(BQ) Part 1 book Macroeconomics has contents: Introduction to macroeconomics, measuring the macroeconomy, a model of production, the solow growth model, growth and ideas, the great recession - A first look, an introduction to the short run,...and other contents.
MACROECONOMICS Third Edition MACROECONOMICS Third Edition Charles I Jones Stanford University, Graduate School of Business W W NORTON & COMPANY NE W YORK LONDON W W Norton & Company has been independent since its founding in 1923, when William Warder Norton and Mary D Herter Norton first published lectures delivered at the People’s Institute, the adult education division of New York City’s Cooper Union The firm soon expanded its program beyond the Institute, publishing books by celebrated academics from America and abroad By mid-century, the two major pillars of Norton’s publishing program—trade books and college texts—were firmly established In the 1950s, the Norton family transferred control of the company to its employees, and today—with a staff of four hundred and a comparable number of trade, college, and professional titles published each year—W W Norton & Company stands as the largest and oldest publishing house owned wholly by its employees Copyright © 2014, 2011, 2010, 2008 by W W Norton & Company, Inc All rights reserved Printed in the United States of America Editor: Jack Repcheck Developmental Editor: Susan Gaustad Managing Editor, College: Marian Johnson Project Editor: Sujin Hong Production Manager: Eric Pier-Hocking Copyeditors: Christopher Curioli Emedia Editor: Cassie del Pilar Editorial Assistant: Theresia Kowara Art Director: Rubina Yeh Artist: John McAusland Designer: Lissi Sigillo Composition: Jouve Manufacturing: Quad Graphics Library of Congress Cataloging-in-Publication Data Jones, Charles I (Charles Irving) Macroeconomics / Charles I Jones, Stanford University, Graduate School of Business — Third Edition pages cm Includes bibliographical references and index ISBN 978-0-393-92390-2 (hardcover : alk paper) Macroeconomics I Title HB172.5.J65 2014 339—dc23 W W Norton & Company, Inc., 500 Fifth Avenue, New York, NY 10110 wwnorton.com W W Norton & Company Ltd., Castle House, 75/76 Wells Street, London W1T 3QT 1234567890 2013041076 To Te r r y ; fo r Au d r e y a n d C h a rli e BRIEF CONTENTS >/@B PRELIMINARIES Introduction to Macroeconomics Measuring the Macroeconomy 18 >/@B THE LONG RUN An Overview of Long-Run Economic Growth 42 A Model of Production 68 The Solow Growth Model 99 Growth and Ideas 134 The Labor Market, Wages, and Unemployment 172 Inflation 202 >/@B! THE SHORT RUN An Introduction to the Short Run 230 10 The Great Recession: A First Look 251 11 The IS Curve 274 12 Monetary Policy and the Phillips Curve 305 13 Stabilization Policy and the AS/AD Framework 341 14 The Great Recession and the Short-Run Model 379 15 DSGE Models: The Frontier of Business Cycle Research 406 >/@B" APPLICATIONS AND MICROFOUNDATIONS 16 Consumption 440 17 Investment 463 18 The Government and the Macroeconomy 490 19 International Trade 514 20 Exchange Rates and International Finance 540 21 Parting Thoughts 576 Exercises An important stylized fact of economic fluctuations is that the inflation rate usually falls during a recession This fact lies at the heart of our short-run model in the form of the Phillips curve The Phillips curve captures the dynamic trade-off between output and inflation: a booming economy leads to a rising inflation rate and a slumping economy to a declining inflation rate The essence of the short-run model is that the economy is hit with shocks, which policymakers may be able to mitigate, and inflation evolves according to the Phillips curve Policymakers use monetary and fiscal policy in an effort to stabilize output and keep inflation low and steady This task is made difficult by the fact that potential output is not readily observed, and the economy is always being hit by new shocks whose effects are not immediately obvious Okun’s law, which allows us to go back and forth between short-run output and the unemployment rate, says that a one percentage point decline in output below potential corresponds to a half percentage point increase in the unemployment rate KEY CONCEPTS annualized rate economic shocks the Great Depression long-run trend Okun’s law the Phillips curve recession the short run short-run fluctuation short-run output REVIEW QUESTIONS How the long-run model and the short-run model fit together? What is the purpose of each model? Why we measure short-run output Y˜ in percentage terms rather than in dollar terms? Before the latest financial crisis and recession, when was the largest recession of the past 50 years, and what was the cumulative loss in output over the course of the slowdown? What are some recent shocks that have hit the macroeconomy? How can you “see” the Phillips curve operating in the graph of inflation in Figure 9.5? Why is Okun’s law a useful rule of thumb to keep in mind when analyzing our short-run model? EXERCISES smartwork.wwnorton.com Using the “Country Snapshots” data file, plot per capita GDP over time for two countries Drawing upon Wikipedia and/or other data sources, write a paragraph for each country, discussing the general causes of the major fluctuations in per | 247 248 | Chapter An Introduction to the Short Run capita GDP What shocks appear to be most important in explaining fluctuations in economic activity for the countries you chose? Be sure to document your sources carefully Overstimulating the economy: Suppose the economy today is producing output at its potential level and the inflation rate is equal to its long-run level, with Q 2% What happens if policymakers try to stimulate the economy to keep output above potential by 3% every year? How does your answer depend on the slope of the Phillips curve? The slope of the Phillips curve: Draw a graph with a steep Phillips curve and a graph with a gently sloped Phillips curve (a) Explain how the two economies respond differently to a boom and to a slump (b) What are some factors that might influence the slope of the Phillips curve? (c) Do you think the slope of the Phillips curve has changed over time in the U.S economy? Consider the United States in the 1970s versus today An oil shock: Consider an economy that begins with output at its potential level and a relatively high inflation rate of 6%, reflecting some recent oil price shocks As the head of the Federal Reserve, your job is to pick a sequence of short-run output levels that will get the rate of inflation back down to 3% no later than years from now Your expert staff offers you the following menu of policy choices: —Short-run output— —Inflation— Option Year Year Year Year Year Year 3 6% 4% 2% 2% 2% 0 2% 3% 4% 5% 3% 3% 4% 3% 3% 3% (a) According to these numbers, what is the slope of the Phillips curve? (b) If you as a policymaker cared primarily about output and not much about the inflation rate, which option would you recommend? Why? (c) If you cared primarily about inflation and not much about output, which option would you recommend? Why? (d) Explain the general trade-off that policymakers are faced with according to the Phillips curve A productivity boom: Suppose the economy exhibits a large, unexpected increase in productivity growth that lasts for a decade Policymakers are (quite reasonably) slow to learn what has happened to potential output and incorrectly interpret the increase in output as a boom that leads actual output to exceed potential Suppose they adjust macroeconomic policy so that the mismeasured level of short-run output is zero (a) What happens to the true amount of short-run output Y˜ ? (b) What happens to inflation over time? Exercises (c) This problem outlines a concern economists have had in recent years after the large increase in productivity growth that started around 1995 Now consider the opposite problem: suppose productivity growth declines for a decade What would be predicted to happen? Has this ever happened to the U.S economy? Measuring Yt and Y˜t : A real-world problem faced by policymakers, forecasters, and businesses every day is how to judge the state of the economy Consider the table below, showing hypothetical measures of real GDP in the coming years, starting at a level of $18.0 trillion in 2018 Year Actual output Yt 2018 2019 2020 2021 2022 2023 2024 18.00 18.60 19.00 18.90 19.00 20.00 20.90 Potential output Yt Yt Yt Short-run output Y˜ t Growth rate of actual output %$Y Now fill in the remaining columns of the table by answering the following questions (a) What is potential output in 2018? You could call this a trick question, since there’s no way for you to know the answer! In a way, that’s the main point: fundamentally, we have to take some other measurements and make some assumptions Suppose your research assistant tells you that in 2018, business surveys, unemployment reports, and recent years’ experience suggest that the economy is operating at potential output So go ahead and write 18.0 for potential in this year (b) Assume potential output grows at a constant annual rate of 2.5%, and complete the remainder of the table (c) Comment on the state of the economy in each year When does the economy enter a recession? When does the recession end? (d) How is your answer in part (c) related to the growth rate of actual output in the last column of the table? Okun’s law: Suppose the economy has a natural rate of unemployment of 6% (a) Suppose short-run output over the next years is 1%, 0%, 1%, and 2% According to Okun’s law, what unemployment rates would we expect to see in this economy? (b) Consider another economy in which the unemployment rate over the next years is 6%, 7%, and then 4% According to Okun’s law, what are the levels of short-run output Y˜ in this economy? | 249 250 | Chapter An Introduction to the Short Run E=@932 3F3@17A3 Overstimulating the economy: Figure 9.9 shows the Phillips curve in this case Since output exceeds potential, inflation is increasing according to the Phillips curve: $Q Suppose the slope of the Phillips curve is In this case, the inflation rate rises by percentage points each year For example, if it starts at 2%, then it’s 5% in year 1, 8% in year 2, and 11% in year The cost of maintaining output above potential is that the inflation rate keeps increasing If the slope is even higher, then the rate of increase is also higher — inflation rises faster when the Phillips curve is more steeply sloped 475C@3 ' ' The Phillips Curve and the Booming Economy Change in inflation, $P Phillips curve $P > 0 3% Short-run ~ output, Y 16/>B3@ 5.1 Current H1 Head | 251 10 THE GREAT RECESSION: A FIRST LOOK =D3@D73E In this chapter, we learn the causes of the financial crisis that began in the summer of 2007 and then pushed the U.S and world economies into the deepest recession in many decades how this recession compares to previous recessions and previous financial crises in the United States and around the world several important concepts in finance, including balance sheet and leverage 251 252 | Chapter 10 The Great Recession: A First Look “ Wednesday is the type of day people will remember in quant-land for a very long time Events that models only predicted would happen once in 10,000 years happened every day for three days — MATTHEW ROTHMAN 10.1 Introduction By many measures, the financial crisis of 2007 to 2009 caused the deepest recession in the U.S and world economies in more than 50 years Commercial and investment banks, which earned enormous profits during the run-up of housing prices in the first half of the decade, had literally “bet the bank” on securities backed by mortgages The virtually unprecedented decline in housing prices starting in 2006 roiled financial markets and reshaped Wall Street Financial giants such as Bear Stearns, Lehman Brothers, Merrill Lynch, Wachovia, Washington Mutual, Fannie Mae, Freddie Mac, and AIG suffered colossal losses, resulting either in outright failure or in emergency rescue by the government The last two remaining investment banks, Goldman Sachs and Morgan Stanley, converted to bank holding companies They and other titans such as Citigroup, Bank of America, and Wells Fargo accepted $25-billion capital infusions from the government and were the beneficiaries, either directly or indirectly, of enormous financial interventions and loan guarantees by the Federal Reserve, the U.S Treasury, and other governmental agencies in the United States and around the world The crisis that began on Wall Street migrated to Main Street, pushing the U.S economy into a recession in December 2007 Rising from a low of 4.4 percent in March of that year, the unemployment rate rose steadily, peaking at 10.0 percent in October 2009 U.S employment declined by more than percent, the largest decline of the postwar era World GDP declined in 2009 for the first time in more than half a century Not since the Great Depression had such financial panic and macroeconomic turmoil so thoroughly infected the world And while a repeat of the Depression was avoided, the “Great Recession,” as it is coming to be called, shook the U.S and world economies in ways that almost no one thought was possible The financial crisis and ensuing recession have forced economists to rethink our understanding of financial markets and macroeconomic fluctuations Something that almost no mainstream economist thought could happen did Understanding why and how will ultimately require a decade or more of research But some of the basic lessons and forces at work are already becoming clear And while changes to our understanding of macroeconomics will surely be required, much of the infrastructure that has been built by past research remains intact Epigraph: Quoted in Kaja Whitehouse, “One ‘Quant’ Sees Shakeout for the Ages — ‘10,000 Years,’ ” Wall Street Journal, August 11, 2007 10.2 Recent Shocks to the Macroeconomy This chapter provides an overview of the financial crisis We begin by discussing the events that led up to the crisis and documenting the macroeconomic shocks that struck the economy before and during the financial crisis Next, we consider data on macroeconomic outcomes like inflation, unemployment, and GDP to highlight the basic effect of these shocks The chapter then studies how financial factors impact the economy We introduce several important financial concepts, especially balance sheets and leverage Clearly, there was a crisis among financial institutions tied to a decline in the value of their assets and the effect this had on their solvency in the presence of leverage But the crisis also struck household balance sheets through a decline in their assets, notably housing and the stock market As a result, households cut back their consumption, reducing the economy’s demand for goods and services Finally, the balance sheets of both the U.S government and the Federal Reserve played starring roles in current events Federal debt as a ratio to GDP doubled between 2007 and 2012, from 36 percent to 72 percent And the Federal Reserve more than doubled the size of its balance sheet, pursuing unconventional means to ensure liquidity in financial markets In this sense, the Great Recession is tightly linked to balance sheets throughout the economy — for financial institutions, for households, for governments, and for the Federal Reserve 10.2 Recent Shocks to the Macroeconomy What shocks to the macroeconomy caused the global financial crisis? A natural place to start is with the housing market, where prices rose at nearly unprecedented rates until 2006 and then declined just as sharply We also discuss the rise in interest rate spreads (one of the best ways to see the financial crisis in the data), the decline in the stock market, and the movement in oil prices Housing Prices At the heart of the financial crisis was a large decline in housing prices In the decade leading up to 2006, housing prices grew rapidly before collapsing by more than 40 percent over the next several years, as shown in Figure 10.1 Fueled by demand pressures during the “new economy” of the late 1990s, by low interest rates in the 2000s, and by ever-loosening lending standards, prices increased by a factor of nearly between 1996 and 2006, an average rate of about 10 percent per year Gains were significantly larger in some coastal markets, such as Boston, Los Angeles, New York, and San Francisco Alarmingly, the national index for housing prices in the United States declined by 42 percent between the middle of 2006 and the first quarter of 2012 This is remarkable because it is by far the largest decline in the index since its inception in 1953 By comparison, the next largest decline was just 14 percent during the early 1990s What caused the large rise and then sharp fall in housing prices? The answer brings us to the financial turmoil in recent years | 253 254 | Chapter 10 The Great Recession: A First Look After rising sharply in the years up to 2006, housing prices fell dramatically 475C@3 A Bursting Bubble in U.S Housing Prices? Real housing price index (2000 Q1 100, ratio scale) 200 180 Decline of 42.5 percent since peak! 160 140 120 100 1985 1990 1995 2000 2005 2010 Year Source: Robert Shiller, www.econ.yale.edu/~shiller/data/Fig2-1.xls The Global Saving Glut In March 2005, before he chaired the Federal Reserve, Ben Bernanke gave a speech entitled “The Global Saving Glut and the U.S Current Account Deficit.” With the benefit of hindsight, we can now look at this speech and see one of the main causes of the sharp rise in asset prices The genesis of the current financial turmoil has its source, at least to some extent, in financial crises that occurred a decade ago In this speech, Governor Bernanke noted that financial crises in the 1990s prompted an important shift in the macroeconomics of a number of developing countries, especially in Asia Prior to the crises many of these countries had modest trade and current account deficits Essentially, they were investing more than they were saving, and this investment was financed by borrowing from the rest of the world For rapidly growing countries, this approach has some merit: they will be richer in the future, so it makes sense to borrow now in order to maintain consumption while investing to build new highways and equip new factories For a variety of reasons (discussed in more detail in Chapter 19), these countries experienced a series of financial crises in the 1990s — Mexico in 1994, Asia in 1997–1998, Russia in 1998, Brazil in 1999, and Argentina in 2002 The result was a sharp decline in lending from the rest of the world, steep falls in the value of their currencies and stock markets, and significant recessions After the crises, these countries increased their saving substantially and curtailed their foreign 10.2 Recent Shocks to the Macroeconomy borrowing, instead becoming large lenders to the rest of the world — especially to the United States While developing countries on net borrowed $88 billion in 1996 from the rest of the world, by 2003 they were instead saving a net $205 billion into the world’s capital markets Bernanke argued that this reversal produced a global saving glut: capital markets in advanced countries were awash in additional saving in search of good investment opportunities This demand for investments contributed to rising asset markets in the United States, including the stock market and the housing market One way this happened was through the creation of mortgage-backed securities, as we see in the next two sections Subprime Lending and the Rise in Interest Rates Lured by low interest rates associated with the global saving glut, by increasingly lax lending standards, and perhaps by the belief that housing prices could only continue to rise, large numbers of borrowers took out mortgages and purchased homes between 2000 and 2006 These numbers include many so-called subprime borrowers whose loan applications did not meet mainstream standards; for example, because of poor credit records or high existing debt-to-income ratios According to The Economist, by 2006 one-fifth of all new mortgages were subprime.1 The extent to which lending standards apparently deteriorated is stunning In his speech to the American Economic Association in January 2010, Bernanke highlighted the range of exotic mortgages that allowed people with very little income to borrow large sums to purchase houses As long as housing prices increased, these mortgages were secure: the borrower rapidly accumulated equity in the house that could be taken out in a refinance, allowing the mortgage to be repaid By 2006, these exotic mortgages, which had been negligible just years earlier, accounted for a large fraction of new mortgages Housing prices rose, lending standards deteriorated, more people borrowed to buy houses, and this drove prices even higher.2 Against this background and after more than years of exceedingly low interest rates, the Federal Reserve began to raise its Fed funds target — the rate charged for overnight loans between banks — as shown in Figure 10.2 Between May 2004 and May 2006, the Fed raised its interest rate from 1.25 percent to 5.25 percent in part because of concerns over increases in inflation (This was arguably a reasonable policy — according to the Taylor rule, interest rates were too low in the preceding years, and the Fed raised them to a more reasonable level This will be further discussed later.) Higher interest rates generally lead to a softening of the housing market, as borrowing becomes more costly In an environment with subprime borrowers facing mortgages whose rates were moving from low teaser An excellent early summary of the subprime crisis and the liquidity shock of 2007 can be found in “CSI: Credit Crunch,” The Economist (October 18, 2007) See Ben S Bernanke, “Monetary Policy and the Housing Bubble,” speech given at the Annual Meeting of the American Economic Association, Atlanta, Georgia, January 3, 2010 A fascinating account of these events is also provided in Michael Lewis, “The End,” Portfolio.com, November 11, 2008 For more details, see Lewis’s The Big Short: Inside the Doomsday Machine (New York: Norton, 2010) | 255 256 | Chapter 10 The Great Recession: A First Look After keeping interest rates very low from 2002 to 2004, the Fed raised rates sharply over the next years After the financial turmoil that began in August 2007, the Fed cut interest rates even more sharply, ultimately driving the Fed funds rate all the way to zero, where they have remained for more than years 475C@3 The Fed Funds Rate Percent 2000 2002 2004 2006 2008 2010 2012 Year Source: FRED (Federal Reserve Economic Data), courtesy of the Federal Reserve Bank of St Louis, http://research.stlouisfed.org/fred2/ rates to much higher market rates, the effect on housing prices was even more severe According to Chairman Bernanke, by August 2007, nearly 16 percent of subprime mortgages with adjustable rates were in default.3 The problem then spiraled, as low housing prices led to defaults, which, in a vicious cycle, lowered housing prices even more The Financial Turmoil of 2007–2009 To understand the financial turmoil that followed, it helps to appreciate a (generally valuable) innovation in finance known as securitization Like a decadent buffet at an expensive hotel, securitization involves lumping together large numbers of individual financial instruments such as mortgages and then slicing and dicing them into different pieces that appeal to different types of investors A hedge fund may take the riskiest piece in the hope of realizing a high return A pension fund may take a relatively safe portion, constrained by the rules under which it operates The resulting pieces go by many names and acronyms, such as mortgage-backed securities, asset-backed commercial paper, and collateralized debt obligations (CDOs).4 In principle, combining large numbers of assets can diversify the risk associated with any individual asset For instance, one subprime mortgage may be especially risky; but if you put thousands together and only a few default, the aggregate instrument will be mostly insulated In the case of the subprime crisis, however, Ben S Bernanke, “The Recent Financial Turmoil and Its Economic and Policy Consequences,” speech given at the Economic Club of New York, October 15, 2007 A quick visit to Wikipedia can provide more details on these and other financial instruments 10.2 Recent Shocks to the Macroeconomy the underlying mortgages proved to be significantly riskier than most investors realized Banks that generated the mortgages sold them off and did not have to bear the consequences if their particular mortgages went bad; as a result, lending standards deteriorated Moreover, securitization is based to a great extent on the supposition that a large fraction of mortgages will not go bad at the same time After all, the history of the U.S housing market was that while some regions experienced large declines, the overall national market was relatively stable When the Fed raised interest rates, more and more subprime mortgages went under, housing prices fell nationwide, and this led to even more defaults Securitization did not (and cannot) insulate investors from aggregate risk Remarkably, the investors who were holding these mortgage-backed securities often turned out to be the large commercial and investment banks themselves The collapse of the dot-com stock market bubble in 2000 did not cause a financial crisis because the stock market risk was diversified across a huge number of investors In contrast, a relatively small number of financial institutions held a large amount of mortgage-backed securities, putting their solvency at risk One would have thought that these sophisticated financial institutions would have had all the right incentives to recognize the problems with deteriorating lending standards and the nearly unprecedented rise in housing prices The only way this house of cards could continue to hold together was if housing prices continued to rise And yet for reasons that are somewhat difficult to understand, many of these financial institutions wound up on the wrong side of the housing bubble As sophisticated financial instruments were developed and traded, it became difficult to know how much exposure an individual bank had to this risk In August 2007, these forces came to a head, and banks sharply increased the interest rates that they charged one another: if Bank A worries that Bank B is backed by a large number of bad mortgages, it will demand a premium to lend money or may not lend at all There was a “flight to safety” as lenders decided to place their funds in U.S Treasury bills — government bonds that mature in year or less, sometimes called “T-bills” — instead of lending to other banks As a result, the spread between T-bill yields and interbank lending rates rose dramatically, as shown in Figure 10.3 What had been a modest premium of 0.2 to 0.4 percentage points rose sharply to between 1.0 and 1.5 percentage points If the yield on T-bills was 2.0 percent, banks might lend to one another at 2.3 percent before the crisis Once the crisis started, these rates rose to as much as 3.5 percent, and the amount of lending dropped, producing a classic example of a liquidity crisis — a situation in which the volume of transactions in some financial markets falls sharply, making it difficult to value certain financial assets and thereby raising questions about the overall value of the firms holding those assets In September 2008, the crisis intensified, and the risk premium exploded from around 1.0 percentage point to more than 4.5 percentage points — and panic set in In the course of weeks in September 2008, the government took over the mortgage companies Fannie Mae and Freddie Mac, Lehman Brothers collapsed into bankruptcy, Merrill Lynch was sold to Bank of America, and the Federal Reserve organized an $85 billion bailout of AIG Treasury Secretary Henry Paulson and Fed Chair Ben Bernanke met with congressional leaders to outline the | 257 258 | Chapter 10 The Great Recession: A First Look The rate at which banks borrow and lend to one another rose sharply in August 2007 during the subprime crisis and then spiked in September 2008 with the collapse of Lehman Brothers 475C@3 ! Liquidity and Risk Shocks since August 2007 Percentage points 4.5 3.5 Spread between the 3-month LIBOR rate and the 3-month U.S Treasury bill yield 2.5 1.5 0.5 2000 2002 2004 2006 2008 2010 2012 2014 Year Note: The LIBOR rate is the London Interbank Offer Rate and is a measure of the interest rate charged on loans between banks Source: Federal Reserve Economic Data (FRED) $700 billion Troubled Asset Relief Program (TARP), with Bernanke warning, “If we don’t this, we may not have an economy on Monday.”5 Financial markets declined sharply during this time, as shown in Figure 10.4 The S&P 500 stock price index fell by more than 50 percent from its recent peak in 2007, placing it below levels from a decade earlier Oil Prices If the decline in housing prices and the financial crisis were not enough, the economy also suffered from large movements in oil prices After nearly two decades of relative tranquility, oil prices rose in mid-2008 to levels never seen before These prices are shown in Figure 10.5 From a low of about $20 per barrel in 2002, oil prices peaked at more than $140 per barrel during the summer of 2008 This sevenfold increase is comparable in magnitude to the oil shocks of the 1970s Other basic commodities such as natural gas, coal, steel, corn, wheat, and rice also featured large price increases Then, spectacularly, oil prices declined even more sharply so that by the end of 2008 they hovered around $40 per barrel before rising to the $80 to $100 range in recent years This crisis period is laid out in vivid detail in Joe Nocera, “As Credit Crisis Spiraled, Alarm Led to Action,” New York Times, October 1, 2008, p A1 10.2 Recent Shocks to the Macroeconomy 475C@3 " | 259 The real value of the S&P 500 stock price index declined by 50 percent between its peak in November 2007 and March 2009 The S&P 500 Stock Price Index (Real) Real stock price index (ratio scale) 2,560 1,280 640 320 160 80 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 Year Source: Robert Shiller, www.econ.yale.edu/~shiller/data.htm 475C@3 # Oil prices rose by more than a factor of between 2002 and July 2008, roughly comparable to the increase in the 1970s The Price of Oil Price of oil, per barrel (2012 dollars) 150 100 50 1970 1975 1980 Source: The FRED database 1985 1990 1995 2000 2005 2010 Year 260 | Chapter 10 The Great Recession: A First Look Why did these prices rise and then fall so sharply? It is instructive to consider the case of oil more carefully First, world oil consumption increased significantly during this same period of sharply rising prices For example, during the first half of 2008, a decline in oil consumption among OECD countries (including the United States) was more than offset by increases in China, India, and the Middle East Rising prices coupled with rising quantities are a classic sign of an outward shift in demand, and it appears that rising demand — throughout the world but especially among some rapidly growing emerging economies — was a major driving force behind the increase in the prices of basic commodities Shorter-term factors such as supply disruptions, macroeconomic volatility (in the United States, China, and elsewhere), and poor crop yields appear to have played a role in exacerbating the price movements The economic slowdown associated with the global financial crisis then relieved this demand pressure — at least partially — which goes some way toward explaining the recent declines Nevertheless, it is difficult to justify both $140 per barrel in the summer of 2008 and $40 per barrel just a few months later as both being consistent with fundamentals Some speculative elements may have played a role as well.6 10.3 Macroeconomic Outcomes After the sharp increase in oil prices, the large decline in housing prices, and the ensuing financial turmoil, the macroeconomy entered a recession in December 2007 The recession first showed up in employment, as shown in Figure 10.6 Total nonfarm employment peaked at 138 million in 2007 By February 2010, nearly 8.5 million jobs had been lost As seen in Figure 10.7, short-run output turned sharply negative in the last quarter of 2008 and then bottomed out in the middle of 2009, falling more than percent below potential The recession can also be seen in the unemployment rate in Figure 10.8 From a low in 2007 of 4.4 percent, the unemployment rate rose sharply, peaking at 10 percent toward the end of 2009 A Comparison to Previous Recessions Table 10.1 provides an alternative perspective on the current recession This table shows some key statistics in two ways: averaged over previous recessions going back to 1950, and for the current recession For example, during a typical recession, GDP falls by about 1.7 percent In the recent recession, however, real GDP declined by more than twice as much — 4.7 percent On the recent sharp swings in oil prices, see James Hamilton’s “Oil Prices and Economic Fundamentals,” online at Econbrowser, July 28, 2008, and his more detailed study, “Understanding Crude Oil Prices,” NBER Working Paper No 14492, November 2008 10.3 475C@3 $ Macroeconomic Outcomes | 261 Total nonfarm employment peaked in December 2007, the date the recession is said to have started, at more than 138 million More than 8.4 million jobs were lost by February 2010 Nonfarm Employment in the U.S Economy Millions 139 138 137 136 135 134 133 132 131 130 129 2000 2002 2004 2006 2008 2010 2012 Year Source: The FRED database 475C@3 % After its initial resilience to the financial crisis, the real economy declined sharply At the bottom of the recession, real GDP was more than percent below potential U.S Short-Run Output, Y˜ ~ Short-run output, Y (percent) 4 3 2 1 1 2 3 4 5 6 7 8 2000 2002 2004 Source: The FRED database and author’s calculations 2006 2008 2010 2012 Year ... Introduction to Macroeconomics 1. 1 What Is Macroeconomics? 1. 2 How Macroeconomics Studies Key Questions 1. 3 An Overview of the Book 11 The Long Run 11 The Short Run 12 Issues for the Future 13 A Simple... of Ideas 13 6 99 Ideas 13 6 Nonrivalry 13 7 Increasing Returns 13 8 Problems with Pure Competition 14 0 6.3 The Romer Model 14 3 5 .1 Introduction 10 0 5.2 Setting Up the Model 10 1 Production 10 1 Capital... Exchange Rate Regimes 555 514 19 .1 Introduction 515 19 .2 Some Basic Facts about Trade 516 19 .3 A Basic Reason for Trade 518 19 .4 Trade across Time 519 19 .5 Trade with Production 5 21 Autarky 522 Free