Question

What is a balance sheet recession? What factors make these recessions more difficult to recover from than normal recessions? Illustrate a balance sheet recession in the 3-equation model. (10 points)

Answer 1

Balance sheet recession

A balance sheet recession is a type of economic recession that occurs when high levels of private sector debt cause individuals or companies to collectively focus on saving by paying down debt rather than spending or investing, causing economic growth to slow or decline. The term is attributed to economist Richard Koo and is related to the debt deflation concept described by economist Irving Fisher.

Financial crises commonly arise when there is too much debt and asset prices fall from excessive levels. Examples are to be found in 1929 in the US, 1999 in Japan and 2008 worldwide. Hyman Minsky, in his famous book Stabilising the Unstable Economy, set out the three stages in the pattern of borrowing that involve increasing risk. It starts with borrowers expecting to be able both to pay the interest and to repay the principal from the cash they expect their investment to generate. In the next stage their hopes are limited to paying the interest and refinancing the principal when the repayment falls due. In the final stage not even the interest is expected to be covered and the expected profit derives solely from the hope of being able to sell the debt financed asset at a profit. When continually rising asset prices cease to be an article of faith, the house of cards collapses.

There is then a rush to sell assets which sets off a recession, as borrowers seek to repay their debts. Companies which wish to reduce their borrowing don’t just avoid new borrowing — they seek to repay their existing debt. To do this they need to generate cash. This means spending less than they earn, and their intentions to invest then fall short of their intentions to save. The attempt to improve private sector balance sheets can therefore be described as a balance sheet recession, whose severity can be moderated as fiscal deficits cause the balance sheet of the public sector to weaken, offsetting the negative impact that comes from the strengthening of private sector balance sheets.

Some Causes of the Current Recession

a major underlying cause is also the overextension of supply chains, the overinvestment in marginal business, and the razor-thin inventories and fragile business models that have all become the norm over the decade of extreme low interest rates and monetary policy by central banks everywhere, and especially the Federal Reserve, since the last recession. The deep distortions in business, investment, and consumer behavior, that by 2020 have all become thoroughly addicted to an endless flow of easy money, laid the groundwork for the economic devastation that is currently underway by leaving the economy with zero margin of resilience to buffer against negative economic shocks.

Problems facing an economy recovering from recession

To recover from a recession there needs to be either a rise in AD or a readjustment in prices and wages.

1. Low Consumer confidence

In a recession there will be rising unemployment and therefore a fall in consumer confidence. This will cause a rise in the savings ratio. In other words people will spend less of their disposable income and save more leading to a bigger fall in AD. If confidence remains very low for a long time then it will be difficult for the governmnent to increase AD. For example if the government cut income taxes this would increase disposable income but if confidence was low people would not be willing to spend any extra and the economy would remain in a recession.

1. Ineffectiveness of Monetary Policy

In a recession the Bank of England could cut interest rates to stimulate demand. Lower interest rates reduce the cost of borrowing and therefore people should be more willing to spend and invest. However Monetary policy could be ineffective. Firstly firms may be reluctant to invest, even though it is cheap to borrow, because they cannot see any increase in demand. If a country is a member of the Euro may make it more difficult to increase AD in a recession. This is because interest rates will be set by the ECB and the UK would lose control over interest rates. Interest rates may be too high if the UK is in a recession and other countries in the Euro zone are growing too fast.

A problem in the 2008/09 recession was that interest rates were cut to 0.5% but banks were not keen to lend, therefore the interest rate cut had little impact. In a liquidity trap, monetary policy becomes ineffective.

Equation-

AN APPROXIMATED EQUILIBRIUM

In this section we analyze a log-linearized version of the New-keynesian model that Woodford and Acemoglu explain and we use it to study the effect of government spending. Aggregate demand is composed by two relationships. First, there is the IS equation derived from the optimal consumption decision of the household and the resource constraint (that is, all output is either consumed by the government or the private sector: Yt=Ct+Gt S +Gt N Where Yt is aggregate output, Ct is aggregate consumption, Gt S is that part of government spending that is perfectly substitutable for private consumption, while Gt N is not). The IS becomes: Y^ t= EtY^ t+1−σ(it−Etπt+1−r e t)+(G^N t –EtGN t+1)+σχs Et(τ ^S t+1−τ ^S t)+σχ A τ ^A t where Y^ t= logYt/Ȳ, Et is an expectation operator, it is the one-period risk-free nominal interest rate, πt is inflation, the coefficients σ,χ A,χ S > 0, G^N t=(Gt N−ḠN)/ Ȳ, re t is an exogenous disturbance that is only a function of the shock, τ ^S t=τt S −τ S , and τ ^A t=(1-β) -1 (τt A-τ A) (where τ S t is a sales tax on consumption purchases and τ A t is a tax on financial assets). Finally, β is a discount factor. Second, there is the monetary policy rule approximated by: it=max(0,re t+Φππt+ΦϒY^ t) 32 where the coefficients Φπ>1 and Φϒ>0. When combining these relationships, we simply refer to the result as aggregate demand (AD) as it determines the overall level of spending in the economy given the monetary policy rule. The aggregate supply (AS) is derived from the optimal pricing decision of the firms and it is: πt=κY^ t+κψ(χ wτ ^w t+χ S τ ^S t−σ-1 G^N t)+βEtπt+1 where the coefficients κ,ψ>0 and 0<β<1; furthermore, τ ^W t is a payroll tax. So, an approximate equilibrium determination is a collection of stochastic processes for (Y^ t,πt,re t,it) that solve this two equations given a path for (τ ^w t,τ ^S t,τ ^A t,G^N t) determined by fiscal policy. Serving us of this model , we will focus our analysis on the expansionary government spending. • Effect of gevernment spending Consider the effect of increasing G^S t.We know from our model,we will focus our analysis on the expansionary government spending.