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Economics: Theory Through Applications
30-1
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Chapter 30
The Global Financial Crisis
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Learning Objectives
•
What was the role of coordination games in the crisis?
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What was the monetary policy response to the crisis?
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What was the fiscal policy response to the crisis?
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How did the financial crisis spread to the aggregate economy?
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What was the fiscal policy response?
•
What was the monetary policy response?
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Learning Objectives
•
What are the ways the crisis spread from the United States to the rest of
the world?
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In what ways did the institutional structure of the European Union (EU)
hamper Europe’s ability to cope with the crisis?
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What are the causes of a currency crisis?
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How is a currency crisis related to a financial crisis?
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Crisis in the United States
nominal value of service flow from the house over the next year
nominal interest factor
price of the house next year

nominal interest factor
value of the house this year 
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Figure 30.1 - The Payoffs in a Bank-run Game
with and without Deposit Insurance
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Table 30.1 - The Federal Funds Rate: Target
and Realized Rates
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Lowering Interest Rates
loan rate  probability of loan repayment  cost of funds to the bank
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A $700 Billion Bailout
government deficit  change in government debt  change in money supply
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From Housing to the Aggregate Economy
real GDP  planned spending  autonomous spending  marginal propensity to spend  real GDP
real GDP 
autonomous spending
1  marginal propensity to spend
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Table 30.2 - State of the Economy: Growth
Rates in 2006–2010
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Figure 30.2 - The Foreign Sector in the
Circular Flow
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Figure 30.3 - Stock Markets around the
World Crashed Together
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Key Terms
•
Coordination game: A coordination game is a strategic situation where
there are multiple equilibria
•
Nash equilibria: Nash equilibrium is used to predict outcomes in strategic
situations
– In a Nash equilibrium, (a) each player chooses the action that gives him the
highest payoff, based on his predictions of the other players; and (b) each
player’s predictions of the actions of the other players are correct
•
Coordination failure: A coordination failure occurs if the outcome of the
coordination game is one of the equilibria outcomes which are worse than
other equilibria
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Key Terms
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Discounted present value: Discounted present value is a device for
measuring flows that occur over time
– It tells you the value of something you will receive in the future, discounted
back to the present
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Deposit insurance: Deposit insurance is a government program which
insures the deposits (subject to some limits) of individuals at banks
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Key Terms
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Aggregate expenditure model: The aggregate expenditure framework
studies the relationship between planned spending and output
•
Circular flow of income: The circular flow of income measures the money
flows among the different sectors of the economy as individuals and firms
buy and sell goods and services
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Multiplier: The multiplier equals one divided by one minus the marginal
propensity to spend and is key to understanding how a change in
autonomous spending effects output in the aggregate expenditures model
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Key Terms
•
Contagion effect: A contagion effect arises when outcome in one market
effects the beliefs and thus the behavior of participants in other markets,
perhaps in another country
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Comparative advantage: A person has a comparative advantage in the
production of one good if the opportunity cost, measured by the lost
output of the other good, is lower for that person than for the other
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Commitment problem: A government suffers from a commitment problem
when it is not able to make credible promises to pursue actions regardless
of how others respond to those actions
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Key Terms
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Currency board: Under a currency board, one country maintains a fixed
exchange rate by backing its currency completely with another currency.
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Inflation tax: An inflation tax occurs when the government prints money
to finance its deficit
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Currency crisis: A currency crisis is a sudden and unexpected rapid fall in
the value of a currency
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Fixed exchange rate: In a fixed exchange rate regime, a central bank
uses it tools to target the value of the domestic currency in terms of a
foreign currency
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Key Terms
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Flexible exchange rates: Under a flexible exchange rate system, market
forces determine exchange rates
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Devaluation: A devaluation is a decrease in the value of a currency in a
fixed exchange rate
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Coordination game: A coordination game is a strategic situation where
there are multiple equilibria
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Key Takeaways
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Though there were no bank runs in the U.S. during the recent crisis, the
structure of coordination games is useful for thinking about instability of
the housing sector, the interactions of banks within the financial system
and the interaction between income and spending
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During the crisis, the Fed moved aggressively to lower interest rates and
provide liquidity to the system
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The Bush administration created a $700 billion program to purchase or
guarantee troubled assets, such as mortgages and shares of financial firms
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Key Takeaways
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Disruptions in the financial system led to reductions in consumption and
investment and this led to a fall in real GDP
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An $800 billion stimulus package was passed in February 2009 to offset the
recessionary effects of the financial crisis
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From December 2008 through (at least) the summer of 2010, the target
federal funds rate was near zero
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Key Takeaways
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The United States and the rest of the world are linked through many
channels
– Key channels that allowed the crisis to spread were financial links due to both
holdings of assets across borders and the spread of pessimism across markets
– In addition, links across countries due to trade flows meant that as real GDP
fell in some countries, exports and thus real GDP fell in others
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Key Takeaways
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Within the EMU, individual countries were limited in fiscal policy
responses due to restrictions on debt outstanding
– Further, the ECB supposedly follows an inflation target rule and thus is not able
to directly intervene to stabilize outcome
– In the end, countries did take fiscal actions and the ECB ultimately did provide
needed liquidity to Europe
– But this experience highlighted some of the costs of a monetary union
•
A currency crisis can occur for a number of reasons including being a
consequence of a financial crisis or of a fiscal crisis or, in some cases, just
driven by expectations like a bank run
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Key Takeaways
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A financial crisis can lead to a currency crisis if depositors in one country,
seeing the collapse of a financial system, rush to convert home into
foreign currencies
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