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The banking sector and the IS/PC/MR model

The financial crisis

The credit crunch

Macroeconomic CSI: The 2008 financial crisis and the credit crunch Rodolphe Desbordes

http://www.rodolphedesbordes.com/


The banking sector and the IS/PC/MR model

The financial crisis

Table of Contents I

1

The banking sector and the IS/PC/MR model

2

The financial crisis

3

The credit crunch

The credit crunch


The banking sector and the IS/PC/MR model

The financial crisis

The credit crunch

The banking sector

1 2 3 4 5

QI: The central bank sets r0 . QI: Commercial banks ‘borrow’ reserves from the central bank at the rate r0 . QII: They want to make a profit, they lend at the rate rL = (1 + m)r0 . QIII: Commercial banks supply the volume of loans LS necessary to satisfy the demand of loans LD , which depends on the price level, real output and rL . QIV: Loans (L) create deposits (D), which are backed up by reserves (DR).


The banking sector and the IS/PC/MR model

The financial crisis

The credit crunch

The banking sector and the IS/PC/MR model

The only modification is that the IS curve depends now on the loan rate of interest rL . The central bank still sets the interest rate r0 and the banking sector reflects changes in r0 in rL .


The banking sector and the IS/PC/MR model

The financial crisis

The credit crunch

Revisiting the permanent AD shock

B

LD’’

1

2 3

Y −Y

Positive AD shock [Z ] 0Y e > 0, π0 − πT > 0, LD , the demand for loans is very e high at rL = (1 + m)r0 . The central bank raises r0 to r000 . Commercial banks raise rL to rL00 . In the next period [B],

Y1 −Ye Ye

< 0, π1 < π0 , L00 D < LD .


The banking sector and the IS/PC/MR model

The financial crisis

The credit crunch

A stylised narrative I 1

After the 2001 recession, the Fed prolonged its low-interest rate policy. Borrowing was cheap.

2

Interest rates were also low in other countries.

3

The low interest rates (short-term and medium-term) fueled a global housing boom.

4

This housing boom led financial institutions to relax their lending requirements. They made subprime loans, including to NINJA (No income, no job and no asset) households.

5

They did not really care because they could (partially) get rid of them by repackaging these subprime loans into mortgage/asset-backed securities (MBS) that they sold to investors all over the world.


The banking sector and the IS/PC/MR model

The financial crisis

The credit crunch

A stylised narrative II 6

Investors, such as other financial institutions, bought these MBS because they provided a high return and because rating agencies assured them that MBS were safe investments.

7

The Fed, and other central banks, worried by rising inflationary pressures, increased their interest rate targets over the period 2005-2007.

8

Many subprime borrowers could no more pay their mortgage payments.

9

Residential investment (spending on the construction of new houses and apartment buildings) and the associated consumption on durable goods fell (first AD shock).

10

The MBS, whose returns were derived from the mortgage interest payments, became worthless.


The banking sector and the IS/PC/MR model

The financial crisis

The credit crunch

A stylised narrative III

11

Financial institutions which had invested in MBS, often by borrowing a lot, made huge losses.

12

Banks stopped trusting each other. It was harder and more expensive to borrow and they preferred to keep any excess money they had in reserves. The credit crunch started in mid-2008 (second AD shock).


The banking sector and the IS/PC/MR model

The financial crisis

The credit crunch


The banking sector and the IS/PC/MR model

The financial crisis

The credit crunch


The banking sector and the IS/PC/MR model

The financial crisis

The credit crunch

Source: http://www.nytimes.com/imagepages/2008/09/16/business/16primer.span.ready.html


The banking sector and the IS/PC/MR model

The financial crisis

The credit crunch

Source: http://cfec.ca/en/conference/2008/taylor.pdf

The line â&#x20AC;&#x153;counterfactualâ&#x20AC;? depicts what would have happened if the Taylor rule had been followed, according to a statistically estimated model of housing starts. Inappropriate expansionary monetary policy played a role in the crisis of 2008.


The banking sector and the IS/PC/MR model

The financial crisis

The credit crunch

The fall of bank lending in the UK: businesses

Source: http://www.bankofengland.co.uk/publications/other/monetary/TrendsAugust10.pdf


The banking sector and the IS/PC/MR model

The financial crisis

The credit crunch

The fall of bank lending in the UK: mortgages

Source: http://www.bankofengland.co.uk/publications/other/monetary/TrendsAugust10.pdf


The banking sector and the IS/PC/MR model

The financial crisis

The credit crunch

The fall of bank lending in the UK: consumers

Source: http://www.bankofengland.co.uk/publications/other/monetary/TrendsAugust10.pdf


The banking sector and the IS/PC/MR model

The financial crisis

The credit crunch

Credit crunch Interest rates

B

C

Mark-up increase

r_L’

r_L A r_0

LD’ L’

L Rationing

LD Loans

A credit crunch is an increase in the cost of obtaining a loan from commercial banks, potentially coupled with a rationing of bank loans [A → C]. Higher mark-up m increases the cost of a loan [A → B]. Rationing reduces the availability of loans, even when individuals are wiling to pay a higher interest rate. Banks have higher requirements for borrowers to qualify for loans than normal [B → C].


The banking sector and the IS/PC/MR model

The financial crisis

The credit crunch

Impact on aggregate demand Interest rate

r_L’ C

B

r_L A

IS’ Rationing

Higher mark-up

IS Output

The loan rate of interest is higher and, at a given interest rate level, a fraction of potential borrowers are excluded from the market. Higher costs and more stringent requirements reduce debt-financed spending. Along the IS curve: rL → rL0 :movement along the IS curve, investment and other debt-financed components of AD, e.g. consumption of durable goods fall [A → B]. Shift of the IS curve: At a given level of the interest rate, a fraction of the desired debt-financed spending cannot occur. IS curve shifts to the left [B → C].


The banking sector and the IS/PC/MR model

The financial crisis

The credit crunch

Impact on output and inflation PC

PC1

Target A

Deflationary spiral

C

D MR Ye Impact credit crunch

Output

The credit crunch is a negative AD shock. AD falls, output falls, inflation falls [A â&#x2020;&#x2019; C]. If the central bank does not intervene OR commercial banks are unwilling to ease credit conditions, output remains stuck at a low level and inflation falls to dangerous levels [C â&#x2020;&#x2019; D].


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