The Long Slump Robert Hall Stanford American Economic Association - - PowerPoint PPT Presentation

The Long Slump

Robert Hall Stanford American Economic Association Presidential Address January 8, 2011 ·

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The message

Overhang of housing and consumer durables

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The message

Overhang of housing and consumer durables High consumer commitments to debt service

4

The message

Overhang of housing and consumer durables High consumer commitments to debt service Financial friction

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The message

Overhang of housing and consumer durables High consumer commitments to debt service + An economy unable to low er its interest rate to generate alternative spending Financial friction

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The message

Overhang of housing and consumer durables High consumer commitments to debt service + An economy unable to low er its interest rate to generate alternative spending = Long slump Financial friction

2 4 6 8 10 12

Unemployment 2007 2015

The Long Slump

Actual and CBO forecast

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The problem

12 Normal demand function Supply function 8 4 t rate Normal employment and normal interest rate Interest 4 8 ‐4 ‐8

0.2 0.4 0.6 0.8 1 1.2 1.4 1.6

Employment

8

September 15, 2008

·

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The problem

12 Normal demand function Supply function 8 4 t rate Normal employment and normal interest rate Crisis Interest Crisis demand function 4 Normal employment and l i i i 8 ‐4 low crisis interest rate ‐8

0.2 0.4 0.6 0.8 1 1.2 1.4 1.6

Employment

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The problem

12 Normal demand function Supply function 8 4 t rate Normal employment and normal interest rate Crisis Interest Crisis demand function ‐4 Normal employment and

‐2.5

8 ‐4 Normal employment and low crisis interest rate

5

‐8

0.2 0.4 0.6 0.8 1 1.2 1.4 1.6

Employment

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The interest rate fails to do its job

12 Supply function 8 4 t rate Crisis demand function Excess Interest supply Interest rate pinned at zero 4 8 ‐4 ‐8

0.2 0.4 0.6 0.8 1 1.2 1.4 1.6

Employment

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Literature

Krugman (1998,2010), Eggertsson-Woodford (2003) and Eggertsson (2001-2010), Christiano-Eichenbaum-Rebelo (2010) ·

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Ratios of capital and durables to GDP

1.6 1.8

Housing and

1.4

consumer durables

1.0 1.2

B i i l

0.8

Business capital

0.4 0.6 0.2 0.0 1990 1995 2000 2005 14

Households at a Corner Solution in Intertemporal Trade

In the 2007 Survey of Consumer Finances, 58 percent of consumption occurs in households with less than 2 months of net liquid financial assets ·

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Calculating debt service

st = rD,t−1Dt−1 − ∆Dt ·

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Burden of Debt Service, as a Fraction of GDP

0.06 0.08 0.10 0.12 0.14 0.16 ‐0.02 0.00 0.02 0.04 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 17

Spread, in Percentage Points, between Business Loan Rates and Banks’ Borrowing Rate

1.5 2.0 2.5 3.0 3.5

, percentage points

0.0 0.5 1.0 2000 2002 2004 2006 2008 2010

Spread

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Spread, in Percentage Points, between Credit-Card Rates and Banks’ Borrowing Rate

6 8 10 12 14 16

, percentage points

2 4 6 2000 2002 2004 2006 2008 2010

Spread

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Spread, in Percentage Points, between Mortgage Rates and 10-year Treasurys

1.5 2.0 2.5 3.0 3.5

d, percentage points

0.0 0.5 1.0 2000 2002 2004 2006 2008 2010

Spread

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Indexes of Lending Standards Inferred from the FRB Senior Loan Officer Survey

5 6

Mortgages

3 4 2 3 1

Credit cards

‐1

Business loans

‐3 ‐2 ‐4 2003 2005 2007 2009 21

Google Searches for “withdrawal penalty”

70 80 60 70 50 30 40 20 30 10

2004 2005 2006 2007 2008 2009 2010 22

The nominal interest rate cannot fall below zero

Currency is a safe asset paying zero.

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The nominal interest rate cannot fall below zero

Currency is a safe asset paying zero. The Fed will always pay out currency in exchange for reserves.

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The nominal interest rate cannot fall below zero

Currency is a safe asset paying zero. The Fed will always pay out currency in exchange for reserves. If the market return for a bond fell below zero, the owner could sell it, convert the proceeds to currency, and earn a safe higher return.

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The nominal interest rate cannot fall below zero

Currency is a safe asset paying zero. The Fed will always pay out currency in exchange for reserves. If the market return for a bond fell below zero, the owner could sell it, convert the proceeds to currency, and earn a safe higher return. Thus market prices of bonds would fall so that their returns rose to zero. ·

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A long period with nominal short rate pinned at zero

6.0

Actual CBO forecast

5.0 4.0

per year

3.0

, percent

2.0

Rate,

1.0 0.0 2008 2009 2010 2011 2012 2013 2014 2015 24

The real interest rate

The real rate is the return measured in output units available from a one-period investment at the safe nominal rate: rt = rn,t − pt+1 − pt pt , where p is the dollar price of output.

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The real interest rate

The real rate is the return measured in output units available from a one-period investment at the safe nominal rate: rt = rn,t − pt+1 − pt pt , where p is the dollar price of output. The real rate is a basic price that clears the current labor and

• utput markets.

·

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Pinned real rate?

If the nominal rate is pinned at zero (rn = 0), the real rate is minus the rate of inflation: rt = −pt+1 − pt pt

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Pinned real rate?

If the nominal rate is pinned at zero (rn = 0), the real rate is minus the rate of inflation: rt = −pt+1 − pt pt If the rate of inflation is exogenous, the real rate is pinned at minus the rate of inflation. ·

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The near-exogeneity of inflation in today’s economy

6 8 10 12

Unemployment rate

2 4 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009

One‐year‐ahead inflation forecast

27

Fisher diagram of two-period equilibrium

0.55 0.60 0.65 0.70 0.75

mption in second period Indifference curve

0.40 0.45 0.50 0.40 0.45 0.50 0.55 0.60 0.65

Consum Consumption in first period

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Fisher diagram of two-period equilibrium

0.55 0.60 0.65 0.70 0.75

mption in second period Standard Indifference curve Isoquant

0.40 0.45 0.50 0.40 0.45 0.50 0.55 0.60 0.65

Consum Consumption in first period Standard equilibrium

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Fisher diagram of two-period equilibrium

0.55 0.60 0.65 0.70 0.75

mption in second period Standard Indifference curve Isoquant

0.40 0.45 0.50 0.40 0.45 0.50 0.55 0.60 0.65

Consum Consumption in first period Standard equilibrium Equilibrium interest rate

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Fisher diagram of two-period equilibrium

period Indifference curve

second p Isoquant Trade to a better point by holding cash which earns more than the

mption in Standard equilibrium rate

Consum Standard equilibrium

Equilibrium interest rate

Consumption in first period

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Fisher diagram of two-period equilibrium

Superior indifference curve

period Superior indifference curve Indifference curve

second p Isoquant Trade to a higher indifference curve by holding cash earning

mption in s Standard above the equilibrium rate

Consum equilibrium

Equilibrium interest rate

Consumption in first period

32

Two-period equilibrium with pinned interest rate

period

second p Standard equilibrium without high return on currency

mption in high return on currency

Consum

Consumption in first period

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Two-period equilibrium with pinned interest rate

period

second p Standard equilibrium without high return on currency

mption in s high return on currency Low‐employment equilibrium with high return to currency

Consum with high return to currency

Consumption in first period

34

Two-period equilibrium with pinned interest rate

period Slope = real return

• n

second p Standard equilibrium without high return on currency

• n

currency

mption in high return on currency Low‐employment equilibrium with high return on currency

Consum with high return on currency

Consumption in first period

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Dynamic equilibrium

Solow model

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Dynamic equilibrium

Solow model Life-cycle consumption

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Dynamic equilibrium

Solow model Life-cycle consumption Inelastic labor supply

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Dynamic equilibrium

Solow model Life-cycle consumption Inelastic labor supply Capital utilization proportional to employment ·

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Dynamic equilibrium, continued

Stock of houses and consumer durables as well as business capital, with adjustment cost for both kinds of capital

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Dynamic equilibrium, continued

Stock of houses and consumer durables as well as business capital, with adjustment cost for both kinds of capital Diamond-Mortensen-Pissarides labor market

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Dynamic equilibrium, continued

Stock of houses and consumer durables as well as business capital, with adjustment cost for both kinds of capital Diamond-Mortensen-Pissarides labor market Some households liquidity-constrained and with debt service commitments

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Dynamic equilibrium, continued

Stock of houses and consumer durables as well as business capital, with adjustment cost for both kinds of capital Diamond-Mortensen-Pissarides labor market Some households liquidity-constrained and with debt service commitments Financial friction drives a wedge between the return that households earn from savings and the rate at which businesses and households borrow ·

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Scenario

Fixed slight deflation at 0.12 percent per year for 16 quarters, followed by 3 percent per year (no binding limit on real rate)

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Scenario

Fixed slight deflation at 0.12 percent per year for 16 quarters, followed by 3 percent per year (no binding limit on real rate) Stock of housing and consumer durables 14 percent above normal at the outset

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Scenario

Fixed slight deflation at 0.12 percent per year for 16 quarters, followed by 3 percent per year (no binding limit on real rate) Stock of housing and consumer durables 14 percent above normal at the outset 58 percent of consumption in liquidity-constrained households with debt-service commitments of 6.7 percent of GDP, gradually declining

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Scenario

Fixed slight deflation at 0.12 percent per year for 16 quarters, followed by 3 percent per year (no binding limit on real rate) Stock of housing and consumer durables 14 percent above normal at the outset 58 percent of consumption in liquidity-constrained households with debt-service commitments of 6.7 percent of GDP, gradually declining Financial friction equivalent to a property tax on both types of capital at 2 percent per year, gradually declining ·

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Response of the unemployment rate to all three adverse forces jointly

35 40

Interest rate pinned Interest rate free

30 35 25

ment rate

15 20

employm

10 15

Une

5 1 3 5 7 9 11 13 15 17 19 21 23 25 27 Quarter 39

Response of consumption of to all three adverse forces jointly

0.9 1.0

Interest rate pinned Interest rate free

0 7 0.8

tput

0.6 0.7

• nary out

Consumption of liquidity‐ constrained households

0.4 0.5

n of statio

0 2 0.3

Fraction Consumption of unconstrained lifey‐cycle households

0.1 0.2 0.0 1 3 5 7 9 11 13 15 17 19 21 23 25 27 Quarter 40

Response of investment of to all three adverse forces jointly

0.5 0.5

Interest rate pinned Interest rate free

0 4 0.4

tput Business plant and equipment

0.3 0.4

• nary out

0.2 0.3

n of statio

0.1 0.2

Fraction

0.1 0.1

Houses and consumer durables

0.0 1 3 5 7 9 11 13 15 17 19 21 23 25 27 Quarter 41

Response of the interest rate of to all three adverse forces jointly

0.15 0.20

Interest rate pinned Interest rate free

0.10

cent

0.00 0.05

nual perc

‐0.05

t rate, an

‐0.15 ‐0.10

Interest

‐0.20 ‐0.25 1 3 5 7 9 11 13 15 17 19 21 23 25 27 Quarter 42

Responses of the unemployment rate to the three adverse forces

35 40

Interest rate pinned Interest rate free

30 35

Elevated housing‐durables, tight credit, and financial friction

25

ment rate Elevated housing‐durables and tight credit

15 20

employm

10 15

Une Elevated housing‐ durables

5

durables

1 3 5 7 9 11 13 15 17 19 21 23 25 27 Quarter 43

Shares of output with flexible interest rate

0.8

Consumption of nondurables

0.6 0.7

Consumption of nondurables and services

0.5 0.4 0.2 0.3

Investment in plant and equipment

0.1

Investment in houses and consumer durables

0.0 2008 2010 2012 2014 2016 2018 44

Market-clearing real interest rate

0.0 ‐0.5 ‐1.0 ‐1.5 ‐2.0 ‐2.5 ‐3.0 2008 2010 2012 2014 2016 2018 45

Policy

The Fed has done all that it can, subject to its firm commitment to keep currency and reserves at par.

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Policy

The Fed has done all that it can, subject to its firm commitment to keep currency and reserves at par. Though the government purchases multiplier is higher when the real interest rate is pinned, the government seems unable to crank up purchases.

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Policy

The Fed has done all that it can, subject to its firm commitment to keep currency and reserves at par. Though the government purchases multiplier is higher when the real interest rate is pinned, the government seems unable to crank up purchases. A gradual switch to a consumption tax that is added to product prices rather than subtracted from factor incomes would make current consumption cheaper in nominal terms and eliminate the zero bound.

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Policy

The Fed has done all that it can, subject to its firm commitment to keep currency and reserves at par. Though the government purchases multiplier is higher when the real interest rate is pinned, the government seems unable to crank up purchases. A gradual switch to a consumption tax that is added to product prices rather than subtracted from factor incomes would make current consumption cheaper in nominal terms and eliminate the zero bound. The main lesson is to avoid the regulatory lapses that caused the accumulation of housing, its associated debt load, and resulting frictions. ·

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