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The Global Financial Crisis of 2007–20??
Charles I. Jones
∗
 A Supplement to
Macroeconomics 
(W.W. Norton, 2008)
March 12, 2009
 Abstract
This note provides a macroeconomic analysis of the global financial crisis thatbegan in 2007 and continues to this day. What caused the crisis, where does theeconomy currently stand, and what are the prospects going forward? One way toview recent events is as a balance sheet crisis, both among financial institutionsand households. The associated recession is already long and deep. And whilethe economy will surely recover at some point, the prospects for a recovery in thenear term do not look good. This note reviews key macroeconomic facts, providesan introduction to balance sheets and various financial concepts, and studies thefinancial crisis through the lens of some standard macroeconomic models.
∗
Graduate School of Business, Stanford University. Preliminary — comments welcome. I am gratefulto Jules van Binsbergen, Pierre-Olivier Gourinchas, Pete Klenow, James Kwak, Jack Repcheck, and DavidRomer for helpful suggestions.
 
2
CHARLES I. JONES
1. Introduction
The world economy is currently beset by more macroeconomic uncertainty than atanytimeinthelast25years. Thefinancialcrisisthatstartedinthesummerof2007andintensified in September 2008 has remade Wall Street. Financial giants such as Bear-Stearns,LehmanBrothers,Merrill-Lynch,AIG,FannieMae,FreddieMac,andCitigrouphaveeitherdisappearedorbeenrescuedthroughlargegovernmentbailouts. Goldman-Sachs and Morgan-Stanley converted to bank holding companies in late September,perhaps marking the end of investment banking in the United States. While the U.S. economy initially appeared surprisingly resilient to the financial cri-sis, that is clearly no longer the case. The crisis that began on Wall Street has migratedto Main Street. The National Bureau of Economic Research, the semi-official organiza-tionthatdatesrecessions,determinedthatarecessionbeganinDecember2007. Bythestart of 2009, the unemployment rate had risen to 7.6%, up from its low before the cur-rent recession started of 4.4%. Forecasters expect this rate to rise to 9% or even higherby2010,anditseemslikelythatthiswillgodowninhistoryastheworstrecessionsincethe Great Depression of the 1930s.Thischapterprovidesanoverviewoftheseeventsandplacesthemintheirmacroe-conomiccontext. Howdid weget here, what are policymakers doing, and, most specu-latively, where is the economy headed? We begin by documenting the macroeconomicshocks that have hit the economy in recent years. Next, we consider data on macroe-conomic outcomes like inflation, unemployment, and GDP to document the perfor-mance of the economy to date.The chapter then studies how financial factors impact the economy. We begin by introducing several financial concepts, especially balance sheets and leverage. Clearly,there is a crisis among financial institutions tied to a decline in the value of their assetsand the effect this has on their solvency in the presence of leverage. But the crisis hasalsostruckhouseholdbalancesheetsthroughadeclineintheirassets,notablyhousing and the stock market. As a result, households have cut back their consumption, reduc-ing the economy’s demand for goods and services. In this sense, the current crisis istightly linked to balance sheets, both on the firm side and the household side.The chapter then turns to augmenting the IS/MP and Aggregate Supply / Aggregate
 
THE GLOBAL FINANCIAL CRISIS, MARCH 2009
3Demand (AS/AD) frameworks of 
Macroeconomics 
to study recent events. In particu-lar, we show how the financial crisis has generated a wedge between the relatively low interestratessetbytheFederalReserveandtheinterestrateatwhichfirmsintheecon-omycanborrow. Thesehigherinterestratesreduceinvestment. Atthesametime,thereis the balance sheet crisis on the household side: a large decline in household wealth,both through the value of housing and through the decline in the stock market. To-gether with a substantial increase in uncertainty faced by firms and households, thesefactors combine to represent a very large negative shock to aggregate demand in theeconomy.The chapter concludes with a discussion of the various policy actions that are tak-ing place in response to the crisis, ranging from the enormous expansion of the Fed’sbalance sheet in an effort to stimulate lending to the recent $787 billion fiscal stimuluspackage passed as the American Recovery and Reinvestment Act of 2009.
2. RecentShockstotheMacroeconomy 
 What shocks to the macroeconomy have caused the global financial crisis? A naturalplace to start is with the housing market, where prices rose at nearly unprecedentedrates until 2006 and then declined just as sharply. We then discuss the rise in interestrate spreads (one of the best ways to see the financial crisis in the data), the decline inthe stock market, and the movement in oil prices.
2.1. HousingPrices
The first major macroeconomic shock in recent years is a large decline in housing prices. In the decade leading up to 2006, housing prices grew rapidly before collaps-ing by more than 25 percent over the next three years, as shown in Figure1. Fueled by demand pressures during the “new economy” of the late 1990s, by low interest ratesin the 2000s, and by ever-loosening lending standards, prices increased by a factor of nearly 3 between 1996 and 2006, an average rate of about 10% per year. Gains were sig-nificantly larger in some coastal markets, such as Boston, Los Angeles, New York, andSan Francisco. Alarmingly, the national index for housing prices in the United States declined by 
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