WELCOME

This interactive learning package provides a macroeconomic perspective of financial crises. It demonstrates how financial crises may grow into major national or global economic downturns, and it asks students to explore what policy makers can do to soften the impact of financial crises on national income and employment. In this context, it takes a close look at the conditions under which monetary policy or fiscal policy (so-called stimulus packages) may or may not be effective.

The package consists of several modules that ask
 What is a financial crisis?
 What are outstanding examples of financial and economic crises in recent history?
 What are the macroeconomic repercussions of and the policy options during financial crises?

Please use the above buttons to navigate through the main modules of this package. You may do so either in the proposed sequence, or by jumping directly to the module you are most interested in. Navigation to sub-pages within modules is placed directly into the text frames.


Prerequisites: Users should be familar with the key concepts from undergraduate macroeconomics, including a basic understanding of the IS-LM and Mundell-Fleming models taught in intermediate macroeconomics courses and covered in accompanying textbooks.

Recommendation: For your convenience, depending on the size and format of your screen, you may want to select full-screen mode.

Disclaimer: This package does not explain what triggers financial crises, how bubbles can be prevented, or what regulations the financial industry needs. Its focus is on how financial crises, that started for whatever reason, affect the macroeconomy, spread accross borders, and what policy makers can do to fend off the worst.

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Authors: Manfred Gärtner, Björn Griesbach, Florian Jung and Andreas Kleiner. Institute of Economics, University of St. Gallen, Switzerland, 2010.

WHAT IS A FINANCIAL CRISIS?

We speak of a financial crisis when things start to go wrong and confidence is lost in the financial markets of the economy. It is the primary function of financial markets to direct the savings of households (and other actors) to firms who apply for loans to pay for investments in their production facilities (or to governments who need to finance public deficits).

The figure on the left draws a simplified picture of this and reveals that banks act as intermediaries between households and firms in this process. The workhorse models of undergraduate macroeconomics ignore the role of banks, thereby pretending that households forward their savings directly to firms. Then the interest rate that households receive is the same as the interest rate that firms pay on their loans. Hence, the standard IS-LM model, for example, can make do with one interest rate i only, which denotes both the money market and the capital market rate at the same time.

Leaving banks out of the picture is a useful simplification during normal times. As long as there is certainty, and perfect competition prevents banks from adding a mark-up to the interest rates they pay households (in the money market) when they offer loans to firms (in the capital market), we may indeed assume households to receive very much the same interest rates that firms pay.

In times of crisis, however, when households lose confidence in their loss-making banks, and waves of bankruptcies among firms alarm banks, we cannot ignore the role of banks any longer. Then it becomes mandatory to look at the financial sector and it's two constituent markets, the money market and the capital market, in more detail:

 The money market when banks may become insolvent
 The capital market when firms run into trouble

THE MONEY MARKET WHEN BANKS MAY BECOME INSOLVENT

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As in any market, supply meets demand in the money market. The central bank controls the supply of money M (think of cash in your pocket). The demand for money L goes up when income Y rises and households want to conduct more purchases. It goes down when holding money becomes more costly. This is the case when banks raise the interest rate i_M they offer costumers for putting money into savings accounts. The money market is in equilibrium (supply equals demand) when

(1)     M = L(Y, i_M)

Since this equation denotes an equilibrium between demand L and a given supply M, it is called an LM curve and graphed as an upward-sloping line. The display on the left differs from this because (1) it shows two LM curves for a given supply, and (2) the curves shown include a horizontal segment, a liquidity trap. When money market interest rates drop towards zero, putting money into a savings account has no advantage over holding money in your pocket, and any liquidity supplied by the central bank vanishes into a black hole. The interest rate cannot fall any further, and a money supply increase only pulls LM to the right, extending its horizontal segment. While all LM curves possess a horizontal segment, a dormant liquidity trap, textbooks tend to ignore it because zero interest rates are rare in reality.

The blue line is the LM curve for situations with full confidence in banks. Things change when confidence errodes. Let households fear that during the next year one in 50 banks will shut doors. If they have no clue as to which banks will fail, they must work with probabilities, with risk. Keeping money in a bank carries a risk of 1/50 = 2% that it will be lost. So the expected rate of return is −2%. If a bank wants our money nonetheless, we need compensation for this risk, a risk premium RP_M, which should be 2% in this case [Note]. Generally, the expected rate of return from keeping money in a savings account in the presence of risk is i_M − RP_M. Since it is this expected rate of return that determines money demand, the equation for a more general LM curve becomes

(2)     M = L(Y, i_M − RP_M)

This LM curve has the same properties as a normal LM curve. In addition, the demand for money goes up when confidence in banks deteriorates and the risk premium goes up. In a diagram with i_M on the vertical axis the LM curve shifts up when a financial crisis arrives and the risk premium increases.

THE CAPITAL MARKET WHEN FIRMS RUN INTO TROUBLE

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In the capital market banks extend loans to firms, charging a capital market interest rate i_C, which plays a key role in the goods market. When it rises, it is more expensive for firms to lend money and purchase investment goods, causing them to discard certain investment projects and, thus, reduce their investment demand. Investment demand enters the goods market equilibrium condition [Note]

(1)     Y = C(Y) + I(i_C) + G

where the supply (or income) Y must equal the sum of consumption C (an increasing function of income), investment I (a decreasing function of the capital market interest rate) and government spending G. Equation (1) implies combinations of i_C and Y that yield a goods market equilibrium. These combinations can be graphed as a downward-sloping line, called an IS curve, in an interest rate/income diagram. Note that since our diagram measures the money market interest rate i_M on the vertical axis, we need a relationship between i_C and i_M before we may depict an IS curve.

As long as banks have full confidence in firms, we may assume that they charge firms an interest rate that equals the interest rate banks must pay their customers plus a mark-up: i_C = i_M + markup. Under perfect competition this mark up is driven towards zero and capital and money market interest rates become identical: i_C = i_M. Then the IS curve embedded in (1) can be drawn directly into the diagram on the left.

Things change when confidence erodes. If banks fear that within a year 3 out of 100 firms go out of business and can't tell which ones will survive, they must expect 3/100 or 3% of their loans not to be repaid. The expected interest rate is the interest rate i_C that surviving firms pay minus the 3% banks expect to lose on their loans. If this expected interest rate is to equal the capital cost incurred in the money market, we have i_M = i_C − RP_C, or i_C = i_M + RP_C. Substituting this into (1) we obtain

(2)     Y = C(Y) + I(i_M + RP_C) + G

The implied IS curve has the new property that investment demand falls when firms lose trust. In a diagram with i_M on the ordinate the IS curve shifts down when a financial crisis erupts and the risk premium in the capital market increases.

MAJOR FINANCIAL AND ECONOMIC CRISES IN RECENT HISTORY

The most scary economic development in modern history was the financial crisis, or, actually, the sequence of financial crises that led into the Great Depression which lasted from 1929 to 1933 and deeply rattled the economies of most countries on both sides of the Atlantic.

The current global economic crisis that had started in 2007 as the subprime crisis in the US housing market, and is sometimes called the financial crisis of 2007−2010, was often compared to the Great Depression in the threat it posed to the world and many national economies. Apparently, unprecedented government stimulus packages, bailouts of financial institutions, and huge injections of liquidity into the banking sector by central banks prevented the worst and stopped this crisis from triggering an economic downturn of similar magnitude as the Great Depression. We will never know what would have happened had policy responses be similar to those of the early 1930s.

Other financial crises, less scary, some will argue, though others may disagree, were the Asian financial crisis of 1997−1998 and the bursting of the dot-com bubble in the year 2000 that wiped out $5 trillion in the stock market value of internet-related companies.

To provide a first impression of what may happen when a serious financial crisis infects the entire economy we take a closer look at two major crises:

 The Great Depression
 The current global economic crisis

THE GREAT DEPRESSION 1929-1933

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The most striking feature of the Great Depression was the breathtaking downturn of economic activity in virtually all industrial countries. Among the countries that were hit hardest are Germany and the United States of America. We take a look at some major macroeconomic variables for these two countries. (You may toggle between the data for the two countries by simply clicking when your cursor is on one of the graphs.)

 The downturn in the United States of America
A reliable indicator of how a country's economy is doing, is the level of income. After U.S. GDP had peaked at an index value of 108 in the year 1929, the eruption of a confidence crisis in the U.S. banking sector cast the economy on a downturn that lasted a full 4 years and bottomed out at an index value of 77 in 1933. This reduction of economic activity by 30% led to an increase of the unemployment rate from 3% in 1929 to 25% in 1933. As a consequence of sharply receding and insufficient demand deflation set in, leading to a fall in consumer prices by almost 25%. Nominal interest rates fell from 6% in 1929 to below 2%, indicating that the Federal Reserve System's monetary policy was indeed expansionary. Obviously that was not enough to stop the downturn, and there still may have been some leeway, given that interest rates were still above zero.

 The German experience
Developments in Germany very much mirrored what was happening in the United States. Real GDP fell from an index value of 104 in 1929 to 80, though it hit bottom a bit earlier and there were already signs of recovery in 1933. The unemployment rate rose from 5% in 1928 to 22% in 1932. Also mimicking developments in the U.S.A., there was significant deflation during which consumer prices receded by almost 25%. Different from what happened in the U.S., though, there is no clear indication of an expansionary monetary policy by Germany's Reichsbank, given that interest rates remained rather high.


You may look at income developments during the Great Depression in other countries that are of interest to you   here.

THE CURRENT GLOBAL ECONOMIC CRISIS 2007−

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There is widespread agreement that the current global economic crisis was triggered by the collapse of the U.S. housing bubble in 2007, followed by the bursting of similar bubbles in other countries. With the dramatic collapse of real estate prices, prices of securities tied to real estate values plummeted as well. Since such securities had been created and sold in staggeringly huge volumes, with many buyers unaware of the involved risk, financial institutions ran into trouble on a scale that many commentators feared and convinced governments that a global economic downturn was in the offing that might match the experience of the Great Depression.

In the Spring of 2010 it looks like the worst might be over. Nevertheless, patterns resemble what happened during the Great Depression, though in a muted form.

 The United States of America
Though first signs of serious crisis in the U.S. financial sector were observed in early 2007, income continued to grow for more than another year (though at rapidly shrinking rates). From the first quarter of 2008 to the first quarter of 2009 income fell by almost 5%. Triggered by that, unemployment started to rise and rates doubled from below 5% to almost 10%. Consumer prices remained pretty much stable throughout, though the risk of a deflationary spiral appeared real when prices fell by about 3% between late 2008 and early 2009. One of the biggest difference to the 1930s was the response of monetary policy in the U.S. At the first signs of slowing income growth interest rates were aggressively reduced and hit the zero bound in late 2008.

 Germany
German GDP also responded slowly to the evolving financial crisis. While growth had slowed early, income receded by a scary 8% between the 3rd quarter of 2008 and the first quarter of 2009. Growth returned after that, but income remains substantially below potential income. Surprisingly, not much of all that is seen in unemployment rates. There could be two reasons for this. First, unemployment rates were on a downward path before the crisis after severe structural labour market reforms in the middle of the decade. Second, there has been a surge in part-time work, which may camouflage some unemployment. Consumer prices remained stable throughout the crisis. Monetary policy, which Germany cannot control autonomously but has been handed over to the independent European Central Bank (ECB), responded late. When the ECB finally decided to act before the end of 2008, however, interest rate were driven down quickly, from 4.5% to close to zero within a year.

You may look at the development of income, unemployment, prices and interest rates in other countries of interest to you   here.

MACROECONOMICS OF FINANCIAL CRISES: GLOBAL PERSPECTIVE 1

We now study how financial crises affect the macroeconomy, and how fiscal and monetary policy can fight the detrimental effects of such crises on income.

The vehicle for studying these issues will be interactive models of the IS-LM and Mundell-Fleming type. These provide a laboratory environment in which we can simulate different crisis scenarios and policies and help to obtain insights in an intuitive fashion, driven by hands-on experience rather than math. [Note]

We start with a global perspective. Since viewing the world as one economy we do not have to take into account cross-border transactions in goods, services and financial assets. Therefore, we may use the IS-LM model as a backbone. In addition to conventional textbook treatments of the IS-LM model, our crisis version of the IS-LM model features a dormant liquidity trap and permits risk premiums in the money and capital markets when confidence crises erupt.

The charts below underscore that risk premiums did play a pivotal role during the current crisis. While they fall way short of 1% during normal times, risk premiums hovered between 1 and 2% in the U.S. money market, peaking briefly near 4%. In the U.S. capital market they rose even higher and still exceeded 5% in 2009.

MACROECONOMICS OF FINANCIAL CRISIS: GLOBAL PERSPECTIVE 2

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The applet features a global economy in which a dormant liquidity trap looms, as in every economy (  view equations). Since the macroeconomic equilibrium does not lie on the horizontal part of LM, the economy is not trapped and both monetary policy and fiscal policy work. Using the arrow buttons, you may check this by first raising the money supply M from 360 to 460 and then government spending from 210 to 230, noting each time by how much income goes up.

Press INITIALIZE to return to initial parameters. Now let a financial crisis erupt that triggers a confidence crisis. Suppose households expect 1 in 50 banks to fail, which gives rise to a risk premium RP_M in the money market. Banks anticipate 1 in 100 firms not to survive the crisis, which makes them add a risk premium RP_C to the loans extended to firms in the capital market.

Use the arrow buttons to increase RP_M and RP_C to the appropriate level [Hint]. Make sure you understand why these risk premiums shift the IS and LM curves the way they do [Hint]. Note that the combined effect of the rising risk premiums is to drive the economy into a recession. Press SAVE.

Can the central bank help the economy out of this recession? Check by increasing the money supply M and watching the income response. Press RECALL to drop the economy back into recession. Can the government help the economy out of this recession? Check by increasing government spending G. Watch how income responds.

 Insight 1: Financial crises do not necessarily invalidate standard policy. Both monetary and fiscal policy still work.

Press INITIALIZE. A more severe financial crisis hits the economy. Let households expect 1 in 25 banks to fail, and let banks anticipate 1 in 50 firms not to survive the crisis. Increase risk premiums to RP_M = 4 and RP_C = 2 to reflect these deteriorations in confidence, driving the economy into a recession. Press SAVE.

Again, check whether economic policy can help end the recession. Start by increasing M and observing the response of income. Then press RECALL and increase G. Why is income responding stronger than when G increased before the crisis?

 Insight 2: A severe financial crisis may drive an economy into a liquidity trap. Then monetary policy becomes ineffective. Fiscal policy becomes more effective instead. Money market interest rates may remain positive in this trap when a substantial risk premium in the money market contributes to the crisis.

MACROECONOMICS OF FINANCIAL CRISES: NATIONAL PERSPECTIVE 1

We now proceed to look at how financial crises affect individual countries that are linked with the rest of the world, and what the fiscal and monetary policy options are to fight the detrimental effects of such crises on employment and income.

The rest of the world is represented by the crisis IS-LM model we used when we studied financial crises from global perspective (  view equations). To represent the individual country we need to extend the crisis IS-LM model to a crisis Mundell-Fleming model (  view equations). This is done in two steps:

First, we introduce exports and imports to obtain the open-economy goods market equilibrium condition

(1)     Y = C(Y, t) + I(i_M + RP_C) + G + EX(Y^W, R) − IM(Y, R)

where IM denotes imports, EX denotes exports, R is the real exchange rate, and the superscript W characterizes variables for the rest of the world. The implied IS curve still moves down when the risk premium in the capital market increases, and it moves right when the home currency depreciates or world income goes up.

Second, we must add an equilibrium condition for the international capital market (which, under perfect capital mobility is also an equilibrium condition for the foreign exchange market). This amounts to requiring that expected returns on financial investments at home and abroad are the same:

(2)     i_C − RP_C = i_C^W − RP_C^W

In the absence of mark ups expected rates of return relate to money market interest rates via i_M = i_C − RP_C and i_M^W = i_C^W − RP_C^W. We may substitute these into (2) to obtain

(3)     i_M = i_M^W

which is the familiar foreign exchange market equilibrium line (FE curve) that graphs as a horizontal line positioned at i_M^W in an i_M−Y diagram.


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MACROECONOMICS OF FINANCIAL CRISES: NATIONAL PERSPECTIVE 2

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An important point to note before we get started is that there is no such thing as a financial crisis. Financial crises come in many different shapes, depending on whether they originate in the money market or in the capital market, affect financial markets in all countries symmetrically or remain confined to one country or a group of countries, or whether they spread across borders under fixed or flexible exchange rates.

The navigation matrix below provides a classification along these lines and offers direct access to each scenario. You may use the matrix to go directly to the type of financial crisis you are most interested in. Still, we strongly encourage you to go through the different scenarios in the indicated order, row by row. This way you avoid encountering too many complications at once.

The first row considers the case when there is only turmoil in financial markets at home and the rest of the world may be considered a stabilizing anchor. The second row turns the table. Now there is only a shake up in financial markets abroad. Financial markets at home are sound, but what goes on in the rest of the world nevertheless spreads to the individual country via goods and capital markets. The third row sort of merges the first two. Now confidence crises affect financial markets at home and abroad in a similar fashion. This is the most complex constellation, but by now we can draw on what we learned in the first two rows.

FINANCIAL CRISIS AT HOME AND ABROAD: FLEXIBLE EXCHANGE RATE 1

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We now look at truly global financial crises, defined as symmetrical crises during which confidence deteriorates at home and abroad in very much the same way. [Note]

Press INITIALIZE and make sure exchange rates are flexible. Let firms world-wide be subject to a modest confidence crisis. Raise first RP_C and then RP_C^W to 2% to reflect this. Note that while a rising risk premium at home is neutralized by full crowding in via exchange rate depreciation, a rising risk premium in the rest of the world drives down global interest rates and, thus, the FE curve, throwing the small country into a recession. An increase in the money supply helps in this case. Fiscal policy does not work, as you may want to convince yourself.

 Insight 1: Under flexible exchange rates a modest symmetric confidence crisis in the global capital markets drives the small open economy into a recession. Conventional policy recipes continue to apply.

Press INITIALIZE. Now let the confidence crisis be big. Raise first RP_C and then RP_C^W to 4.5% to reflect this, and observe what happens to income (it falls to 230). Try to escape from the recession by increasing G. Then try to stimulate demand by expanding the money supply. Neither policy works, right? This is because we are caught in a perfect trap. A full escape from the recession can only be engineered if, in a first step, the money supply expands to 400 or more to pave the way for fiscal policy, and then government spending increases in a second step at at least 340.

Press INITIALIZE. We have a big confidence crisis, as before, but with reversed timing. Start by raising RP_C^W to 4.5%. Then do the same thing with RP_C. This drives the small country into a much more serious recession. The equilibrium has even been driven off the display, into negative-income territory. [Note] Try to fight this depression by increasing G. Why does it work this time? [Hint] Try to bring Y back to 423 by increasing G further and further. Why does income get stuck at 230? [Hint] Try to use what you learned before to get income back to potential income.

 Insight 2A: Under flexible exchange rates a symmetric confidence crisis in the global capital markets drives the small country into a recession. Timing determines the scale of the recession. When the confidence crisis affects the capital market in the small country later than in the rest of the world, the recession is much more severe.

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FINANCIAL CRISIS AT HOME AND ABROAD: FLEXIBLE EXCHANGE RATE 2

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 Insight 2B: When the confidence crisis affects the capital market in the small country later than in the rest of the world, fiscal policy can prevent the worst. Following a fiscal expansion, the economy gets caught in a perfect trap, though, before income approaches potential income. After that, further income gains require a coordinated effort by monetary and fiscal policy.

Press INITIALIZE. Now there is a confidence crisis in the world's banking sector. Let the crisis be modest and raise both RP_M and RP_M^W to 2. Note that the first move has a negative, the second one a positive effect on the small country's income. Why is that? [Hint] Since the combined effect on income is negative: What can you do to end the recession? Here the answer is that conventional recipes apply: a small open economy under flexible exchange rates may use monetary policy to affect aggregate demand. Fiscal policy does not work. You may check that, lowering the tax rate t this time. By how much do you have to increase M to return to full employment? [Hint]

Press INITIALIZE. Let there be a major confidence crisis in the world's banking sectors during which both RP_M^W and RP_M increase to 6. The consequences for the small country again depend on the timing. Raise RP_M^W first and then RP_M. This drives income down to 230. The situation is one of a perfect trap. [Hint] Do you remember the recipe to free the economy from a perfect trap and restore full employment? [Hint]

Press INITIALIZE. This time raise RP_M to 6 and afterwards RP_M^W. Why are you not even getting to the second step? Why does the domestic economy appear to become unstable as soon as RP_M exceeds 2.3? [Hint] Please convince yourself that in such a situation of instability neither fiscal nor monetary policy can raise income, even if used in coordination. Only after the confidence crisis in the rest of the world catches up (or confidence in domestic banks improves again) macroeconomic stability is restored and fiscal policy works again.

 Insight 3: When there is a major symmetrical confidence crisis in the global money markets, effects on the small country's income crucially depend on the timing. When the timing is very much symmetrical, the small country ends up in a perfect trap and needs a coordinated effort by the central bank and the government. When the crisis hits the small country first and faster, it may be thrown into an outright depression with a temporarily unstable economy. This requires either a massive fiscal stimulus package, or the rescue of banks to improve confidence in the banking sector.

FINANCIAL CRISIS AT HOME AND ABROAD: FIXED EXCHANGE RATE 1

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Press INITIALIZE and select fixed exchange rates in the SCENARIO panel. Let the corporate sector world-wide be subject to a modest confidence crisis. Raise first RP_C and then RP_C^W to 2(%) to reflect this. Note that while a rising risk premium in the domestic capital market shifts down the IS curve and lowers income, a rising risk premium in the rest of the world's capital market lowers global interest rates and, thus, the FE curve, which stimulates investment demand in the small country and raises income. The net effect is a reduction of income to 342. By how much would you have to reduce the tax rate to end the recession in the small country? [Hint]

 Insight 1: Under fixed exchange rates a modest symmetric confidence crisis in the global capital markets drives the small open economy into a recession. Conventional policy recipes still apply.

Press INITIALIZE. Now there is a major confidence crisis that raises both RP_C and then RP_C^W to 5%. Observe the reduction of income to 150, and that the small country sits in a liquidity trap. But monetary policy is not available anyway, because the money supply is driven be the central bank's obligation to intervene in the foreign exchange market. The familiar remedy is fiscal policy. By how much do you have to raise G to return Y to 423?

Press INITIALIZE. Suppose there is a confidence crisis in the world's banking sectors. Let the crisis be modest and raise both RP_M and RP_M^W to 2. Note that the first change has no effect and the second a negative effect on the small country's income. Why is that? [Hint] Since the net effect on income is negative: what can you do to end the recession? Yes, you could raise government spending G or reduce the tax rate t. Alternatively, you could devalue the currency. Would increasing the exchange rate R from 1.0 to 1.2 reestablish full employment (that obtains when income is at potential income Y*=423)?

 Insight 2: When the world is hit by a confidence crisis in the banking sector, a small country under fixed exchange rates could use fiscal policy to fight the recession, or it could devalue its currency.

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FINANCIAL CRISIS AT HOME AND ABROAD: FIXED EXCHANGE RATE 2

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Press INITIALIZE. Let there be a major confidence crisis in the world's banking sectors during which both RP_M and RP_M^W increase to 5%. The consequences for the small country again depend on the timing. Raise RP_M^W first and then RP_M. This drives income to the very low level of 150. The situation is equivalent to the one we encountered before. [Hint] The fact that the small country is caught in a liquidity trap does not really matter, since monetary policy is not available anyway. The way to go is use fiscal policy, which can bring income all the way back to potential income.

Press INITIALIZE. This time reverse the sequence and raise RP_M to 5% first and afterwards RP_M^W. You are not even getting to the second step, right? This is a by now familar experience. Why does the domestic economy appear to turn unstable as soon as RP_M exceeds 2.3? [Hint] After the crisis in the rest of the world's money market has caught up, the economy settles into a new equilibrium with income Y=150.

The relative speed at which the confidence crisis unfolds at the money markets at home and abroad does not matter for the depth of the generated recession. In both cases income dropped to 150. The difference is in how the domestic money supply developped. When the crisis unfolds more quickly at home, this destabilizes the small country temporarily and makes the money supply increase without bounds. When the crisis unfolds more quickly abroad, the money supply remains within reasonable bounds. In both cases a fiscal expansion is all that is needed to end the recession. In the first case the central banks need to keep an eye on uncontrolled liquidity growth and the threat this may pose to price stability once circumstances change.

 Insight 3: When there is a major symmetrical confidence crisis in the global money markets, effects on the small country's income are independent of timing. Only the consequences for money growth differ, but this does not affect income. Fiscal policy (or a devaluation) can drive the country out of the recession.

FINANCIAL CRISIS ABROAD: FLEXIBLE EXCHANGE RATE

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There is a confidence crisis in the banking sector abroad. Press INITIALIZE and make sure exchange rates are flexible. Raise the risk premium in the world's banking sector to 3%. Watch how this raises the foreing money market interest rate i_M^W and shifts up the FE curve. Make sure you understand why this leads to a boom in the small open economy [Hint]. Conventional policy results still apply in this new equilibrium: Fiscal policy does not work, while monetary policy does. You may verify this by, first, lowering G from 150 to 120 (why does fiscal policy not work? [Hint]) and then M from 200 to 150.

 Insight 1: Under flexible exchange rates, a crisis among banks abroad has a positive effect on a small country's income. Monetary policy works, but is not needed.

Press INITIALIZE. Now there is a confidence crisis in the foreign capital market. Raise RP_C^W to 2. Watch how this lowers i_M^W and shifts the FE curve down. Make sure you understand why this leads into a recession in the small country. [Hint] Conventional results still apply in this new equilibrium: Fiscal policy does not work, while monetary policy does. Increase the money supply just enough to bring income back to potential income. Use the tax rate t this time to convince yourself that fiscal policy has no effect on income. Why does the IS curve become flatter when you lower t? [Hint]

 Insight 2: A modest crisis in the corporate sector abroad pushes small countries with flexible exchange rates into recessions. Monetary policy can reverse the downturn.

Press INITALIZE. Now a major confidence crisis erupts in the corporate sector abroad that pushes the risk premium to 4.5%. Raise RP_C^W appropriately. Observe how this drives both the rest of the world and the small country into a severe recession. Try to lead the small country out of the recession by increasing G from 150 to 200. This does not seem to work. Why? [Hint]. Next, try to use monetary policy to fight the recession by increasing the money supply by 50, too. This does not work either. Why? [Hint]

 Insight 3: A massive confidence crisis in the rest of the world's corporate sector may drive a small open economy into a special kind of liquidity trap in which neither fiscal nor monetary policy work. We call this a perfect trap.

Just out of curiosity, raise G further, in small increments from 200 to 300. Why does it work now, but only for a while, until income reaches 280? [Hint] Now the country is still in a serious recession. Devise a plan to drive Y back to potential income. [Hint]

 Insight 4: A small country caught in a perfect trap under flexible exchange rates needs a coordinated effort by the government and the central bank to end a recession.

FINANCIAL CRISIS ABROAD: FIXED EXCHANGE RATE

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Press INITIALIZE and select fixed exchange rates in the SCENARIO panel. There is a confidence crisis in the money markets abroad. Raise the risk premium in the world's banking sector to 3(%). Watch how this raises i_M^W and shifts the FE curve up. Make sure you understand why this leads to a recession in the small open economy. [Hint] Conventional results still apply in this new equilibrium: Fiscal policy works, while monetary policy is unavailable. By how much do you have to raise government spending G in order to engineer a full recovery?

 Insight 1: Under fixed exchange rates, a crisis among banks abroad drives a small country into a recession. Fiscal policy may be used to fight the downturn.

Press INITIALIZE. Now there is a confidence crisis in the corporate sector abroad. Raise RP_C^W to 3. Watch how this lowers i_M^W and shifts FE down. Make sure you understand why this leads to a boom in the small open economy. [Hint] Conventional results still apply in this new equilibrium: Fiscal policy works, while monetary policy remains unavailable.

 Insight 2: Under fixed exchange rates, a modest crisis in the corporate sector (i.e. the capital market) abroad leads to a boom in the small country. Fiscal policy would work, but is not needed.

Press INITALIZE. This time there is a major confidence crisis in the corporate sector abroad during which the risk premium jumps to 4.5%. Raise RP_C^W appropriately. Observe how this drives the rest of the world into a deeper recession and the small country's income way beyond potential income. Policy options are the same as when the confidence crisis was more moderate. Fiscal policy would work, but is not needed. Monetary policy remains unavailable, but would not work anyway, since the economy is stuck in a liquidity trap. So insight 2 still applies.

Raise RP_C^W further still, say to 6%. Why does this additional increase now have a negative effect on the small country's income? [Hint]

FINANCIAL CRISIS AT HOME: FLEXIBLE EXCHANGE RATE 1

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There is a confidence crisis in the small country's corporate sector. No such crisis erupts in the rest of the world. Suppose 1 in 100 firms are expected to falter within a year, but banks cannot tell which ones. Raise the risk premium RP_C accordingly. [Hint] Why does our country appear unaffected? Why is there no response in income? [Hint] If you are not sure, press INITIALIZE to recall initial parameters, raise RP_C again and pay close attention to the response of I, EX, IM and R in the endogenous variables panel.

 Insight 1. A confidence crisis in a small country's corporate sector has no aggregate effect on income under flexible exchange rates.

Press INITIALIZE. Now a crisis in the domestic banking sector erupts that lets households fear that 1 in 100 banks will close doors. Raise RP_M to 1 to reflect this. Why did the country slide into a recession (income fell from 423 to 375)? [Hint] What can you do to fight the recession? Try raising government spending G. Try expanding the money supply M. By how much do you have to raise the money supply to return Y to potential income 423?

 Insight 2. A confidence crisis in a small country's banking sector causes a recession under flexible exchange rates. This can be fought by means of expansionary monetary policy.

Press INITIALIZE. Let a more serious crisis erupt in the banking sector that raises the risk premium to 2.3. and generates a major recession. Again, try to stimulate demand by raising G from 150 to 180. Income does not respond. Now try monetary policy, raising M from 200 to 250. Still, income appears stuck at 230. The economy not only seems stuck in a liquidity trap, but in a perfect trap, in which neither fiscal policy nor monetary policy appears to work. Has economic policy run out of options?

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FINANCIAL CRISIS AT HOME: FLEXIBLE EXCHANGE RATE 2

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Start over by pressing INITIALIZE and raising RP_M again to 2.3. This time let the central bank move first, raising the money supply from 200 to 250. No effect on income, right? Now let the government increase G from 150 to 220. Why does this work now, raising income from 230 to 280? The reason is that when G rises, the point where IS intersects LM is on LM's horizontal segment. When this segment expands to the right, the home interest rate remains unchanged, no capital flows are triggered, the exchange rate remains unaffected, and there is no crowding out.

Try to bring income still closer to potential income by raising G to 250. Now fiscal policy does not work anymore! Do you have an explanation? [Hint] Now try the same, raising the money supply M to 300. This does not work either. The economy appears to be stuck in the kind of super trap we already encountered and called a perfect trap, in which neither fiscal nor monetary policy works. Can you design a policy strategy that would reestablish full employment by returning Y to 423? [Hint]

 Insight 3. Under flexible exchange rates a serious confidence crisis in a small economy's banking sector may drive the economy into a perfect trap, in which money market interest rates are positive, and neither fiscal nor monetary policy works when used in isolation. A synchronized effort by monetary and fiscal policy is called for and works.

Press INITIALIZE. Now let there be a really big crisis in the domestic banking sector that carries a risk premium of 3%. Raise RP_M accordingly and observe at each step what happens. Why is there an alarm once the risk premium exceeds 2.3? The problem is that LM has lost contact with the FE curve. So the domestic money market rate is driven above the foreign one and forced to stay there. This attracts international wealth on a grand scale. The exchange rate appreciates and never stops doing so, driving IS all the way to the left [Note]. The country is cast into a depression in which no overall macroeconomic equilibrium exists and no endogenous forces counter the continuing downturn.

 Insight 4. Under flexible exchange rates a major confidence crisis in the banking sector may destabilize the economy at large and set the economy onto a path into an outright depression. Then only unconventional measures may work, such as bank bailouts, that restore confidence.

FINANCIAL CRISIS AT HOME: FIXED EXCHANGE RATE

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Press INITIALIZE and switch to fixed exchange rates in the SCENARIO panel. A confidence crisis hits the small country's corporate sector. Suppose 1 in 50 firms are expected to go bankrupt within a year, but banks cannot tell which ones. Raise the risk premium RP_C to 2 to reflect this. Why does our country dip into a recession? [Hint]. Conventional policy recommendations do apply. By how much do you have to raise G to return income Y to potential income Y* = 423? [Hint]

 Insight 1. Under fixed exchange rates, a confidence crisis in a small country's corporate sector (i.e., in the capital market) causes a recession. This can be successfully fought by means of expansionary fiscal policy.

Press INITIALIZE. Now a modest crisis in the domestic banking sector erupts that lets households fear that 1% of all banks may have to close doors. Raise RP_M to 1 to reflect this. Why does income in the small country remain unaffected? If you are not sure: Press INITIALIZE and raise RP_M again. While you do, watch what happens to the money supply M. [Hint]

 Insight 2. Under fixed exchange rates, a modest confidence crisis in a small economy's banking sector has no effect on aggregate income.

Press INITIALIZE. Now let there be a more serious confidence crisis in the domestic banking sector that carries a risk premium of 3%. Raise RP_M accordingly and observe at each step what happens. Why does the applet issue an alarm in the form of a red frame as soon as the risk premium exceeds 2.3? The reason is that LM has lost contact with the FE curve. So the domestic money market rate is driven above the foreign one and it is forced to stay there. This attracts international wealth, the central bank is obliged to purchase huge amounts of foreign currency and thereby expand the domestic money supply period after period. This does not affect income, neither positively nor negatively. But the uncontrolled growth in liquidity (that expands the horizontal segment of the LM curve all the way accross the display panel) poses a threat to price stability once the confidence crisis is over.

 Insight 3. Under fixed exchange rates a major confidence crisis in a small country's banking sector has no direct effect on income, but leads to uncontrolled growth in the money supply.

LESSONS LEARNED − and further reading

 Financial crises are situations in which confidence deteriorates in one or more financial markets (comprising the money market and the capital market).

 The most significant downturn in recent history that resulted from a financial crisis was the Great Depression (1929-1933). Affecting most industrialized countries, the Great Depression brought massively receding incomes, exploding unemployment rates, falling prices and near-zero interest rates. The global financial crisis of 2007-2010 shares many of these macroeconomic repercussions, though in a muted fashion.

 Financial crises come in many guises, depending on the exchange rate system, on whether the confidence crisis erupts in the money or in the capital market, and on whether it affects countries around the globe symmetrically or not.

 Modest financial crises may be dealt with following orthodox policy recommendations. For a small country this means that fiscal policy may be used to stimulate aggregate demand when exchange rates are fixed. Monetary policy may be used when exchange rates are flexible.

 When financial crises are severe enough to push a small open economy into a liquidity trap this may turn traditional policy prescriptions upside down. A small country under flexible exchange rates, for example, should use fiscal policy to fight the recession, while monetary policy would be ineffective.

 When the small country is stuck in a liquidity trap, fiscal policy could only dampen the crisis, but not eliminate it. A perfect trap emerges while income is still below potential income. Here neither fiscal nor monetary policy work when used in isolation. A coordinated effort, in which the money supply expands first and a fiscal expansion follows, can overcome the recession, however. [Note]

 Severe financial crises that are either more pronounced or unfold more rapidly at home than in the rest of the world may destabilize a small country's economy. Results may be full-scale depressions when exchange rates are flexible that can only be overcome after reestablishing confidence in the money market. Or, when exchange rates are fixed, there may be no immediate effect on income, but an uncontrolled growth of the money supply may be triggered.

More undergraduate macroeconomics of financial crises can be found in   this paper.