UMD ECON 201 - Chapter 15: Financial Crises, Stabilization, and Deficits

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Chapter 15: Financial Crises, Stabilization, and Deficits -Problems with trying to stabilize the economy: stock market and housing market prices have important effects on the economy and theses changes in prices are unpredictable; getting the timing right; government deficit issues The Stock Market, the Housing Market, and Financial Crisis - The stock market contributed to the boom in the last half of the 1990s and to the recession that followed - The housing market contributed to the expansion in 2002-2007 and to the recession that followed - Firms can finance their investments by...o Borrowing from a bank; bank loans the money to the firm, the firm uses the money, the firm pays back the loan over time with interest o Firm can issue a bond; people buy bonds from a firm thereby making a loan to the firm o Firm can issue additional shares of stock: a certificate that certifies ownership of a certain portion of a firm; when a firm issues a new share of stock it does not add to its debt  Share of common stock: is a certificate that represents the ownership of a share of a business almost always a corporation Shareholders share in the company’s profit  Dividend: when profits are pa id directly to shareholders Capital gains: an increase in the value of an asset; stockholders who own stocks that increase in value  Realized capital gains: the gain that occurs when the owner of an asset actually sells it for more than he paid for it Price of stock is affected by what people expect its future dividends will be, the time the dividends are expected to be paid (the farther into the future the dividend is expected to be paid, the more it will be discounted; depends on interest rate; the larger the interest r ate, the more expected future dividends will be discounted); certainty If everyone expects that everyone else expects that the price will be driven up, the price may be driven up. One might call this outcome a bubble bc the stock price depends on what ppl expect that other ppl expect and so on. - Dow Jones Industrial Average: an index based on the stock prices of 30 actively traded large companies. The oldest and most widely followed index of stock market performance- NASDAQ Composite: an index based on the stock prices of over 5,000 companies traded on the NASDAQ Stock Market. The NASDAQ market takes its name from the National Association of Securities Dealers Automated Quotation System.- Standard and Poor’s 500 (S&P 500): an index based on the stock prices of 500 of the largest firms by market value. o Boom between 1994 and 2000: puzzle as to why; bubble? >> problem for the stability of the economy: large and seemingly unpredictable swings in the stock market - Housing prices grew roughly in line with the overall price level until about 2000; 2000-2006 grew rapidly; 2006-2009 huge fall - An increase in wealth increases consumer spending; much of the fluctuation in household wealth is due to fluctuations in stock prices and housing prices - Fall of housing prices that began in 2006 led to financial crisis of 2008/2009: some of the reasons for this fall…o Lax government regulations led to excessive risk taking during the housing boom, with many people taking out mortgages that could only be sustained if housing prices kept rising; once prices began to fall it became clear that people had taken on too much debt and the value of many mortgage-backed securities dropped >> many large financial institutions were involved in the mortgage market and they began to experience financial trouble - US gov bailed out many of the large financial institutions o Positive side: lessened the negative wealth effect and possibly led to more loans to businesses; much of the lending has or will be repaido Negative side: political and social costsTime Lags Regarding Monetary and Fiscal Policy- Stabilization policy: describes both monetary and fiscal policy, the goals of which are to smooth out fluctuations in output and employment and to keep prices as stable as possible; achieve inflation rate that is as close as possible to a target rate of about 2% - Time lags: delays in the economy’s response to stabilization policies o Recognition lags: it takes time for policy makers to recognize a boomor a slumpo Implementation lags: the time it takes to put the desired policy into effect once economists and policy makers recognize that the economy is in a boom or a slump; monetary policy implementation lag is much shorter than for fiscal o Response lags: the time that it takes for the economy to adjust to the new conditions after a new policy is implemented; the lag that occurs bc of the operation of the economy itself  Response lags for fiscal policy: think about the response lag for fiscal policy through the government spending multiplier; when the gov spends more money, firms do not adjust their spending instantaneously Response lags for monetary policy: the response of consumption and investment to interest rate changes takes time; monetary policy has longer response lags than fiscalGovernment Deficit Issues- Recession: cyclical deficit - Deficits require that the government borrow money to finance them; US Treasury must sell bills and bonds; if the Fed buys them which increases the money supply the government is simply financing the deficit by printing money; this is not a viable long run strategy >> will lead to excess aggregate demand and hyperinflation; if US Treasury is forced to sell the bonds to the US public and foreigners this may drive down the price of bonds and drive upthe interest rate on the bonds which makes deficit worse - Long run concerns from continuing deficits: interest rates are driven up thus exacerbating the deficit problem; possibility of a negative reaction from the stock market - Gramm-Rudman-Hollings Act: passed by Congress and signed by PresidentReagan in 1986, this law set out to reduce the federal deficit by $36 billion per year, with a deficit of zero slated for 1991; ruled unconstitutional so then changed; these targets never came close to being achieved >> deficit targeting can make the economy more unstable - Automatic stabilizers: revenue and expenditure items in the federal budget that automatically change with the economy in such a way as to stabilize GDPo Thus the decrease in aggregate output caused by a negative demand shock is lessened somewhat by the growth of the deficit o Without deficit targeting: negative demand shock >> income


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UMD ECON 201 - Chapter 15: Financial Crises, Stabilization, and Deficits

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