These notes were prepared based on the lectures and supplemented by information from textbooks and tutorials where parts of the lecture were unclear. Graphs, equations, and bullet-point explanations included. Prepared by a first class Economics and Management student for the FHS Macroeconomics pape...
HT3 Macroecons (Macroeconomics at the Zero Lower Bound)
Lecture 7 & 8
Outline
The Great Recession –how did we get there and what was the policy response?
The tragedy of the zero lower bound (ZLB) for interest rates – conventional monetary policy
loses traction when it is needed most
What does macro theory say about optimal central bank policy at the ZLB?
o Forward guidance on interest rates to shape the yield curve and especially long-term
interest rates
o Going beyond the assumption that policy interest rates define the IS curve
Time inconsistency of optimal monetary policy at the ZLB
o Purely a theoretical concern or a practical obstacle?
Overcoming the time inconsistency problem
o Should the inflation target underpinning monetary policy be altered?
o How might a switch to price path targets limit probability of hitting ZLB, and address
time inconsistency of optimal policy at ZLB?
o Discussion of broader advantages and disadvantages of price path targets
o Absent a shift to PP target, are there commitment technologies that can be used to
improve credibility of forward guidance?
If forward guidance on interest rates proves ineffective, what else can central banks do?
o New perspective: deficient demand from financial frictions
o Tools for tackling financial frictions (central banks acting as commercial banks;
quantitative easing)
The Great Recession –how did we get there and what was the policy response?
Weakness in Macroeconomic Performance Since 2008
Weakness in the UK seen in unemployment, average real wages, productivity and GDP
o
o Near 7% drop in UK output in less than 18 months at the start of the recession; output
then became essentially flat for 3 years
o Absence of output recovery left UK economy entering 2013 14% smaller than projected
in 2008 based on assumption of growth at historical average
o Slightly above trend growth returned in 2013 and 2014 but the 14% missing output
remains and per capita output only passed its 2008 peak in 2015
o GDP per capita data is even worse since population increased during that period
Similar overall picture in much of the OECD though with some differences across countries
o US had somewhat faster GDP recovery but weaker unemployment recovery
o Depth and breadth of downturn labelled the ‘Great Recession'
, How did things get so bad?
Keynesian view
o Leading up to 2007, US sub-prime mortgage sector grew
Financial innovation/deregulation plus push to support homeownership
Many new borrowers are “subprime”: poor credit records, high Loan-To-Value
(LTV) ratios, low income relative to mortgage size
o When interest rates start to rise subprime mortgages become unsustainable
Almost all subprime mortgages have adjustable rates
Initial “teaser” period made interest payments low
But then interest rate linked to official rate, which is increasing
By Aug 2007, ≈ 16% of subprime mortgages in default
Later defaults extend beyond subprime segment to “prime” mortgages
Lenders initially refinanced at the end of teaser period to continue enjoying low
rates. With increasing house prices, this was possible especially since LTV lowers
as collateral value (the house price) increases which enables lower rates
When house prices fall, harder to refinance. Face higher interest payments
Incentive to foreclose- price of house < mortgage owed
o 2007: wave of US sub-prime mortgage defaults
Banks took possession of houses and tried to sell them, causing house price cash
which leads to more defaults (vicious cycle)
o 2008: financial contagion of losses
Losses by lenders: house sold at a price less than value of mortgage lent out
Securitization of mortgages: bonds held by banks, institutional investors, insured
by insurers (such as AIG)
Defaults -> mortgage related securities drop in value -> large losses of financial
institutions
Lehman's failure; Royal Bank of Scotland held many mortgage bonds and
needed government bailout
o 2010: European sovereign bond crisis starting in 2010
o Liquidity crisis (flight to safety): less and stricter lending
As banks’ balance sheets deteriorated, they lent out less and charged higher
interest rates to remain profitable.
o This led to the problem Keynes had focused on in "The General Theory": a pool of
savings that could not be recycled as expenditure due to lack of bank lending or other
financial intermediation
o Result was a demand deficit that impacted IS curve and GDP
Key question for Keynesians is 'what policies will restore demand/output'?
o A large part of this lecture is motivated by this question
Alternative view: Financial crisis left scar of lower equilibrium output originating from supply
shortage rather than demand shortage
o Decline in supply from impaired capital stock, resource mismatch, and tech regress in
sectors like financial services
o Covered in the next lecture
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