Assignment:

You work as an analyst at an investment bank. The CEO of the firm just came back from the Annual Policy Symposium at Jackson Hole. He tells you that he listened to the presentation by Professor Robert Hall, who chairs the National Bureau of Economic Research's Recession

Dating Committee. The CEO hands you the paper by Professor Hall, "Why Does the Economy Fall to Pieces after a Financial Crisis?" and wants you to update the figures 1 and 4 in the paper. Specifically, figure 1 plots the change of components of GDP from the second quarter (April- June) of 2008 on, and figure 4 plots the yield spread between 20-year Treasury bond and Baa corporate bond from January 2007 on.

a. You have to update the figures 1 and 4 using the most recent data available. Use Excel andcreate graphs similar to the figures 1 and 4 using data up to the most recent period. All data series are available at St. Louis Federal Reserve Bank's FRED® (http://research.stlouisfed.org/fred2/). Download appropriate series in Excel.

• To download data from FRED®, you have to register.
• You have to use "real" series for all GDP-related data. They are available quarterly.

• You need the following quarterly series for figure 1:

Consumption:
Real Personal Consumption Expenditures: Nondurable Goods

Real Personal Consumption Expenditures: Services

Investment:
Real Personal Consumption Expenditures: Durable Goods
Real Gross Private Domestic Investment, 3 Decimal

Government:
Real Government Consumption Expenditures & Gross Investment, 3 Decimal
Net Exports:

Real Net Exports of Goods & Services, 3 Decimal
• Use the monthly series for the interest rates (figure 4): 20-Year Treasury Constant Maturity Rate Moody's Seasoned Baa Corporate Bond Yield
• Since the oldest data you need for this exercise is from January 2007. You may want to delete data prior to January 2007 to simplify your worksheet
• You need to combine worksheets for figure 1 and figure 4 into one file. To combine two
files into one, use "Home-Format (Cells)-Move or Copy Sheet" and move one sheet to the other "book."

Journal of Economic Perspectives-Volume 24, Number 4-Fall 2010-Pages 3-20 The worst fi nancial crisis in the history of the United States and many other countries started in 1929. The Great Depression followed. The second-worst struck in the fall of 2008 and the Great Recession followed. Commentators
have dwelt endlessly on the causes of these and other deep fifi nancial collapses. Less conspicuous has been the macroeconomists' concern about why output and employment collapse after a fifi nancial crisis and remain at low levels for several or many years after the crisis. This article pursues modern answers to that question. It focuses on events in the United States since 2008. Existing macroeconomic models account successfully for the immediate effects
of a fifi nancial crisis on output and employment. I will lay out a simple macro model that captures the most important features of modern models and show that realistic increases in fifi nancial frictions that occurred in the crisis of late 2008 will generate declines in real GDP and employment of the magnitude that occurred. But this model cannot explain why GDP and employment failed to recover once the fifi nancial crisis subsided-the model implies a recovery as soon as fifi nancial frictions return to normal. At the end of the article I will mention the ideas that are in play to explain the persistent adverse effects of temporary crises, but these ideas have not made their way into the mainstream model. This article cites only a few of the many important contributions to the mainstream model. My paper Hall (2009) contains many citations and the forthcoming new volume of the Handbook of Monetary Economics discusses the literature fully. Figure 1 shows what happened to four components of real GDP after the second quarter of 2008. Three components were only slightly affected. Net exports and Why Does the Economy Fall to Pieces after a Financial Crisis?

4 Journal of Economic Perspectives

government purchases rose-the latter refl ects in part the fi scal stimulus authorized in February 2009. Consumption of nondurables and services sagged a little immediately, before beginning a recovery in the later half of 2009. Essentially the entire large decline in real GDP was in investment, broadly conceived. This measure includes investment-type purchases by consumers (cars, appliances, furniture), business investment in plant, equipment, and inventories, and residential investment. The crisis did not cause a general contraction in spending. Rather, the contraction is essentially entirely in investment.

All components of investment rely on fifi nancial markets for funds. Residential investment relies on it the most-homebuilders fifi nance construction with bank loans and homebuyers almost always fifi nance a substantial fraction of the price of a newly
built home. The majority of new car buyers take out loans and the car-making industry depends heavily on borrowing in the bond market. Across all industries, borrowing to fifi nance plant, equipment, and inventories is common. It is not surprising that when
investment declines after a fifi nancial crisis these flfl ows dry up. What is surprising is that almost all of the huge decline in output in the U.S. economy following the crisis was confifi ned to investment.

Standard principles of macroeconomics hold that interest rates are the regulator of investment and saving. When demand is strong, interest rates are high, so investment projects with lower returns fail to make the bar; the claimants on output

Figure 1
Changes from the Second Quarter of 2008 in Four Components of Real GDP
during the Crisis
Source: U.S. National Income and Product Accounts, Table 1.1.6.
-700
-600
-500
-400
-300
-200
-100
0
100
200
Billions of 2005 dollars
2008-II 2008-III 2008-IV 2009-I 2009-II 2009-III 2009-IV
Net exports
Government purchases
Consumption:
nondurables
and services
Investment: Consumer
durables, business,
residential
specialists deploy wealth put in their hands by fi nancial institutions. If the wealth

suddenly disappears, as it did when real-estate-based assets collapsed, the specialists are unable to function. In particular, they lack the means to buy underpriced securities.

In the fullness of time, the specialists hook up with other sources of wealth
and those affifi liated with wealth gain the expertise-at which point the asset-pricing
anomalies disappear. Two episodes in the crisis provide good examples. In August 2007, when hedge funds and other wealth-holders felt the fifi rst tremors of real-estate declines, a number found it necessary to wind down similar positions in the stock market to meet cash requirements related to holdings of declining real-estate-based assets. The simultaneous sales of volumes of shares well above normal transaction volume depressed the prices of a vector of stocks without any noticeable effect on the stock market as a whole. If this pattern of sales had occurred regularly in the past, specialists ready to trade against it would have stabilized prices, but there were no such specialists for this isolated event. Similarly, in November 2008 at the height of the crisis, some hedge funds specializing in inflfl ation-protected Treasury bonds had to sell out their positions, causing a temporary depression in the values of these bonds. Not enough

Figure 4

The Difference between the Baa Corporate Bond Rate and the 20-Year Treasury Bond Rate
(in percentage points)
Source: Federal Reserve Bank of St. Louis FRED database (Federal Reserve Economic Data).
6
Percentage points
5
4
3
2
1
0
Jan. 07
March 07
May 07
July 07
Sept. 07
Nov. 07
Jan. 08
March 08
May 08
July 08
Sept. 08
Sept. 09
July 09
May 09
March 09
Jan. 09
Nov. 08