Government policy, credit markets, and economic activity

The recession that began in late 2007 poses new challenges for macro-economic modeling. Asset values collapsed, initially in housing and then in equity [see Figure 5.1(a)]. In late 2008, interest rate spreads suddenly jumped to levels not seen in over seventy years [see Figure 5.1(b)]. There was widespread concern among policymakers that financial markets had become dysfunctional because of a deterioration in financial firm balance sheets associated with the fall in asset values. These concerns were reinforced by the dramatic fall in investment in late 2008 [see Figure 5.1(c)], which suggested that a serious breakdown in the intermediation sector might have occurred. The U.S. Treasury and Federal Reserve (Fed) reacted forcefully. The Fed‘s actions had the effect of reducing the cost of funds to financial institutions. For example, the Federal Funds rate was driven to zero [see Figure 5.1(d)] and the interest rate on the three-month commercial paper of financial firms also fell sharply. In addition, the Fed took a variety of unconventional actions by acquiring various kinds of financial claims on financial and nonfinancial institutions. Standard macroeconomic models are silent on the rationale and on the effects of the Fed‘s unconventional monetary policies. Still, there is casual evidence that suggests the Fed‘s unconventional monetary policy helped. The Fed began to purchase financial assets in late 2008, and financial firm commercial paper spreads dissipated quickly thereafter. In March 2009 the Fed expanded its asset purchase program enormously and corporate bond spreads also began to come down [Figure 5.1(b)]. Soon, aggregate output began to recover and the National Bureau of Economic Research declared an end to the recession in June 2009 [Figure 5.1(c)].