Final Topic 15

Question 1

low borrowing rates were a result of …

Answer 1

1. global saving glut
2. low federal funds rate
3. innovations in the banking sector.

Question 2

why were housing prices driven up?

Answer 2

driven up by the expectation of higher housing prices in the future. Individuals bought real estate because they were enticed by prospects of future increases in housing prices continuing (speculative bubble that lacked prospects of greater returns, as MPk wasn’t really going up).

Question 3

how did financial innovations contribute to the housing bubble?

Answer 3

misinterpretation of risk, lack of monitoring (MBS’s and no need to track these on the bank’s balance sheet) and the low level of the real interest rate –> led to a significant increase in the availability of credit, feeding the housing bubble.

Question 4

the drop in aggregate demand in the Great Recession was caused by…

Answer 4

1. burst of real estate bubble and resulting decline in consumers’ optimism–> decline in consumption.
2. crisis in banking system caused borrowing interest rate to increase (loans, credit cards)–>reduced consumption and investment.
3. reassessed MPk, not as high as expected–>additional drop in investment.
4. reassessment of real estate property prices resulted in reduction in property tax revenues –> reduction in local and state government funding. (also balanced budget requirements)

Question 5

No policy intervention: what happens after price adjustments

Answer 5

price level falls, return to initial output.

Question 6

No policy intervention: drawbacks

Answer 6

1. question of time horizon for price adjustment: cost of unemployment, cost of foregone income, cost of lower investment
2. deflationary risk: individuals and firms may reduce expected inflation and change consumption and investment decisions. This results in a further contraction of the AD and downward spiral (like in the Great Depression)

Question 7

expansionary monetary policy: advantages

Answer 7

1. faster attainment of full employment (if monetary policy causes faster responses than price adjustments)
2. no deflationary risk: price level is more stable.

Question 8

expansionary monetary policy: drawbacks and difficulties

Answer 8

1. no overshooting: ‘step-wise’ responses and announcements of policy changes in advance
2. ‘zero-bound’: limited because the CB cannot reduce its policy rate below zero.

Question 9

expansionary monetary policy: what it is and what it aims to do

Answer 9

increase money supply by decreasing the federal funds reserve rate (FFRR), discouraging commercial banks to hold excess reserves and increase loans/money creation. –> meant to increase C, I and shift AD to right.

Question 10

unconventional policy instruments

Answer 10

1. asset swaps
2. liquidity provision
3. troubled asset relief program
4. quantitative easing.

Question 11

asset swaps

Answer 11

The Fed let financial institutions ‘swap’ their less liquid long-term financial assets for short-term US Treasury securities.

Question 12

liquidity provision

Answer 12

The Fed acquired parts of government-sponsored mortgage companies (Fannie Mac, Freddie Mac) to increase liquidity

Question 13

Troubled Asset Relief Program (TARP)

Answer 13

The Fed and US Treasury provided $700 billion to purchase troubled assets from commercial banks in order to stabilize commercial banks, reduce risk, and increase lending.

Question 14

Quantitative Easing

Answer 14

CB is buying financial assets from commercial banks and other private institutions. The purchases increase the monetary base and inject a specific quantity of money into the economy (not from printing money itself but from reduction in excess reserves by commercial banks).

Question 15

future policies

Answer 15

1. increase in asset requirements for commercial and investment banks
2. increase in transparency over assets in banks’ balance sheets
3. stronger separation of commercial banks and investment banks to contain risk and ensure liquidity
4. reduction in Fed’s assets and a slow reduction in P(NM) an increase in r.

Question 16

expansionary fiscal policy and how it works

Answer 16

increase G (or TR/ decrease T, if myopic). –> leads to shift in AD. Initial output level and stable price level.

Question 17

expansionary fiscal policy: advantages

Answer 17

1. faster attainment of full employment (if monetary policy causes faster responses than price adjustments)
2. no deflationary risk: price level more stable
3. another policy instrument if monetary policy has limited effects (or if there are political constraints).

Question 18

expansionary fiscal policy: drawbacks/difficulties.

Answer 18

1. Fiscal instability: government deficits/debts go up
2. country risk: fiscal instability may result in increased default risk–>increased country risk and loans become more expensive because of higher risk compensation.

Question 19

fiscal space

Answer 19

provides a measure of a country’s fiscal capacity for a stimulus. How an economy can respond to a recession and how much it can stimulate the aggregate demand without losing its fiscal stability. (things to look at: reserves, debt level, credit rating and risk premium, future tax revenues, interest rate)

Question 20

fiscal retrenchment

Answer 20

should happen when economy recovers (G goes down, TR goes down and/or T goes up) in order to regain sufficient fiscal space for the future again.

Question 21

why is fiscal retrenchment difficult to implement?

Answer 21

1. political costs: setting priorities for various sectors and battling special interests that oppose reductions in benefits and increases in costs.
2. timing: fiscal retrenchment is contractionary and causes a reduction in the aggregate demand. The economy’s recovery and expansion must be stable enough to bear a step-wise reduction in deficit/debt levels.

Question 22

bubble

Answer 22

unsustainable price increases compared to future price and earnings [price-to-earnings ratio]

Question 23

liquidity trap

Answer 23

banks hold onto money (supply) and don’t let it go–may be able to inject liquidity but doesn’t change how banks have many risky assets. as a result of this, governments also pursued unconventional monetary policy.

Question 24

American recovery and reimbursement program

Answer 24

transfers, with unemployment benefits, grants to states (if balanced budget requirement, federal government borrowed for states and transferred it over to them).

focused on infrastructure, education and research, increasing LRAS future. (they knew the risk of debt, decided to focus on increasing A of the future, long-term benefits)