Current Recovery Review: Home Prices, Consumer Confidence, and Business Confidence Many homeowners were unable to make their mortgage payments  Homeowners were evicted  MBSs could not make their payments  Banks teeter on bankruptcy   Consumer confidence falls  Business confidence falls Claim: The decline in consumer and business confidence shifts the AD curve left.

At a given inflation rate () Review: Business and Consumer Confidence Claim: Changes in confidence shift the aggregate demand (AD) curve. Increases in confidence shift the aggregate demand (AD) curve right. Decreases in confidence shift the aggregate demand (AD) curve left. FP Question: What would the real interest rate (r) equal, if the inflation rate () were _______ percent, given that the Fed does not change its inflation policy? AD Question: How many final goods and services would be purchased, if the inflation rate () were _______ percent, given that all other factors relevant to demand remained the same?  (%)  (%) FP At a given inflation rate () AD AD r (%) G&S Consumer and/or business confidence decline Households and/or firms purchase less Fewer goods and services purchased Aggregate demand (AD) curve shifts left     C and/or I down  AD = C + I + G down

Late 2000’s Unemp Real Actual Infl Expected Infl Govt Productivity   Unemp Real Actual Infl Expected Infl Govt Productivity Year Rate (%) GDP Purch Growth (%) 2006 3.1 2007 4.6 14,875 2.7 2,915 2008 5.8 14,835 2.0 2,995 0.8 2009 9.3 14,420 3,090 3.1 2.7 2.0  (%) Puzzle: Despite that fact that government purchases increased the AD curve had to shift left not right. First, the AS curve. AS2007 2007 3.0 Next, the AD curve. AS2008 2.5 2008 2.0 1.5 AS2009 AD2007 1.0 2009 G&S 14,400 14,600 14,800 15,000

In net, AD curve shifts left   In net, AD curve shifts left  (%) AS2007 2007 3.0 AS2008 2.5 2008 2.0 1.5 AS2009 AD2007 1.0 2009 AD2009 AD2008 G&S 14,400 14,600 14,800 15,000 2007-2008 2008-2009 Fiscal Policy expansionary Confidence falls Fiscal Policy expansionary Confidence falls  AD shifts right  AD shifts left  AD shifts right  AD shifts left   In net, AD curve shifts left   In net, AD curve shifts left

Shift the AD curve right Government Response Targeted Asset Relief Program (TARP) American Recovery and Reinvestment Act of 2009 (Stimulus Bill) Quantitative Easing (QE) Strategy: Shift the AD curve right  (%) AS  Increases GDP  Decrease unemployment AD’ AD G&S

U.S. Treasury (billions $) Repaid TARP money (billions $) Targeted Asset Relief Program (TARP) Stock Purchases MBS Purchases Whole Loan Purchases Company Preferred Stock Purchases by U.S. Treasury (billions $) Repaid TARP money (billions $) Citigroup 45.0 Bank of America AIG 40.0 36.0 JPMorgan Chase 25.0 Wells Fargo GMAC Financial (Ally) 17.3 General Motors 13.4 Goldman Sachs 10.0 Morgan Stanley PNC Financial Services 7.6 U.S. Bancorp 6.6 Chrysler 4.0 Capital One Financial 3.6 Regions Financial Corp 3.5 American Express 3.4 Bank of New York Mellon 2.0-3.0 State Street Corporation Discover Financial 1.2 Question: What is the difference between a bond and a stock? Answer: When a corporation (or the federal government, state government, etc.) sells a bond it is borrowing. It incurs a liability by promising to repay the bond in the future. When a corporation issues new stock it is giving the new stockholder partial ownership in the corporation. The corporation makes no promises to the stockholder regarding future dividends, the price of the stock, etc.

Citigroup sells $10 worth of Citigroup bonds to the U.S. Treasury Citigroup Bond: Citigroup promises to repay the U.S. Treasury in the future. U.S. Treasury U.S. Treasury Washington, DC Pay to the order of Citigroup $10 Jacob Lew Citigroup U.S. Treasury Check Question: What does Citigroup do with the Treasury’s check? Fed Assets Liabilities RES 60 50 DEP 500 Vault Cash 30 Net Worth = 560 – 510 = 50 Dep at Fed 30 20 570 520 50 SEC 70 Stock&Bonds 60 BOR 10 20 Citigroup’s net worth is unaffected when it issues bonds. MBSs 10 LOANS 440 Elaine 20 Total Assets 560 570 Total Liabilities 510 520

Citigroup Stock: U.S. Treasury becomes a part owner of Citigroup Citigroup issues $10 worth of new Citigroup stock and sells it to the U.S. Treasury Citigroup Stock: U.S. Treasury becomes a part owner of Citigroup U.S. Treasury U.S. Treasury Washington, DC Pay to the order of Citigroup $10 Jacob Lew Citigroup U.S. Treasury Check Question: What does Citigroup do with the Treasury’s check? Fed Assets Liabilities RES 60 50 DEP 500 Vault Cash 30 Citigroup’s liabilities are unaffected. Dep at Fed 30 20 SEC 70 Stock&Bonds 60 Net Worth = 560 – 510 = 50 BOR 10 MBSs 10 570 60 LOANS 440 Citigroup’s net worth is increases when it issues stock. Elaine 20 Total Assets 560 570 Total Liabilities 510 Question: Why is this relevant?

To illustrate AD curve shifts keep the inflation rate () constant Rationale behind TARP  (%) AD G&S To illustrate AD curve shifts keep the inflation rate () constant Increase in confidence  Households and/or firms purchase more goods  C and/or I increase Question: How did this affect the aggregate demand (AD) curve?  GDP increases Claim: Shifts the aggregate demand (AD) curve right.  AD curve shifts right

American Recovery and Reinvestment Act of 2009 (Stimulus Bill) Tax incentives for individuals: $237 billion Tax incentives for companies: $51 billion Healthcare: $155.1 billion Education: $100 billion Aid to low income workers, unemployed and retirees: $82.2 billion Infrastructure Investment: $105.3 billion Water, sewage, environment, and public lands: $18 billion Energy Infrastructure: $21.5 billion Energy efficiency and renewable energy research and investment: $27.2 billion Housing: $14.7 billion Question: How did this affect the aggregate demand (AD) curve?  (%) Claim: Shifts the aggregate demand (AD) curve right. Increase in government purchases Lower taxes AD’   Expansionary fiscal policies AD  AD curve shifts right G&S

Government’s Goal: Shift the AD curve back to the right. Quantitative Easing   Unemp Real Actual Infl Expected Infl Govt Year Rate (%) GDP Purch 2006 3.1 2007 4.6 14,875 2.7 2,915 2008 5.8 14,835 2.0 2,995 2009 9.3 14,420 0.8 3,090 3.1 2.7 2.0  (%) AS2007 2007 3.0 AS2008 2.5 2008 2.0 AD2007 1.5 AS2009 AD2008 1.0 2009 Government’s Goal: Shift the AD curve back to the right. AD2009 GDP 14,400 14,600 14,800 15,000

Government’s Goal: Shift the AD curve back to the right. The Policies Pursued Targeted Asset Relief Program (TARP) American Recovery and Reinvestment Act of 2009 (Stimulus Bill) Quantitative Easing (QE)  (%) AS AD’ AD GDP Government’s Goal: Shift the AD curve back to the right.

Required reserve ratio Quantitative Easing (QE1, QE2, and QE3) QE1: November 2008 to June 2010. The Fed purchased $1,800 billion of mortgage-backed securities (MBSs), U.S. Treasury bonds, etc. QE2: November 2010 to June 2011. The Fed purchased an additional $600 billion QE3: September 2012 until recently. The Fed authorized the purchase of up to $95 billion of mortgage-backed securities (MBSs) and Treasury bonds. $4 worth of MBSs Federal Reserve Board Washington, DC Pay to the order of Citigroup $4 Janet Yellen Citigroup Fed Required reserve ratio equals 10%. Fed Check Required reserves = Required reserve ratio  Deposits Liabilities Assets Reserves 54 50 Deposits 500 = 10%  500 Vault Cash 30 = 50 Dep at Fed 24 20 Excess reserves = (Actual) reserves  Required reserves Securities 66 70 Stock&Bonds 60 Borrowing 10 = 54  = 50  50 MBSs 10 6 = 0 = 4 Loans 440 Total Assets 560 Total Liabilities 510

Positive excess reserves i (%) MS MS’  Bank loans increase Question: How will this affect the money market and the nominal interest rate (i)? Money Market Positive excess reserves i (%) MS MS’  Bank loans increase Review: When banks issue more loans, loans and deposits increase by the amount of the new loans.  Bank deposits increase  Money supply (MS) curve shifts right MD  Nominal Interest Rate (i)  Lower Real Interest Rate (r) M Inflation Rate () =   Lower  Constant Claim: At a given inflation rate () the real interest rate (r) will be lower Question: How will this affect the aggregate demand (AD) curve?

At a given inflation rate () FP Question: What would the real interest rate (r) equal, if the inflation rate () were _______ percent, given that the Fed does not change its inflation policy? AD Question: How many final goods and services would be purchased, if the inflation rate () were _______ percent, given that all other factors relevant to demand remained the same?  (%)  (%) FP curve shifts left  AD curve shifts right FP FP  Expansionary At a given inflation rate () AD AD r (%) G&S Fed decreases the real interest rate (r) Loans become less costly Households and firms purchase more More goods and services purchased Aggregate demand (AD) curve shifts right    

Rationale behind quantitative easing (QE) Quantitative Easing (QE1, QE2, and QE3) QE1: November 2008 to June 2010. The Fed purchased $1,800 billion of mortgage-backed securities (MBSs), U.S. Treasury bonds, etc. QE2: November 2010 to June 2011. The Fed purchased an additional $600 billion QE3: September 2012 until recently. The Fed authorized the purchase of up to $95 billion of mortgage-backed securities (MBSs) and Treasury bonds. Rationale behind quantitative easing (QE)  Creates excess reserves  Banks increase loans  Banks increase deposits  Money supply curve shifts right  Nominal interest rate falls  At a given inflation rate, the real interest rate falls  FP curve shifts left  AD curve shifts right

Recovery – The Aggregate Supply (AS) Curve   Unemp Real Actual Infl Expected Infl Govt Year Rate (%) GDP Purch 2008 2.0 2009 9.3 14,420 0.8 3,090 2010 9.6 14,780 1.2 2011 9.0 15,050 2,990 2012 8.1 15,520 1.7 2,965 2013 7.4 15,760 1.5 2,895 2.0 0.8 1.2 2.0 1.7 First, the AS Curve  (%) AS2011 Adaptive Expectations: The expected inflation rate depends on the actual inflation rate in the recent past. AS2012 2.0 2011 ? AS2013 2012 AS2010 2013 1.5 AS2009 2010 1.0 2009 0.5 GDP 14,200 14,600 15,000 15,400 15,800

The AD curve had to shift right between 2009 and 2011. Recovery – The Aggregate Demand (AD) Curve   Unemp Real Actual Infl Govt Year Rate (%) GDP Purch 2008 2.0 2009 9.3 14,420 0.8 3,090 2010 9.6 14,780 1.2 2011 9.0 15,050 2,990 2012 8.1 15,520 1.7 2,965 2013 7.4 15,760 1.5 2,895 The AD curve had to shift right between 2009 and 2011.  (%) Next, the AD Curve 2.0 2011 2012 AD2011 2013 1.5 2010 1.0 AD2013 2009 AD2012 AD2010 0.5 AD2009 GDP 14,200 14,600 15,000 15,400 15,800

Recovery  (%) AS Curve AS2011 AD Curve AS2012 2.0 AS2013 AD2011   Unemp Real Actual Infl Expected Infl Govt Year Rate (%) GDP Purch 2008 2.0 2009 9.3 14,420 0.8 3,090 2010 9.6 14,780 1.2 2011 9.0 15,050 2,990 2012 8.1 15,520 1.7 2,965 2013 7.4 15,760 1.5 2,895 2.0 0.8 1.2 2.0 1.7  (%) AS Curve AS2011 AD Curve AS2012 2.0 2011 AS2013 2012 AD2011 AS2009 AS2010 2013 1.5 2010 1.0 AD2013 2009 AD2012 AD2010 0.5 AD2009 GDP 14,200 14,600 15,000 15,400 15,800

TARP: Consumer and Business Confidence Assessing the Effectiveness of the Policies: TARP, Stimulus Bill, and the QE’s   Unemp Real Actual Infl Expected Infl Govt Year Rate (%) GDP Purch 2008 2.0 2009 9.3 14,420 0.8 3,090 2010 9.6 14,780 1.2 2011 9.0 15,050 2,990 2012 8.1 15,520 1.7 2,965 2013 7.4 15,760 1.5 2,895 2.0 0.8 1.2 2.0 1.7 TARP: Consumer and Business Confidence  (%) AD GDP

Government purchases fell modestly which is not expansionary. Assessing the Effectiveness of the Policies: TARP, the QE’s, and the Stimulus Bill   Unemp Real Actual Infl Govt Year Rate (%) GDP Purch 2008 2.0 2009 9.3 14,420 0.8 3,090 2010 9.6 14,780 1.2 2011 9.0 15,050 2,990 2012 8.1 15,520 1.7 2,965 2013 7.4 15,760 1.5 2,895 The QE’s The fact that the excess reserves held by banks are at unprecedentedly high levels suggest that quantitative ease was not as effective as hoped. Stimulus Bill Government purchases fell modestly which is not expansionary. The reduction in taxes was expansionary. Question: Why weren’t Congress and the President more aggressive in reacting to the recession