to households who could not really afford to repay.
1933 - Roosevelt changes to economic policy
The New Deal: This committed federal government spending to a range of programs to increase aggregate demand. The US left the gold standard: In April 1933 the US dollar was devalued to $35 per ounce of gold, and the nominal interest rate was reduced to close to the zero lower bound (see Figure 17.8). Roosevelt also introduced reforms to the banking system: This followed bank runs in 1932 and early 1933.
Shifts in the price-setting curve and the wage-setting curve
The actors agree At point B, unions and employers agree about the scope for wage increases.
QUESTION 17.6 CHOOSE THE CORRECT ANSWER(S) Figure 17.15 describes the movements in employment, profits, and wages in the 1950s to 1970s using the labour market model. Which of the following statements is correct regarding this period? a) The collapse of postwar accords in the late 1960s/early 70s led to workers demanding higher wages, leading to an upward shift in the wage-setting curve. b) The reduction in the tax rate introduced to counter the effect of the oil shock led to the fall in the price-setting curve. c) The rise in the wage-setting curve led to the wage rate rising to point C. d) The economy swiftly settled at the new labour market equilibrium at D, with stable inflation, unemployment, profits, and wages.
The collapse of postwar accords in the late 1960s/early 70s led to workers demanding higher wages, leading to an upward shift in the wage-setting curve. ** Workers increasingly used the tactic of industrial strikes to attempt to push up wages.
What made it profitable for banks to become more highly leveraged
The combination of the great moderation, rising house prices, and the development of new, apparently less risky financial assets such as the derivatives called: collateralized debt obligations (CDOs), based on bundles of home loans called mortgage-backed securities(MBSs)
wage-setting curve
The curve that gives the real wage necessary at each level of economy-wide employment to provide workers with incentives to work hard and well.
price-setting curve
The curve that gives the real wage paid when firms choose their profit-maximizing price. **shows the real wage consistent with employers maintaining investment at a level that keeps employment constant. This means that a real wage below the price-setting curve will encourage firms to enter or raise their investment, and employment rises.
the operation of the money market relies on borrowers and lenders having trust in the solvency of those with whom they trade.
The expected profit on a loan is the interest rate multiplied by the probability that the borrower will not default: Expected profitability of loan=(1+𝑟)(1−probability of default)
Figure 17.17 The golden age and its aftermath: Real wages and output per production worker in manufacturing in the US (1949-2016).
The figure shows two dramatically different periods: Before 1973: Fair-shares bargaining meant that wages and productivity grew together. After 1973: Productivity growth was not shared with workers. For production workers in manufacturing, real wages barely changed in the 40 years after 1973. ** The period from this time until the global financial crisis of 2008 was called the great moderation because inflation was low and stable, and unemployment was falling.
House prices and bank solvency
The financial crisis was a banking crisis—and it was global, as BNP Paribas demonstrated in August 2007 when it would not pay out to bondholders in one of its investment funds. The banks were in trouble because they had become highly leveraged and were vulnerable to a fall in the value of the financial assets that they had accumulated on their balance sheets (refer back to Figure 17.21 for the leverage of US and UK banks). The values of the financial assets were in turn based on house prices.
The subprime housing crisis of 2007
The interrelated growth of the indebtedness of poor households in the US and global banks meant that when homeowners began to default on their repayments in 2006, the effects could not be contained within the local or even the national economy. The crisis caused by the problems of subprime mortgage borrowers in the US spread to other countries.
Figure 17.20 Household wealth and debt in the US: Poorest and richest quintiles by net worth (2007).
The left-hand bar is the poorest 20% of households. The right-hand bar is the richest 20%. The data is shown in a way that allows us to compare the assets and liabilities (debt) of the two groups. In each case, total assets, or equivalently, the total of debt plus net worth is made equal to 100%.
financial accelerator
The mechanism through which firms' and households' ability to borrow increases when the value of the collateral they have pledged to the lender (often a bank) goes up. The left-hand side of Figure 17.18 shows the outcome of the interaction between the bubble in house prices and its transmission through the economy via the financial accelerator during a boom. On the right-hand side, we see what happens when house prices decline. The value of collateral falls and the household's spending declines, pushing house prices down.
Great Depression
The period of a sharp fall in output and employment in many countries in the 1930s. Caused by 3 simultaneous positive feedback mechanisms in the US: • Pessimism about the future - households reacted to the 1929 stock market crash by saving more, further decreasing consumption • Banking system failure - many banks failed because loans could not be repaid; surviving banks raised interest rates • Deflation - Overall, prices in the economy fell due to falling demand
Golden age (of capitalism) High investment, rapid productivity growth, rising wages, and low unemployment defined the golden age.
The period of high productivity growth, high employment, and low and stable inflation extending from the end of the Second World War to the early 1970s. ** The gold standard was replaced by the more flexible Bretton Woods system. ** Employers and employees shared the benefits of technological progress, thanks to the postwar accord. ** The golden age ended with a period of stagflation in the 1970s. - The growth rate of GDP per capita was more than two-and-a-half times as high during the golden age as in any other period. Instead of doubling every 50 years, living standards were doubling every 20 years.
supply-side reforms, aimed to address the causes of the supply-side crisis of the 1970s.
The policies were centered on the need to shift the balance of power between employer and worker in the labour market, and in the firm. Government policy at this time achieved this goal in two main ways: Restrictive monetary and fiscal policy: Governments showed that they were prepared to allow unemployment to rise to unprecedented levels, weakening the position of workers and restoring the consistency of claims on output per worker as the basis of modest and stable inflation. Shifting the wage-setting curve down: As we saw in Unit 15, these policies included cuts in unemployment benefits and the introduction of legislation to reduce trade union power. Figure 17.16 illustrates the new policy environment.
QUESTION 17.5 CHOOSE THE CORRECT ANSWER(S) Figure 17.14 is a graph of days on strike per 1,000 industrial workers (left-hand axis) and the average wages relative to share prices (right-hand axis) in advanced economies between 1950 and 2002. Based on this information, which of the following statements is correct? a) Strikes are beneficial to all workers. b) Nearly half of the workers went on strike at the peak of the strike activity between 1975 and 1980. c) The postwar accord of cooperation between employers and employees broke down in the late 1960s. d) The first oil shock of 1973 triggered a sharp rise in average wages.
The postwar accord of cooperation between employers and employees broke down in the late 1960s. ** This is indicated by the fact that days on strike started to rise sharply in the late 1960s.
In the US, additional military spending to fund the Vietnam War added to aggregate demand, keeping the economy at unsustainably high levels of employment.
The process is represented in Figure 17.15 by an upward shift in the wage-setting curve (to the one labelled 'late 1960s/early 70s').
Figure 17.22 Unstable and stable equilibria in the housing market.
The right-hand panel shows how a stable equilibrium is one in which initial price changes are dampened rather than exaggerated as a result of what is called negative feedback. Here a rise in price leads to a fall in demand for houses, which depresses the price. Eventually the price returns to the initial level. This is a stable equilibrium.
liquidity risk
The risk that an asset cannot be exchanged for cash rapidly enough to prevent a financial loss.
fire sale
The sale of something at a very low price because of the seller's urgent need for money.
Gold Standard
The system of fixed exchange rates, abandoned in the Great Depression, by which the value of a currency was defined in terms of gold, for which the currency could be exchanged. There was a very large outflow of gold from the US after the UK left the gold standard in September 1931.
leverage ratio (for banks or households)
The value of assets divided by the equity stake in those assets. Suppose a house costs $200,000, and the household makes a down payment of 10% ($20,000). This means it borrows $180,000. Its initial leverage ratio, in this case the value of its assets divided by its equity stake in the house, is 200/20 = 10. Suppose the house price rises by 10% to $220,000. The return to the equity the household has invested in the house is 100% (since the value of the equity stake has risen from $20,000 to $40,000: it has doubled) Households who are convinced that house prices will rise further will want to increase their leverage: that is how they get a high return. The increase in collateral, due to the rise in the price of their house, means they can satisfy their desire to borrow more.
The recession that swept across the world in 2008-09 was the worst contraction of the global economy since the Great Depression.
The world's economic policymakers were unprepared. They discovered belatedly that a long period of calm in financial markets could make a crisis more likely.
Global Financial Crisis
This began in 2007 with the collapse of house prices in the US, leading to the fall in prices of assets based on subprime mortgages and to widespread uncertainty about the solvency of banks in the US and Europe, which had borrowed to purchase such assets. The ramifications were felt around the world, as global trade was cut back sharply. Governments and central banks responded aggressively with stabilization policies.
effective tax rate on profits
This is calculated by taking the before-tax profit rate, subtracting the after-tax profit rate, and dividing the result by the before-tax profit rate. This fraction is usually multiplied by 100 and reported as a percentage.
Fiscal policy made little contribution to recovery until the early 1940s.
Under Roosevelt, from 1932 to 1936 the government ran deficits. When the economy went into recession in 1938-39, the deficit shrank from its peak of 5.3% in 1936 to 3% in 1938. This was another mistake that reinforced the downturn. The big increase in military spending from early 1940 (well before the US entered the Second World War in late 1941) contributed to the recovery.
Figure 17.27 The financial crisis: Housing boom, household debt, and house price crash.
Wealth is below target The fall in house and asset prices, combined with lower expected earnings, reduced wealth below target. Households cut consumption and increased savings. Column A in Figure 17.27 shows the situation in the 1980s. The 1990s to mid-2000s, as we saw, was a period of rapidly rising house prices. Column B shows the outcome by 2006. In the figure, the house price is the sum of the blue box for home equity, and the red box for debt (the mortgage). The increase in house prices increased home equity and pushed up households' assessment of their wealth, which was inflated by the expectation that house prices would continue to rise. One effect was that they uprated their target wealth. But target wealth did not grow as much as perceived wealth, so they also borrowed more in order to consume more. This meant that home equity grew, but so did debt. The higher level of household debt is shown by the larger debt rectangle in column B.
Figure 17.11 Catching up to the US during the golden age and beyond (1950-2016).
What was the secret of golden age performance in the productivity leader (the US) and in the follower countries? Changes in economic policymaking and regulation: These resolved the problems of instability that characterized the Great Depression. New institutional arrangements between employers and workers: These created conditions in which it was profitable for firms to innovate. In the US, the technology leader, this meant new technologies, while the follower countries often adopted improved technology and management already in use in the US. Because trade unions and workers' political parties were now in a stronger position to bargain for a share of the productivity gains, they supported innovation—even when it meant temporary job destruction.
Housing booms and the financial accelerator
When the house price goes up—driven, for example, by beliefs that a further price rise will occur—this increases the value of the household's collateral (see the left-hand diagram in Figure 17.18) Using this higher collateral, households can increase their borrowing, and move up the housing ladder to a better property. This, in turn, pushes up house prices further and sustains the bubble, because the banks extend more credit based on the higher collateral. Increased borrowing, made possible by the rise in the value of the collateral, is spent on goods and services as well as on housing.
Monetary policy prolonged the Great Depression
monetary policy was contractionary in the US economy from 1925 onwards: the real interest rate increased, reaching a peak of 13% in 1932. Once the downturn began in 1929, this policy stance reinforced, rather than offset, the decline of aggregate demand.
Figure 17.6 The effect of the Great Depression on the US economy (1928-1941)
shows the fall in industrial production that started in 1929
Figure 17.3 - Upper panel: Capital stock growth and profit rates for US non-financial corporations (1927-2015). Lower panel: Effective tax rate on profits for US non-financial corporations (1929-2015).
shows the growth rate of the capital stock and the profit rate of firms in the non-financial corporate sector of the US economy (before and after the payment of taxes on profits) ** The data in Figure 17.3 illustrates that capital stock growth and firm profitability tend to rise and fall together. On the eve of the financial crisis, Figures 17.2 and 17.3 show that the richest Americans were doing very well.
Hyman Minsky (1919-1996)
was an American economist who developed a financial theory of the business cycle.
New institutions marking the golden age of capitalism
—increased trade union strength and government spending on social insurance —addressed the aggregate demand problems highlighted by the Great Depression and were associated with rapid productivity growth, investment, and falling inequality.
QUESTION 17.12 CHOOSE THE CORRECT ANSWER(S) Which of the following statements are correct regarding fire sales in the housing market? a) A household is underwater when the value of the house it owns is less than the value of the mortgage on the house. b) A fire sale occurs when a household cannot repay its mortgage and sells its house. c) Fire sales have a positive externality for prospective buyers who are able to purchase the foreclosed houses cheaply. d) Fire sales have a negative externality on other owners of similar assets by lowering the value of their assets.
- A household is underwater when the value of the house it owns is less than the value of the mortgage on the house. - Fire sales have a negative externality on other owners of similar assets by lowering the value of their assets. ** This is the definition of an 'underwater' household. ** This is a negative externality because owners of similar assets are not parties to this particular transaction.
QUESTION 17.9 CHOOSE THE CORRECT ANSWER(S) Figure 17.21 is the graph of leverage of banks in the UK and the US between 1960 and 2014. The leverage ratio is defined as the ratio of the banks' total assets to their equity. Which of the following statements are correct? a) A leverage ratio of 40 means that only 2.5% of the asset is funded by equity. b) The total asset value of US banks doubled between 1980 and later 1990s. c) A leverage ratio of 25 means that a fall of 4% in the asset value would make a bank insolvent. d) UK banks increased their leverage rapidly in the 2000s in order to make more loans to UK house buyers.
- A leverage ratio of 40 means that only 2.5% of the asset is funded by equity. - A leverage ratio of 25 means that a fall of 4% in the asset value would make a bank insolvent. ** 2.5% equity means total assets are equal to 40 times the value of equity. ** If assets fall by 4% then they lose one twenty-fifth of their value, which is exactly the value of the equity. This would imply a net worth of zero, so the bank would be just insolvent.
QUESTION 17.10 CHOOSE THE CORRECT ANSWER(S) Figure 17.24 shows some S-shaped price dynamics curves for the housing market. Based on the figure, which of the following statements is true? a) The parts of the PDC where the slope is less than 45 degrees represent a negative feedback process. b) Points Z and K represent unstable equilibria. c) A positive feedback process means that housing prices are always increasing. d) Optimism about housing prices would shift the PDC upwards.
- The parts of the PDC where the slope is less than 45 degrees represent a negative feedback process. - Optimism about housing prices would shift the PDC upwards. ** At these points, next period's price will be a movement towards a stable equilibrium, in the opposite direction from the initial shock. ** Optimism would result in higher prices for both of the stable equilibria (the opposite of what the figure shows).
Great Depression
- known as Black Thursday. On Thursday 24 October 1929, the US Dow Jones Industrial Average fell 11% on opening, starting three years of decline for the US stock market. ** Countries that left the gold standard earlier in the 1930s recovered earlier. ** In the US, Roosevelt's New Deal policies accelerated recovery from the Great Depression, partly by causing a change in expectations.
QUESTION 17.2 CHOOSE THE CORRECT ANSWER(S) The following figure shows the income share of the top 1% richest households in the US between 1914 and 2013. Based on this information, which of the following statements are correct? a) Inequality always rises in boom years. b) Inequality can either rise or fall during recessions. c) The great moderation era was distinct from the other two boom periods in that inequality rose during the period. d) The top 1% richest US households received nearly one-fifth of the total income in 2010.
-Inequality can either rise or fall during recessions. -The top 1% richest US households received nearly one-fifth of the total income in 2010. - Inequality had years of decline and years of increase in both the Great Depression and the recession after the financial crisis. - They received 19% of total income.
Golden Age - virtuous circle
1) After-tax profits in the US economy remained high: . 2) Profits led to investment: 3) High investment and continued technological progress created more jobs: 4) The power of workers:
The increased unemployment beginning with the first oil price shock in 1973 had two effects:
1) It reduced the bargaining gap in Figure 17.15: This brought down inflation (shown in Figure 17.16). 2) It put labour unions and workers on the defensive: The cost of job loss rose and employees had less bargaining power.
Great Moderation masked three changes that would create the environment for the global financial crisis.
1) Rising debt 2) Increasing house prices 3) Rising inequality
Rising house prices in the US in the 2000s:
1) driven by the behaviour of lenders, encouraged by government policy, to extend loans to poorer households. 2)able to fund these subprime loans by packaging them into financial derivatives, which banks and financial institutions across the world were eager to buy. 3) Rising house prices created the belief that prices would continue to rise, which shifted the demand curve for housing further to the right by providing households with access to loans based on housing collateral.
3 distinctive economic epochs following WWI
1) the roaring twenties and the Great Depression, 2) the golden age of capitalism and stagflation, and 3) the great moderation and subsequent financial crisis of 2008 End of each of these epochs the stock market crash of 1929, the decline in profits and investment in the late 1960s and early 1970s culminating in the oil shock of 1973, and the financial crisis of 2008, respectively
3 distinctive epochs
1921 to 1941: The crisis of the Great Depression is the defining feature of the first epoch. It inspired Keynes' concept of aggregate demand, now standard in economics teaching and policymaking. 1948 to 1979: The golden age epoch stretched from the end of the Second World War to 1979, and is named for the economic success of the 1950s and 1960s. The golden age ended in the 1970s with a crisis of profitability and productivity, and the emphasis in economics teaching and policymaking shifted away from the role of aggregate demand toward supply-side problems, such as productivity and decisions by firms to enter and exit markets. 1979 to 2015: In the most recent epoch, the global financial crisis caught the world by surprise. The potential of a debt-fueled boom to cause havoc was neglected during the preceding years of stable growth and seemingly successful macroeconomic management, which had been called the great moderation.
QUESTION 17.3 CHOOSE THE CORRECT ANSWER(S) Franklin Roosevelt became the US President in 1933. In the period after he became the president: * The federal government deficit increased to 5.6% of GNP in 1934. * The short-term nominal interest rate fell from 1.7% in 1933 to 0.75% in 1935. * The CPI fell by 5.2% in 1933 and rose by 3.5% in 1934. * The US left the gold standard in April 1933. * The New Deal was launched in 1933 and included proposals to increase federal government spending in a wide range of programs and reforms to the banking system. Which of the following statements is correct regarding the years immediately after Roosevelt became the US president? a) A change in the expectations of consumers of their future earnings, as a result of the New Deal, would have contributed to an expansion in the economy's aggregate demand. b) The value of the US dollar increased as the result of the abandonment of the gold standard and allowed the nominal interest rate to be cut to close to zero. c) The real interest rate rose after 1933. d) Fiscal contraction from the increased government deficit would have contributed to the economy escaping from the Depression.
A change in the expectations of consumers of their future earnings, as a result of the New Deal, would have contributed to an expansion in the economy's aggregate demand. ** More optimistic expectations lead to increased consumer spending, as shown in Figure 17.9.
Deflation
A decrease in the general price level
credit ratings agency
A firm which collects information to calculate the credit-worthiness of individuals or companies, and sells the resulting rating for a fee to interested parties. (the big three are Fitch Ratings, Moody's and Standard & Poor's) assess the risk of financial products, and part of their role is to provide evidence to reassure lenders that their investments are safe.
Figure 17.25 The financial crisis: The US housing price collapse.
A positive feedback process Once prices were falling, the belief that prices would fall further became widespread. This led to further declines in demand, all the way down to C. The house price index fell to a level of 76 in 2008.
negative feedback (process)
A process whereby some initial change sets in motion a process that dampens the initial change.
positive feedback (process)
A process whereby some initial change sets in motion a process that magnifies the initial change.
subprime mortgage
A residential mortgage issued to a high-risk borrower, for example, a borrower with a history of bankruptcy and delayed repayments.
supply-side policies
A set of economic policies designed to improve the functioning of the economy by increasing productivity and international competitiveness, and by reducing profits after taxes and costs of production. Policies include cutting taxes on profits, tightening conditions for the receipt of unemployment benefits, changing legislation to make it easier to fire workers, and the reform of competition policy to reduce monopoly power.
2008 Global Financial Crisis
An apparently small problem in an obscure part of the housing market in the US caused house prices to plummet, leading to a cascade of unpaid debts around the world, and a collapse in global industrial production and world trade. Economists applied the lessons they had learned from the Great Depression in the US: cut interest rates, provide liquidity to banks, and run fiscal deficits.
subprime borrower
An individual with a low credit rating and a high risk of default.
postwar accord
An informal agreement (taking different forms in different countries) among employers, governments, and trade unions that created the conditions for rapid economic growth in advanced economies from the late 1940s to the early 1970s. Trade unions accepted the basic institutions of the capitalist economy and did not resist technological change in return for low unemployment, tolerance of unions and other rights, and a rise in real incomes that matched rises in productivity. ** In the US and the successful catch-up countries, postwar accords succeeded in creating the conditions for a high profit and high investment equilibrium.
Bretton Woods system (1944 named after the ski resort in New Hampshire where representatives of the major economies, including Keynes, created a system of rules that was more flexible than the gold standard)
An international monetary system of fixed but adjustable exchange rates, established at the end of the Second World War. It replaced the gold standard that was abandoned during the Great Depression.
Tipping Point
An unstable equilibrium at the boundary between two regions characterized by distinct movements in some variable. If the variable takes a value on one side of the tipping point, the variable moves in one direction; on the other, it moves in the other direction. A ridge dividing two valleys is a tipping point; for example, water falling on one side runs away from the ridge in one direction towards an inland lake while water falling on the other side (even very close to the ridge) flows in the other direction towards the sea. In the case of the housing bubble, beyond a certain price (the tipping point price), prices will increase creating a bubble and below that price they fall (a bust) **Point A is called a tipping point. For a price above A, prices increase continuously until point B; for a price below A, prices decrease continuously until point C. The direction of the change in price switches from rising to falling at the tipping point A. ** At B, house prices are high, but stable. They will remain unchanged at the high level from year to year. Even if there are blips up or down, we know that the price will return to its level at B.
QUESTION 17.1 CHOOSE THE CORRECT ANSWER(S) The following figure shows the unemployment rate (left-hand axis) and productivity growth (right-hand axis) in the US between 1914 and 2015. Based on this information, which of the following statements is correct? a) The US has been able to achieve increasingly lower unemployment rates in its boom years through this period. b) There was a consistent and significant fall in productivity growth during the Great Depression era. c) The US economy's performance in 1979-2008 was less strong than during the other two boom periods, with a higher average unemployment rate and lower average productivity growth. d) The unemployment rate reached in the recent financial crisis was the highest since the stagflation years of 1973-79.
Answer: The US economy's performance in 1979-2008 was less strong than during the other two boom periods, with a higher average unemployment rate and lower average productivity growth. The average unemployment rates in the boom years of the first two epochs were below 5%, while the average productivity growth rates were around 2.2% and 3.2% respectively. Over the 1979-2008 period, the average unemployment rate was around 6% while the average productivity growth rate was 2.1%.
