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Macro/Finance

No prior Gordon text (11 editions) has deemed

the financial sources of instability a worthy topic

of detailed investigation. These were assumed

away to simplify the presentation. Now that the

global credit-contraction crisis is in full force,

some of the prior assumptions need to be

revisited.

Normal operations: with a floating/flexible

exchange rate, the stabilization of the economy

normally falls to monetary policy, despite the

long and variable lags in its effectiveness.

Assumptions made for simplification purposes

may need to be relaxed:No financial market instability e.g. from

innovation (Volcker)

Central bank can not detect asset price

bubble, but floods the market to fix

Financial bubbles take longer to recover

from than cyclical fluctuationsSingle interest rate, real, riskless

modified by term and risk premiums

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Long-term unemployment no specific

threat

Multipliers may be adversely affected

Political stalemate may prevent needed

adjustments

Permanent prosperity, housing prices

will rise forever nationwide

Multiple culprits: central bank (low interest

rates), financial sector innovations (risk and

leverage), regulators (sluggish and lax), creditagencies (S&P, Moodys, Fitch), Congress

(ownership society), nonbank/securitization

(Countrywide and Washington Mutual), humans

(something for nothing), world wide

(globalization),

Markets work by overacting initially. Butthey can freeze if trust disappears, e.g. in federal

funds, commercial paper, money market funds,

term auctions

Analysis:

wealth effect, Ca and Ip decline, Ap

moves left and with multiplier IS shifts left;s rises as c falls cause IS to shift left;

housing (part of Ip) usually revives the

economy as r declines, but given the housing

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bubble, that did not work this time; financial

markets depend on trust; when trust

disappears, panic ensures.

Measurement: Output gaps

Financial institutions, Balance sheets

and Leverage

Matching savers and borrowers

(markets vs intermediaries)

Leverage limits relaxed; works both

waysBank insolvency covered by FDIC

insurance for depositers

Nonbank (Bear, Lehman) a) no

reserves, b) funds by borrowing, minimal equity

Bubbles (stocks compared to

earnings) and buildings (houses/office comparedto rents); causes (innovation optimism, easy

credit, recycled credit efficiency) leverage,

credit supply, financial innovation

Subprime NINJA and securitization

and ARMs

IS/LM must now consider cash-outfinancing, multiple interest rates, loan

premiums)

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Box p. 146 summary of IS/LM and

the global crisis

In a crisis, monetary policy may not be enough

and with trust low and a contracting IS curve,

only a rightward shift of IS can possibly restore

the natural income level. These activities

include reducing taxes, increasing income

transfers and increasing G.

Quantitative easing: FED cannotcontrol the more important long-term interest

rates with Treasury bill actions

Subprime global amplification factors:

a) interest-rate risk premia rises, b) runs c)

uncertain valuations, d) rise in international

purchases of mortgage-backed securities, MBS,due to ignorance and misinformation.

Unmentioned:

Glass Steagall (separation of investment andcommercial banks)

Fannie Mae/ Freddie Mac

CDO, CDS, synthetic CDO