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PA R T V I I Monetary Theory
APP LI CAT IO N
The Subprime Recession
With the advent of the subprime financial crisis in the United States in the summer
of 2007, the Fed and many other central banks around the world, including the
Bank of Canada, began very aggressive easing of monetary policy. For example,
the Fed dropped the target federal funds rate from 5.25% to between 0% and 0.25%
over a fifteen-month period from September 2007 to December 2008. At first, it
appeared that the Fed s actions would keep the growth slowdown mild and prevent a recession. However, the U.S. economy proved to be weaker than the Fed
or private forecasters expected, and a recession began in December of 2007. Why
did the economy become so weak despite this unusually rapid reduction in the
Fed s policy instrument?
The subprime meltdown led to negative effects on the economy from many of
the channels we have outlined above. The rising level of subprime mortgage
defaults, which led to a decline in the value of mortgage-backed securities and
CDOs, led to large losses on the balance sheets of financial institutions. With
weaker balance sheets, these financial institutions began to deleverage and cut
back on their lending. With no one else to collect information and make loans,
adverse selection and moral hazard problems increased in credit markets, leading
to a slowdown of the economy. Credit spreads also went through the roof with
the increase in uncertainty from failures of so many financial markets. The decline
in the stock market and housing prices also weakened the U.S. economy, because
it lowered household wealth. The decrease in household wealth led to restrained
consumer spending and weaker investment, because of the resulting drop in
Tobin s q.
With all these channels operating, it is no surprise that despite the Fed s aggressive lowering of the federal funds rate, the U.S. economy still took a big hit.