Financial Crisis

Question 1

Theory of Macroeconomic Policy

Answer 1

Neoclassical (Freshwater) vs. New Keynesian (Saltwater) Schools
- Neo purists = rationality for people and free markets, unemployment was temporary without gov intervention
- Saltwater = Believed in fiscal expansion

Question 2

Krugman who?

Answer 2

Article ‘How did Economists Get it so wrong’ in 2009
- Talks about 2008 financial crash

Question 3

Krugman Success of Policy

Answer 3

1. Before credit crunch economists congratulated themselves heavy on their successes - the long periods of stable growth and low inflation
2. Convergence of views about how the economy functions
3. Common beliefs in the efficacy of free markets, limited gov intervention and economic rationality
4. Development of complex mathematical models, used fore forecasting the policy analysis.

Question 4

Before 2008 Crash

Answer 4

1980-2007 known as period of macroeconomic stability (‘Great Moderation’)
- Association with expansion of US housing market
- In 2007: losses on mortgage related financial assets
1. Subprime crisis = successive decreases in prime rate meant bankers issued loans at a lower rate (considered a high risk)
- Interest rates increased in 2005 = house demand and prices fell, subprime borrowers couldn’t pay back their loans
- Financial firms experiences distress leading to economic contraction (‘Great Recession’)

Question 5

2008 Economic Faults

Answer 5

1. Increasing GDP = strong economy = economists turned a blind eye to any faults
2. Decreasing inflation after great depression = saw no need to fall back

Question 6

Great Moderation Consensus Agreements

Answer 6

• Shifts in aggregate demand affected output in the short run.
• Output will return to the natural level in the medium run.
• Capital accumulation and the growing rate of technological progression are the main factors that determine the evolution of the level of output in the long run.
• Monetary policy affects output in the short run but not in the medium or long run.
• Fiscal policy has effects on all short, medium and long runs.
• People are rational and financial markets are perfectly efficient.

Question 7

Great Moderation Consensus Disagreements

Answer 7

• Disputes were mainly about theories and not policies or actions.
• The actual role of policies.
• The length of the ‘short run’ where aggregate demand affects output.
• Not a lot of discussions were about fiscal policies, most were about monetary policies.

Question 8

Implications of the Financial Crisis: Post 2008-09 Keynesian resurgence

Answer 8

• Interest rates close to 0 = limit on what more can be achieved in stimulating the economy through monetary policy
• When private sector is persuaded to borrow more and monetary policy is ineffective = public sector needs to step up to support the economy
• Need for fiscal expansion
• After 2010 = end of discal expansion and back to austerity

Question 9

Other Developments after 2008

Answer 9

• Departure from trad assumptions of rational behavioural economics and finance
• Lack of rationality meant economic models are harder to construct but should still be tried

Question 10

Prices and Beliefs

Answer 10

Idea of ‘efficient-market hypothesis’ (Eugene Fama) = financial market price assets precisely at their intrinsic worth given all publicly available information.
- Beliefs may dampen or amplify price rises.
–> Behavioural finance showed this to be incorrect.

Question 11

Decade after- 2010s

Answer 11

• First time in centuries that we end a decade with wages roughly the same as when they started
• GDP growth per capita = 1.1% lowest in any decade since the war
• Decade marked by lack of volatility- first post-war decade without a recession
• British struck by 7% of GDP