1.

INTRODUCTION :
Ec250 2022 Class notes Introduction
GOALS OF THE COURSE

• Expand your knowledge of macroeconomics, building on material

covered in the first-year course
• Enable you to understand and analyze recent economic events.

What is special this year?

The macroeconomy!
Which means that:
• Events will be interesting
• We will discuss things as they happen
• We will try to predict what is going to happen (although the course is
short – many changes in the economy take more time).
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Ec250 2022 Class notes Introduction

What is going on?

• Big changes in the economy during the pandemic
Now: – Supply chains disorganized
– Shortages of workers
– Shortages of many products, both final and intermediate
Examples: microprocessors, my favourite lemon juice
– Result: a combination of low unemployment and high
inflation
– Policy: raise interest rates to reduce demand and inflation
But – likely will cause another recession

Hence the title: Recession, Recession and another Recession? below

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Ec250 2022 Class notes Introduction

We will illustrate the topics of the course in a two-part introduction:

• Part one: the Great Lockdown Recession
Great lockdown – term used by Gita Gopinath, then Chief Economist
of the International Monetary Fund (or: the coronavirus recession, or
the current recession).

• Part two: the Great Recession

The goal of part one is to bring you up to date with current events
which are the most dramatic since the Great Depression in 1930s
The goal of part two is to have a look at a more regular recession, the
effects of which still lingered when the coronavirus hit.
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Ec250 2022 Class notes Introduction

A BRIEF HISTORY
THE GREAT RECESSION (2008-2009)
• House price boom
• Innovations in the credit market – mortgage-based securities
• Complex financial links
Result: financial market collapse
Table 1.1a Changes in the unemployment rate
Canada US
2008-01 2009-05 Difference 2007-05 2009-10 Difference
5.9% 8.7% 2.8% 4.4% 10% 5.6%

QUIET YEARS (2009-2019)

The economy systematically, if slowly, improved
Canada US
2009-05 2020-02 Difference 2009-10 2020-02 Difference
8.7 5.7% -2.9% 10% 3.5% -6.5%
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Ec250 2022 Class notes Introduction

THE GREAT LOCKDOWN RECESSION (2020)

First case in Canada – end of January 2020
Local transmission – beginning of March
March 12 – schools closed; March 16 – Laurier closed
March 21 – land border with the US closed.
Provincial responsibility – no uniform federal schedule
May 19 – first stage of reopening
More waves of the pandemic, but no general lockdowns
Canada US
Rising 2020-02 2020-05 Difference 2020-02 2020-04 Difference
unemployment 5.7% 13.4% 7.7% 3.5% 14.7% 11.2%
Falling 2020-05 2022-02 Difference 2020-04 2022-03 Difference
unemployment 13.4% 5.5% -7.9% 14.7% 3.6% -11.1%
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Ec250 2022 Class notes Introduction

15
US
12 Canada

3
2006 2008 2010 2012 2014 2016 2018 2020 2022

Unemployment rates
• The Great Recession was much more serious in the US, with the unemployment
rate increasing about twice as much between 2008 and 2010;
• The recovery from the Great Recession was more rapid in the US, with the
unemployment rate falling twice as much over the 10 years to 2020;
• Overall, the effects of the Great Recession in both countries lasted a long time,
with unemployment falling below pre-recession levels only after 10 years;
• The Great Lockdown Recession was much more rapid: unemployment increased
about 5% more than during the Great Recession, but fell rapidly to the pre-
recession levels within only 2 years;
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Ec250 2022 Class notes Introduction

• The cycle is much more volatile in the US than in Canada, with bigger variations
in unemployment.

THE BRIEF POST-PANDEMIC LULL (2020-2021)

The great resignation, as many people appeared to have left the labour force.

INFLATION RESURGENCE (2021-2022)

8%
Canada US
6%

4%

2%

0%

-2%
2006 2008 2010 2012 2014 2016 2018 2020 2022

So, in the current situation, central banks may:

(a) do nothing and wait for the inflationary period to pass;
(b) increase the inflation target to, for example, 4%;
(c) fight inflation by raising interest rates.
 1.8

Ec250 2022 Class notes Introduction

Central banks tried (a) – did not work

Unlikely they will try (b) – they invested a lot of reputation into the 2% target
Most likely: (c): fight inflation by raising interest rates
Soft landing – hard landing
Question: how far will interest rates have to go.
Talk: about 4%
Historical experience:

Month Inflation Bank Rate

Jul-77 8.31% 7.50%
Jan-83 8.24% 9.81%
22-Jun 8.13% 1.75%
 1.9

CHAPTER 1A: RECESSION , RECESSION , AND (PERHAPS )

Ec250 2022 Class notes Introduction

ANOTHER RECESION

THE GREAT LOCKDOWN RECESSION – THE EFFECT ON THE

CANADIAN ECONOMY, AND A COMPARISON WITH THE GREAT
RECESSION
PART 1: MACROECONOMIC VARIABLES
What you should know: What happened with
- output
- hours worked
- inflation
- labour force and employment
- employment and earnings
- unemployment
- foreign trade
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Ec250 2022 Class notes Introduction

Figure 1.1a. Output (2007-2022) Figure 1.1b. (1/2019-4/2022)

Much bigger drop of output than in the Great Recession:

- services fell 15%; in the Great Recession fell 0.7%
- output fell 17%, in the Great Recession fell 5%
Recovery: Are we good by now?
Has the economy made up the losses?
Difficult to see in the figure above as it shows changes from the year before. The
big increase in 2021 is relative to the big decrease in 2020.
Better: compare to trend – before the lockdown recession started
Answer: we are still behind.
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Ec250 2022 Class notes Introduction

Fig 1.1c

Average growth rate 2011-2019 = 2.26%

output is still about 2% below trend.

Output is growing faster than before the recession (4/2021-4/2022: 4.99%).

Will catch up in June 2023 - unless there is another recession.
We describe how Real GDP and other measures of output in chapter 2: “Calculating
Output”.
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Ec250 2022 Class notes Introduction

TWO EXTREMES: PUBLIC SECTOR AND RETAIL TRADE OUTPUT: FIG 1.1D,E

• big drop in retail trade (shut down stores): 30%; compared to only
5% drop in the Great Recession
• decline in the public sector (12% in April) – furloughed workers; in
the Great Recession there was little change in the public sector
Imputations: public services are included in GDP at cost. As long a
government worker gets paid, GDP is created.
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Ec250 2022 Class notes Introduction

HOURS WORKED: FIG 1.2 A, B

• usually – hours fall less than output: labour hoarding

• current recession: drop in hours (27%) bigger than output (17%)
(large proportion of jobs lost in low-productivity sectors)
• after the recession – a reversal: increase in hours (33%) greater
than in output (18%) (large proportion of jobs regained in the low-
productivity sectors)
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Ec250 2022 Class notes Introduction

Have hours returned to the pre-recession level? It is difficult to see from

the above graph. So we need to draw the graph relative to January 2020.
Hours

-10%
All industries

Goods-producing sector

-30%
Jan-20 Apr-20 Jul-20 Oct-20 Jan-21 Apr-21 Jul-21 Oct-21 Jan-22 Apr-22

Change 1/2011-4/2022, goods producing industries:

Output +3.0%
→ Productivity +1.5%
Hours +1.5%
Explanation: following the recession, firms increased productivity.
We describe the labour market, employment and unemployment in
chapters 7: The Labour Market and chapter 8: Unemployment.
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Ec250 2022 Class notes Introduction

INFLATION: FIG 1.3 A, B

8% 8%
All-items All-items

6% 6%
All-items excluding food and All-items excluding food and
energy energy
4% 4%

2% 2%

0% 0%

-2% -2%
2007 2009 2011 2013 2015 2017 2019 2021 Jul-19 Jan-20 Jul-20 Jan-21 Jul-21 Jan-22

• Inflation fell from 2% in January 2020 to -0.4% in April 2020

2008: huge increase in oil prices, followed by a collapse
2020: Russia – Saudi Arabia oil war, combined with demand decrease
because of the pandemic. Price of Canadian oil – negative!
2021-2022: prices of energy and food, as well as more or less everything,
increasing fast. Main economic problem now
We discuss inflation, its measurement and consequences, in Chapters
2 and 3
 1.16

Ec250 2022 Class notes Introduction

LABOUR FORCE AND EMPLOYMENT: FIG 1.4A, B

15% 15%

10% 10%

5% 5%

0% 0%

-5% -5%
Labour force Labour force
-10% -10%
Employment Employment
-15% -15%
2007 2009 2011 2013 2015 2017 2019 2021 Aug-19 Feb-20 Aug-20 Feb-21 Aug-21 Feb-22

• big drop in labour force in the current recession: in April 2020 – labour force
fell by 8%.
In a regular recession – some people drop out, but not many since recessions
are relatively short. In the Great Recession labour force was actually
increasing
• big drop in employment
In the Great Recession: fell by 2% (smaller than drop in output because of
labour hoarding); In April 2020 – by 15%
 1.17

Ec250 2022 Class notes Introduction

Reason: Canadian government provided support directly to workers

Alternative: provide support to firms to keep people on payroll (in Europe)
Note that the decline in output was 17%; decline in employment was 15%
and decline in hours was almost 30%. This means that labour productivity
(output per person) fell a little, while output per hour increased a lot.
Employment reached pre-recession level only in 10/2021
 1.18

Ec250 2022 Class notes Introduction

FULL-TIME VERSUS PART-TIME EMPLOYMENT: FIG 1.4 C, D

Great Recession: part-time employment increased; full-time employment fell 3.5%.

This is typical.
April 2020: much bigger drop in part-time (30%) than in full-time employment (12%).
Caused by the selection of businesses under lockdown: restaurants, hotels, service
places.
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Ec250 2022 Class notes Introduction

EMPLOYMENT AND EARNINGS (TOTAL): FIG 1.5 A, B

20% 20%

10% 10%

0% 0%

-10% Employment -10% Employment

Earnings Earnings
-20% -20%
2007 2009 2011 2013 2015 2017 2019 2021 Jun-19 Dec-19 Jun-20 Dec-20 Jun-21 Dec-21

• Paradox in the lockdown recession: Total employment falls by 15%;

average earnings increase by 9%
Note: Employment falls by 15% and earnings increase by 9% -> pay per
person rises 28%: 85% of workers get 109% of earnings: 109/85-1=28%
In a regular recession: employment falls, earnings fall or grow at a slower
rate. In the coronavirus recession: job losses were in sectors where pay was
low.
 1.20

Ec250 2022 Class notes Introduction

We can check that, by looking only at goods production: employment falls,

earnings do not change
EMPLOYMENT AND EARNINGS (GOODS PRODUCTION): FIG 1.6 A, B
20% 20%

10% 10%

0% 0%
Employment
(goods production)
-10% -10%
Earnings (goods
Employment (goods production)
production)
Earnings (goods production)
-20% -20%
2007 2009 2011 2013 2015 2017 2019 2021 Jun-19 Dec-19 Jun-20 Dec-20 Jun-21 Dec-21
 1.21

Ec250 2022 Class notes Introduction

FOREIGN TRADE: FIG 1.7 A, B

- Exports and imports fell as much as in the Great Recession

Trade remained open so even though drop in output was bigger than in the Great
Recession, the drop in trade was similar.
- Exports fell more than imports, both in 2020 and in 2008.
Why? US was more affected than Canada; US is by far our biggest trading partner.
We will talk about factors determining foreign trade in chapters 4:
Exchange Rates and chapter 9: The IS-IC Model: the Basic
Framework to Understand Macroeconomic Policy
 1.22

Ec250 2022 Class notes Introduction

SUMMARY

Great Recession Great Lockdown What is different

Output Fell 5%, drop bigger in Fell 17%; big drop in Much bigger drop in services
goods production than in services (15%) because of closures
services (0.7%)
Hours Smaller drop than output Bigger drop than in Hours fell more in low-
(4%) output (27%) productivity sectors
Inflation Fell below zero (-1%) Fell below zero: -0.4% Similar to Great Recession
Lab. Force Labour force increased a Fell 8%, back to pre- Big decline in labour force
little recession level within 6
months
Employment Fell 2% Fell 15% Big drop in part-time employment
Unemployment Rose to almost 9% Rose to over 13% Much bigger increase in
rate unemployment; faster decline
Earnings Slower growth as Increased! Employment fell in low-paying
employment fell businesses
Foreign trade Exports, imports both fell, Exports, imports both Similar to Great Recession
exports fell more fell, exports fell more
 1.23

Ec250 2022 Class notes Introduction

PART 2: POLICY RESPONSE

• Fiscal policy
• Monetary policy
FISCAL POLICY
Numerous fiscal measures:
Canada Emergency Response Benefit (CERB): $2000 per 4 weeks to
unemployed
Canada Emergency Student Benefit (CESB): summer support for students up
to $5000
Canada Emergency Wage Subsidy (CEWS) funds for employers to cover 75%
of employee wages.
Programs for seniors, Indigenous peoples, businesses, tax deferrals, specific
programs for various sectors and many others.
Record deficit: $314bln; in 2008-9 it was $67bln (current dollars)
 1.24

Ec250 2022 Class notes Introduction

Two reasons for deficit: lower revenue (as income and profits fell),
greater spending
FEDERAL DEFICIT: FIG 1.8 FEDERAL DEBT: FIG 1.9
1800
Gross debt Net debt
1600
0 1400
-50 1200
1000
-100
800
-150 600
-200 400
200
-250
0
-300

-350

Net debt (the sum of all past deficits) until 2019: $720bln. So the deficit
is almost 50% of the total before 2020.
But interest payments on debt fell, because of lower interest rates.
We discuss the fiscal policy issues in Chapter 11: Fiscal Policy
 1.25

Ec250 2022 Class notes Introduction

MONETARY POLICY
- Main tool: target for overnight rate - may affect other interest rates
In the Great Recession – reduced by 4%
In March 2020 – reduced by 1.5% - the fastest reduction in history
Zero lower bound – problem with reducing nominal interest rate
below zero
POLICY RATE IN CANADA AND THE US FIG 1.10
10%

8% Canada
US
6%

4%

2%

0%
1995 1999 2003 2007 2011 2015 2019

Note recent increase in the policy rates

 1.26

Ec250 2022 Class notes Introduction

Bank of Canada started buying assets on unprecedented scale

Why?
- Zero lower bound: could not reduce the overnight rate enough
- asset purchases raise asset prices and lower their interest rates
MONETARY POLICY: BANK OF CANADA LIABILITIES FIG 1.11
600

500

400

300

200

100

0
2007 2009 2011 2013 2015 2017 2019 2021

We discuss monetary policy in Chapter 10: Monetary Policy and the

Bank of Canada
 1.27

Ec250 2022 Class notes Introduction

SUMMARY

Great Recession Great Lockdown What is different

Fiscal policy $67 billion deficit $314 billion deficit Much bigger deficit
Monetary policy
Bank of Canada Fell 4% Fell 1.5% Could not reduce as much
policy rate because of zero lower bound
Asset purchases Minimal Huge: BofC assets Bought huge amounts of
increased fivefold assets to increase their prices
and lower their interest rates
 1.28

CHAPTER 1B: THE GREAT RECESSION .

Ec250 2022 Class notes Introduction

We will spend a lot of time discussing the Great Recession and its
aftermath. The goal is twofold:
• it will provide you with the knowledge and understanding of, and the
ability to intelligently discuss, macroeconomics. This may prove
invaluable in your future careers.
• It will show you what a usual recession looks like (as opposed to the
current recession).
The pandemic is a very unusual event; the previous one was 100 years
ago. On the other hand, recessions happen much more often.
 1.29

Ec250 2022 Class notes Introduction

PART 3. LEHMAN BROTHERS BANKRUPTCY AND CREDIT PANIC

• Surprise – as before other companies saved

• Moral hazard
• Silver lining: AIG rescued

Credit panic

• Tangled web of financial obligations

• How we define recessions?
• How bad was it?
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Ec250 2022 Class notes Introduction

The Great Recession started 14 years ago this week! Around 1am Sep 15,
2008. Lehman Brothers filed for liquidation
At that time fourth largest investment bank in the US.
Note: recession in the US started in December 2007. Lehman bankruptcy
made it Great (not a good thing).
Three points:
1. Dates of recessions – determined by independent bodies (NBER in the
US, CD Howe in Canada), not governments
Not: two quarters of falling output
2. Takes time to figure out recession has started (NBER determined it a
year later)
3. Canadian recessions need not coincide with US recessions.
 1.31

Ec250 2022 Class notes Introduction

A BRIEF HISTORY

1.1. LEHMAN BROTHERS BANKRUPTCY.

Lehman Brothers - in trouble for some time.
Bad investments in real estate; rapidly deteriorating assets
The general expectation was that the government and the Federal
Reserve (FED) will step in and find a buyer who will save the firm from
bankruptcy
- March 2008 – FED arranged a purchase of Bear Sterns by JP Morgan
- September 8, 2008 – rescue of Fannie Mae and Freddie Mac: private
companies created by the US government to improve the liquidity
in the housing market and availability of mortgages.
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Ec250 2022 Class notes Introduction

WHY WAS LEHMAN BROTHERS ALLOWED TO FAIL?

Concern about moral hazard.

Moral hazard arises when a company (or an individual) does not have
to bear all consequences of its actions.
(Recall adverse selection and how it differs from moral hazard)
- Treasury and Fed officials concerned that, if they save another failing
investment bank, the pattern of government intervention will be
established and moral hazard will be a big problem
- Later they claimed they did not have legal authority to bail out Lehman
because it did not have sufficient collateral. But recently it was argued
that they did not try to assess the collateral.
 1.33

Ec250 2022 Class notes Introduction

- Largest bankruptcy ever: $700 bln in assets.

- The largest previous bankruptcy was Worldcom, 2002, $100bln in
assets
- Investment banks borrow large amounts; have little capital; owed
lenders $650bln. The have long-term assets, short-term liabilities
Silver lining: two days later, AIG, an insurance company, was collapsing.
Assets – three times bigger than Lehman
AIG sold credit default swaps – private contracts
Concerned by market panic, policymakers bailed out AIG
Scary scenario: Lehman – bailed out, AIG allowed to fail. Would have
been much worse
Markets - caught unprepared.
 1.34

Ec250 2022 Class notes Introduction

1.2. CREDIT PANIC

- tangled web of financial obligations between financial institutions
- derivatives, credit default swaps
- obligations not traded on organized exchanges

→ creditworthiness of potential borrowers difficult to assess

→ banking system froze – very difficult to obtain credit

George Soros: “the economy fell off the cliff”.

Recession - usually defined as two consecutive quarters of falling
output. Actual definition – more complex.
NBER (National Bureau of Economic Research): the recession started in
December 2007. In September 2008 it got much worse
 1.35

Ec250 2022 Class notes Introduction

Most economic activities require credit. Without credit there is:

- decline in investment
- decline in output
- rapid rise of unemployment
- consumer pessimism – decline in consumption
How bad did it look: Ben Bernanke, FED Chair: “the worst financial crisis
in global history, including the Great Depression”
All but one of the largest US financial institutions were a week or two
from collapse.
Why call it the Great Recession? To distinguish from lesser (ordinary)
recessions and from the Great Depression
 1.36

Ec250 2022 Class notes Introduction

PART 4. POLICY RESPONSE

Monetary policy
• Reduce policy rates
• Zero lower bound
• Quantitative easing – purchases of new types of assets
• Forward guidance
• In effect - negative nominal interest rates
Fiscal policy
• Discretionary
• Automatic
• Deficits and debt
 1.37

Ec250 2022 Class notes Introduction

1.3. THE POLICY RESPONSE

In the end – not as bad as feared.
Unemployment peaked at 8.8% in Canada (13.4% in the current
recession, 10.6% in the US (over 14% in the current recession; in the
Great Depression it was over 20%).
We will talk about factors affecting unemployment in chapter 8:
“Unemployment”.
Active macroeconomic policies to counteract the Great Recession:
expansionary monetary and fiscal policies.
- used lessons from the Great Depression.
Main monetary policy intervention: reduce short-term nominal interest
rates. Central bank has direct control of those rates.
Reduced nominal interest rates to near zero.
 1.38

Ec250 2022 Class notes Introduction

Reduction policy rate in 2008 US:

5.25%
Canada: 4.25%

Policy rates in Canada and the US

Zero lower bound – difficult to reduce nominal interest rates below zero
Policy limited by zero lower bound – at that time belief that nominal
interest rates cannot be negative
Recall that low interest rates limited monetary policy in the current
recession
Subsequently central banks employed alternative policies
 1.39

Ec250 2022 Class notes Introduction

- quantitative easing - purchases of assets of longer

maturity, also non-government assets – in the US; in
Canada more recently
- forward guidance - affecting expectations by
promising to keep interest rates low for extended
periods
This – still not enough. In the last few years –
negative nominal interest rates
How low can the nominal interest rate go?
A negative rate – absurd. But around $17 trillion of
assets in 2017 had negative yields
Alternative: safety deposit box. How big?
$1million US in$100 bills weighs 10kg; about 0.05 cubic meters.
$17 trillion = around 1 million m3. That is 1/15th of the volume of the
Boeing Everet Factory – the world’s largest building by volume.
 1.40

Ec250 2022 Class notes Introduction

Fiscal policies: discretionary and automatic

- Discretionary: raise gov purchases and transfers, cut taxes
- Automatic: changes in spending and taxation that take place
without government action: higher unemployment and welfare
payments, lower income taxes as income falls.

Both active and automatic fiscal policies raise deficit and debt →
concerns about debt level and drive to reduce spending in several
countries.
 1.41

Ec250 2022 Class notes Introduction

PART 5. HOW THE GREAT RECESSION CAME ABOUT

• Low interest rates -> High housing demand

Developments in the financial system
• Loan securitization
- Rating companies
- Decline in lending standards
• Sub-prime loans
• Adjustable rate mortgages (ARM)
• Leverage

Rising house prices

• Higher wealth and consumption
• Bubble?
 1.42

Ec250 2022 Class notes Introduction

1.4 HOW THE GREAT RECESSION CAME ABOUT

- 2001 recession – low interest rates
- Low interest rates – encourage house buying
- Low inflation subsequently – the Fed kept interest rates low
Fed goal: “to promote effectively the goals of maximum employment,
stable prices, and moderate long-term interest rates
Bank of Canada – targets inflation between 1% and 3%
 1.43

Ec250 2022 Class notes Introduction

1.4.1 DEVELOPMENTS IN THE FINANCIAL SECTOR

Profitable innovations in the financial system in 1980s

LOAN SECURITIZATION.
Mortgages from many properties are put together (pooled) into a
security (called a Mortgage-Backed Security) which is then sold to
investors
- removes the risk of nonperforming loans from the bank that gave
the mortgage → moral hazard
If the borrower defaults- someone else loses money

- provides the bank with funds to give more mortgages

 1.44

Ec250 2022 Class notes Introduction

Evaluated by rating companies - paid by issuers of securities. The higher

the rating, the higher is the profit of the issuer who may then choose to
rate more securities with the rating company. What could go wrong?!
Profitable process:
- individual mortgages pay high interest rates
- risk appears diversified – it is unlikely that many mortgages in a
pool default at the same time
- pools of mortgages appear less risky, so a mortgage- backed
security has high yield and perceived low risk
Decline in lending standards due to moral hazard
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Ec250 2022 Class notes Introduction

SUB-PRIME LOANS.
Demand exceeded supply –banks increased loans to riskiest borrowers
Sub-prime: loan to borrower who does not qualify for a regular (prime)
loan
- higher default risk, so pay higher interest rates
Pooling sub-prime loans with prime loans created securities with high
yield and relatively low risk
Adjustable rate mortgages (ARM).
- the initial interest rate is low
- it increases significantly after 2 or 3 years
- borrower expects to take advantage of house appreciation and
refinance
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Ec250 2022 Class notes Introduction

LEVERAGE.
Leverage - based on using borrowed money to acquire assets.
Definition: Leverage is equal to the ratio of assets to the difference
between assets and liabilities (excluding capital).
LEVERAGE EXAMPLE.
Assets Liabilities
Loans Short-term
900 300
deposits
Mortgages Long-term
1 000 1 600
deposits
Vault cash and
reserves at the central 100 Capital 100
bank

Leverage = 20
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Ec250 2022 Class notes Introduction

Why leverage?
- Multiplies gains and losses.
- Financial institutions around the world were very heavily leveraged.
Leverage of 33 was not uncommon; some institutions had leverage
of 50.
- Extent of leverage – hidden by accounting tricks.
Why leverage? Higher profits if things work out well
But big losses when things do not work out well
High leverage makes the banking system risky
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Ec250 2022 Class notes Introduction

1.4.2. RISING HOUSE PRICES

Sub-prime and ARM mortgages - ok in a rising market:

- when the value of the house increases, the borrower can refinance
- the proceeds from refinancing can be used to make mortgage
payments.
So even borrowers with weak credit history are expected to be able to
service their mortgage
Too much sub-prime loans:
Loan securitization → moral hazard → sub-prime loans profitable →
easy to obtain
Self-reinforcing process:
- higher house prices →lower risk of default→ higher demand and
supply of mortgages →more house purchases → higher house prices
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Ec250 2022 Class notes Introduction

1.4.3. WEALTH EFFECT OF HIGHER HOUSE PRICES

The increase in house prices makes homeowners feel wealthier.

We discuss the effect of wealth on consumption in chapter 5: “Consumption”
When households feel wealthier, they increase spending.
So: Higher house prices → higher consumption, lower savings
Favourable business conditions:
Consumption – 2/3 of GDP in the US . When consumption rises, so does
investment and output. Higher output leads to higher demand for
housing, higher house prices and higher consumption.
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Ec250 2022 Class notes Introduction

WAS IT A BUBBLE?

A bubble is a situation when the asset is overvalued (relative to fundamentals)

but people continue to buy it in the expectation that its price will increase even
more.
- In retrospect, yes.
- Bubbles - easy to identify after the fact: a rapid increase in prices is
followed by a rapid decrease.
- Difficult to identify contemporaneously
Fundamentals may have changed:
- financial deregulation reduced the cost of financing.
- securitization reduced the risk of sub-prime lending.
So the increase in house prices could be viewed at the time as justified by
changed fundamentals
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Ec250 2022 Class notes Introduction

PART 6. THE FINANCIAL CRASH

• Overbuilding
• Rising interest rates
• Mortgage defaults
• Foreclosures and house price decreases
• Financial institution losses
• Credit market freezes
 1.52

Ec250 2022 Class notes Introduction

1.5 THE FINANCIAL CRASH

1.5.1. THE DECLINE IN HOUSE PRICES.

- large, speculative supply of housing (overbuilding)

- Fed raises interest rates → demand falls
High supply, low demand → prices start falling (in the second half of
2006).
250

200

150
Figure 1.1. US house
prices 100

Source: S&P/Case-Shiller 50
National Home Price Index, 10
cities, seasonally adjusted, 0
nominal 1990 1994 1998 2002 2006 2010 2014 2018
 1.53

Ec250 2022 Class notes Introduction

1.5.2. MORTGAGE DEFAULTS

- No longer possible to refinance – homeowners “under water”
- Non-recourse loans → limited penalty for defaulting
FORECLOSURES AND FURTHER DECREASE IN HOUSE PRICES.
Owner does not pay interest, the mortgage owner can foreclose
Vicious circle: House prices fall →owners are unable to refinance and default
on loans → bank forecloses → bank sells the property → with the extra supply
house prices fall further
FINANCIAL INSTITUTION LOSSES.
- Defaults and foreclosures → the value of mortgage-based securities falls.
- Financial institutions incur losses, sell securities, reducing prices further
Complex web of interrelationships – uncertainty about solvency of the
potential borrower → credit market freezes
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Ec250 2022 Class notes Introduction

PART 7. EFFECT ON THE REAL ECONOMY

• Credit problems
• Lower household wealth - > lower consumption
• Lower investment
Three channels of transmission abroad
• Financial markets
• International trade and integrated supply chains
• The effect of the crash in the US on business and consumer attitudes
in other countries.
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1.6. EFFECT ON THE REAL ECONOMY.

Financial crisis →
- reduced the availability of credit
- lower consumer confidence
- unemployment concerns
Decline in house prices →
- lower household wealth
So:
- lower consumption
- big drop in demand for things bought on credit (cars, large ticket
items)
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Big decline in investment, typical in recessions.

Main reasons: lower demand, uncertainty about the future
- business fixed investment – falls as firms postpone projects
- inventory investment falls since demand is lower and firms reduce
operational costs
- residential construction falls as people stop buying new homes
We discuss factors affecting investment in chapter 6: “Investment”.
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1.7. THE CRISIS SPREADS ABROAD.

US – about 20% of the world economy; world’s biggest importer.
Typical effect of a recession in the US - through international trade.
- US output falls → US imports fall.
- Recession in the US need not cause a recession in other countries
(for example 2001 – did not cause a recession even in Canada).
- Other countries – less affected than Canada as have weaker trade
links

Note: different way GDP and international trade are calculated

• GDP – value added in the product
• Trade: full value of the product
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1.7.1. THREE CHANNELS OF TRANSMISSION IN THE GREAT RECESSION.

1. Through financial markets

The most important channel
- Mortgage-based securities - sold around the world (to German
banks, Spanish pension funds, Argentinean insurance companies
etc).
- Derivative exposure – unknown and so creditworthiness of financial
institutions – suspect.
- High leverage in European institutions.
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2. International trade and interconnected supply chains

Unprecedented trade decline: world trade fell by over 20%; in Taiwan,
it fell over 40%.

- Complex goods - rarely produced in a single country.

- Production - organized through international, interconnected supply
chains: components are made in many different countries, final
assembly somewhere else.
Big problem now as the supply chains got disorganized.
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Note: imagine US tariffs on iphones from China

3. The effect of the crash in the US on business and consumer attitudes
in other countries.
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PART 8. THE CRISIS IN CANADA

• Economy before – in good shape

• Solid banking system
• Strong export channel
• Big effect on business and consumer attitudes
Comparison with the US
• Output
• Unemployment
• Exchange rate
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1.8 THE CRISIS IN CANADA

Before the Great Recession, the Canadian economy was in good shape.
- Low unemployment, fast growth, government budget surpluses
(both federal and provincial), high resource prices.
Limited effect on financial markets: Solid banking system
- Lower leverage, High capital ratios, Less securitization of mortgages,
Few high – ratio mortgages; need to be insured
World Economic Forum – called Canadian banks the best in the world
Export channel - particularly strong in Canada.
- The US economy is our largest trading partner, by far.
- US: 75% of Canadian exports
- Britain: 3% of exports
- Especially hard hit: the car industry - Canadian automobile exports
fell 40%.
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Effect on business and consumer attitudes: important.

- Canadian households became concerned about the severe
recession in the US and reduced spending.
- Investment fell as firms took a “wait and see” approach and
delayed projects.
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1.8.1. OUTPUT
104
Real GDP in Canada and the US, 102
Q4 2007=100 100
98
Output decline in Canada 96
94
- started a quarter later 92
Q1 Q1 Q1 Q1 Q1 Q1 Q1 Q1
- about as deep 2005 2006 2007 2008 2009 2010 2011 2012
Canada US
- the economy rebounded
faster
104
102
100
GDP by quarter
98
0=Q3 2008, Canada 96
94
0=Q2 2008, US -8 -4 0 4 8 12
Canada US
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1.8.2. UNEMPLOYMENT

- Historically – US unemployment lower (around 2% lower)

- just prior to the Great Recession – similar rates (around 6%)
- increase in Canada – smaller (to 8.8%; in the US to 10.6%)
- by 2012 declines to 7% in
Canada, to 9% in the US
- in March 2020: 5.6% in Canada,
3.5% in the US
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1.8.3. EXCHANGE RATE

- reached parity in October 2007,

- depreciated 20% during the recession as there was flight to US
bonds – biggest and most liquid market
- has appreciated after crisis subsided
1.05
1.00
0.95
0.90
0.85
0.80
0.75
2007-01 2008-01 2009-01 2010-01 2011-01 2012-01

We discuss exchange rates in Chapter 4: “Exchange Rates”.

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1.9. SUMMARY
• The Great Recessions
• Caused by financial market developments and credit panic
o Financial crisis and the real economy
o How the crisis spread abroad
• Policy response
o Monetary – traditional and new approaches
o Fiscal – automatic and discretionary
• The crisis in Canada
o Output
o Unemployment
o Exchange rates
• Lessons?
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Leverage example

Leverage is the ratio of the value of the asset to own money

Asset = 100
Borrow 90 so own money = 10
Leverage = 100/10 = 10

100 – value of the house

10 – own money
20 – loss
Return = -20/10=-200%