1. The Current Financial Crisis –that‘s Macro in a nutshell Introduction to Macroeconomics Lecture I

2. What‘s it about • bursted bubble in the housing market (house prices fell by 16% in 1 year in US) • banking crisis • stock market crisis • real effects: recession in the US (and in Europe)

3. House price index US

4. The Dow Jones Index

5. Growth rate of US GDP

6. Unemployment rate 1998-2008

7. How does a bubble work? • Example: 2 goods – cookies, stones (no consumption value) • today: exchange 1 cookie – 1 stone • tomorrow: expect 1.5 cookies – 1 stone • - make profits if buy stone today to sell it tomorrow: 0.5 cookies • but: tomorrow everybody realizes that stone has no value – buyers of stones today have made loss of 1 cookie (bubble has disappeared)

8. So bubble is a redistribution of wealth from buyers to sellers of bubble • Example of bubbles: stocks, houses • Why are there real effects of a bursting bubble? Because bubble was an asset against which could borrow (eg from foreign, from future). American house owners (=consumers) feel much poorer than a year ago – consume less – less demand – output falls.

9. Specific problems of mortgages • Consumers got mortgage with little collateral • expected house price to rise such that could consume out of increase in house price and pay back mortgage • Expected interest rates to remain low • Expected labor income to remain constant or rise

10. In fact: - increase in the interest rate (due to good economic conditions) – many defaults on mortgages – demand for houses decreases – price of houses falls – house owners feel poorer – consume less – economic activity falls – house owners become unemployed – more defaults on mortgages and decrease in the house price….

11. Why a banking crisis? • 1) lenders guaranteeing mortgages (Fanny Mae, Freddy Mac) • 2) Mortgages bundled and sold on financial markets („derivatives“) • Idea: diversification reduces risk (not true since risk depends on Macro environment) • These financial products held mostly by investment banks (Lehman brothers, Bear Stearns…)

12. Why a banking crisis? • As bubble disappeared and borrowers defaulted on loans – value of banks‘ assets declined • Effect 1) banks cannot afford to lend (no short term liquidities) - credit crunch – firms cannot get funds for investment • Effect 2) investors lose confidence in banks, withdraw their funds („bank run“) • Result: banks have to sell assets to be able to pay their lenders („fire sales“)

13. What can be done? • Central banks inject money – to provide the banks with short term funds for lending (to prevent liqudity crisis) • State: takes over defaulted banks, buys up bad loans to improve banks‘ balance sheets (to prevent banking crisis and restore investors‘ confidence) – Bernanke and Paulson plan – costly to US taxpayer (700 billion $)

14. Why a stock market crises? • Fire sales of assets by banks increase supply – stock prices decline

15. Why a real economic downturn? • 1) Banks refuse to lend money for new investment projects – investment supply decreases – less investment – GDP falls • 2) Consumers feel poorer because of reduced value of their savings (houses, stocks) – consume less – final goods demand decreases – GDP falls • 3) since GDP falls (less production) firms demand less labor – unemployment increases

16. Comparison with Crisis of 1930‘s • In October 1929 stock market crisis in US („black Thursday“) • US stockmarket lost 20% of value in a month (bubble disappeared) • Crisis lasted from 1929 until mid 1930‘s • Crisis lead to a crash of banking system („bank runs“) • Consumers not willing to spend • State trying to keep budget in balance • Central bank was inactive • consequence: extremely high unemployment rates (>25% in 1933)

17. US GDP 1920-1940

18. Reaction to crisis • John Maynard Keynes: General Theory of Employment, Interest and Money (1936) • Sees crisis as consequence of wrong policy (restrictive monetary and fiscal policy) • Advocates expansive monetary policy and expansive fiscal policy (to increase aggregate investment and demand)

19. Reaction of Policy • 1933-34 „New Deal“ (F.D. Roosevelt) • Reform of financial system – introduction of deposit insurance – split of banking system into savings banks and investment banks. • increase in government spending to increase aggregate demand • Introduction of minimum wages, social security to increase private demand