Policies and Interest Rates During the Crisis: A Dynamic Approach

©2012 – Daniele Stanizzi Page III 
 
Introduction 
The following research thesis is a study of the recent crisis that struck the global economic system 
in recent years. Throughout this study, we will focus on the cause and effect of the recession, and 
the actions that governments and authorities have undertaken to contain adverse consequences. 
The first step is to give an overview of what happened, examining the historical facts that have 
followed through these recent years, starting with a description of the mortgage crisis in the 
United States, which was also the triggering event. We will illustrate its functioning and how the 
bubble swelled and burst in 2007 as a consequence of the ceasing of the upward trend in housing 
market prices. Then we will discover how this paralysis spread beyond the American system, 
infecting the main economies all around the world. This study is mainly concerned with the British, 
European and American macro areas, and for each of which an attentive analysis will be carried out. 
Indeed, the following step is the purpose of this research, and it will consider the measures 
employed by governments and central banks to control the adverse consequences of the crisis. 
Specifically, a thorough examination will be conducted to estimate the effects that were yielded in 
the aforementioned economies. This analysis will also allow us to conduct a ‘diagnosis’ of these 
macro systems and simulate hypotheses over the evolution of the recessive trend. 
We will look in detail at the monetary and fiscal policies undertaken by the Bank of England, 
European Central Bank, Federal Reserve and their respective governments. A crucial theme to the 
analysis is that of interest rates; we will see how this variable is fundamental within the economy 
and markets in general. As a matter of fact, the influence of interest rates is somehow dominant in 
every aspect and for this reason we will look at their direct and indirect effects on the main 
macroeconomic variables, such as inflation, GDP, production and economic growth, in order to 
evaluate the conditions of the economies at the focus of this study. The research will be conducted 
as follows: we will gather and plot economic, macroeconomic and financial data over the period of 
the last twelve years. This will clarify the trend of the economies even before the crisis, starting 
from the dawn of the new millennium; this will provide a significant visual disruption that, 
unsurprisingly, coincides with years 2007 and 2008.  As previously mentioned, we have decided to 
limit the selection of our analysis to the areas of the United Kingdom, Eurozone and the United 
States; we believe this choice is the most sensible not only because they are the three biggest macro 
economies we are influenced by, but also because they are very influential on the rest of the global 
economies. Furthermore, these are the systems that are suffering the most adverse of consequences 
as a result of the recession; therefore, their analysis is crucial for a thorough understanding of the
©2012 – Daniele Stanizzi Page IV 
 
events that will allow us to examine the whole development and evolution of the crisis from the 
origin to the expansion in the global markets.  
The report contains two main sections entitled literature review and methodology. The literature 
review outlines the theoretical framework and the instruments utilised to conduct the research, as 
well as the technical findings and observations derived from other papers, reports or articles 
developed by economists and specialists in general. This literature review is of crucial importance 
for the complete understanding of the rest of the study; in fact, it is imperative that the notional 
background on which the models and concepts are based upon is clear and understood, so that the 
reader will be able to appreciate the value of the analysis developed in the impending methodology. 
Specifically, we will look at the macroeconomic principles that governments have adopted to 
contain the recession (i.e. monetary and fiscal policies, inflation targeting model, expectation 
theory and term structure of interest rates).  Other than the theoretical framework, the literature 
review will contain some of the history of the crisis, and will look into some of the important 
financial aspects found to be playing a crucial role in the crisis. In particular, we will focus on the 
shadow banking system; a financial system per se that has become a highly debated matter at the heart 
of the markets. We will explain how this system has affected the banking sector and, consequently, 
investors and companies, leading to the crisis of finance as we know it today. Finally, we will provide 
some of the possible solutions that have been suggested throughout the vast literature review 
relative to this topic. 
The methodology is the core of this study and involves the application of the whole theoretical 
approach directly to the economic systems under investigation. For this reason, a few words must 
be spent relative to the method adopted to conduct the following study. Being that this is an 
examination over financial and economic matter, we will deal with vast amounts of data, of which 
great parts will consist of primary data. Therefore, we have opted for a quantitative approach to 
conduct the research, considering such a choice to be the most useful and appropriate, when 
handling such a volume of raw data that, thanks to its nature, is the most suitable for statistical 
computation and modelling. Throughout the research we will show the fitting of each model only 
in relation to one case of the three available, in order to understand its functioning. As for the 
remaining areas, only the outcomes of the same model will be explained, clarifying the results 
throughout a theoretical approach, along with an appropriate explanation and, subsequently, a 
comparison of the results and an evaluation of the findings. This method will allow us to directly 
associate the same model to our different cases, illustrating the main features just once and giving 
way to the more interesting interpretation of the outcomes. Where necessary, the data will be 
processed with the help of the statistical software R©, which will support our research on the
©2012 – Daniele Stanizzi Page V 
 
computational side. This will be in the case of regression tests on datasets and correlation tests 
between variables. Moreover, the support of statistical software will allow us to take a step further 
in the analysis. Indeed, it will be possible to carry out a calculation to estimate future values of 
some macroeconomic variables and, therefore, forecast how these variables could fluctuate within 
the short–period, using a time series approach. Next, we will consider the evolution of the IS–LM 
theory by Olivier Blanchard, the most important model for dynamic analysis. As before, we will 
relate the model to a real case in order to understand its functioning and also to clarify the 
fundamental rules on which the authorities base their choices of monetary and fiscal policy.   All 
specific information about data will be contained in the Appendix, to be found at the back of the 
research thesis.
©2012 – Daniele Stanizzi Page 1 
 
Literature Review 
Financial Crisis: Overview 
The first question we want to answer is how we came to the point where several banks collapsed 
and the major economies are now in trouble. Notably, the responsibilities fall on different subjects; 
the banks are likely to be the first in line. Time has listed 25 people who are to blame for the crisis 
(2009) whose professional belonging leads essentially to banks, governments, rating agencies or 
important companies.  
The most severe financial crisis of the last decade began in the United States in August 2007 in a 
moderately small market segment: subprime mortgage loans. Today we all point the finger at some 
American financial companies (i.e. Fannie Mae, Freddie Mac) whose unwary behaviour triggered a 
series of events that led the major economies to the dire situation in which they find themselves 
today. Let us then illustrate how all of this happened. Before a bank or a financial services company 
lends money to an individual or any legal person, they want to make sure that the loan is going to 
be repaid according to an amortisation plan, which is set up beforehand. This is because of the 
presence of what behavioural finance defines as adverse selection. This term refers to one of the 
information asymmetries that are likely to occur when dealing with risk management. Precisely, it 
implies that borrowers that are subject to a higher credit risk are more likely to require a loan 
(Redhead, 2008), which as we will see later, are defined as subprime. In order to face this problem, 
lenders base their final decision on several aspects which include: borrower’s credit score, LTV 
ratio, interest rate, loan amount, and level of indebtedness (Demyanyk, Van Hemert; 2009). Only 
after an accurate analysis, can they finally make the decision to grant or reject a loan request.  
The first critical mistake we have to point out has been made by some banks, when they decided to 
concede mortgage loans to the above mentioned segment of subprime borrowers, that is, those 
individuals with a higher–than–average risk profile whose ‘financial health’ was not in a 
sufficiently good state to ensure the payback. The first step that encouraged American financial 
institutions to this obviously dangerous behaviour is a change in regulation in 1980 when the 
Deregulation and Monetary Control Act (DIDMCA) was adopted. This act essentially legitimated to 
“charge high rates and fees to borrowers”. Secondly, in 1986, another modification introduced the 
Tax Reform Act which made high–cost mortgage debt quite cheap (even cheaper than consumer 
debt), permitting uncontrolled access to credit for subprime borrowers (Chomsisengphet, 
Pennington, 2006). Indeed, the analysis of this specific market reveals some serious facts as shown
©2012 – Daniele Stanizzi Page 2 
 
in Figure 1 above: risky lending registered a steady growth from 1990, hiking from 28.4% in 1995 to 
58.8% in 2003. A further examination, though, reveals an abnormal peak registered from 2003 to 
2006 (Figure 2). This boom can be easily explained just by looking at the housing market trend in 
those years. Figure 3 shows the firm increase of house prices from 1990. This was due primarily to 
the economic growth of the late 1990s and low interest rates in the 2000s (Labonte, Makinen; 
2008). This upward drift was injecting financial institutions with confidence because in the case of 
delinquency, they could still count on the foreclosure and claim their properties back 
(Chomsisengphet, Pennington, 2006). The mechanism worked fine during the growth but it 
jammed up when the housing market bubble burst in late 2006, when this appreciation stopped 
and began its fall. The bubble was being inflated even by speculative behaviours: many were the 
investors who were buying houses and selling them at a higher value in the future pushed by a 
market that was flourishing and registering growing demand and consequently rising prices.  
It was on 7
th
 of September 2006 when Nouriel Roubini, an economics professor at New York 
University, held a speech warning the 
United States about the housing bubble and 
its immediate consequences (Mihm, 2008). 
During a long interview he held in 2008 he 
forecasted a big recession and hundreds of 
banks failing in view of “mounting losses as a 
result of the housing bust” (Reuters, 2008). 
Indeed, the turmoil began when the Fed 
decided to raise its interest rate in 2004 
(reasons will be explained at a later stage in 
Figure 2: The peak of subprime loans. 
Source: Federal Reserve Bank of San Francisco  
Figure 1: The steady growth of subprime loans from 1995 to 2003. 
Source: Chomsisengphet, Pennington, p. 38
©2012 – Daniele Stanizzi Page 3 
 
the research) leading to a 
downturn of the housing market 
as a  consequence of the higher 
cost of borrowing. However, a 
most severe effect was taking 
place: the default on mortgages 
with adjustable rates. According to 
a speech of Chairman Bernanke 
(2007), by August 2007 about 
16% of loans were already 
compromised. The financial 
tumult was made even worse by 
what has been defined as shadow banking. This vast ‘wild’ quantity of securities, of which we will talk 
in the next section, made it hard to measure the risk exposure for many financial institutions which 
led to an increase of market uncertainty and instability; banks suddenly raised the interest rates 
they were charging each other and started claiming all their funds back, triggering a liquidity crisis. 
The effects immediately hit Wall Street generating the first catastrophic consequences. Some 
banks (Lehman Brothers, AIG, Fannie Mae, Freddie Mac) were on the verge of bankruptcy. On 15
th
 
September 2008, after a sharp fall of 80% on stock prices over the past year, the financial services 
company Lehman Brothers collapsed. The seriousness of the situation was now evident: this was 
the biggest–ever bankruptcy in history (Checkler, 2011).  
After a while, the crisis struck Europe as well. This happened because the banking system is 
internationally linked; hence, each event shakes more or less all markets around the world. Europe 
is in fact economically and financially strictly linked to the American system. Precisely, many 
European and British banks were holding a considerable amount of American mortgage securities 
among which subprime residential mortgage–backed securities (RMBS) (Whittall, 2009) and that 
eventually led to significant losses. We are currently going through probably the biggest recession 
since the Great Depression of the last century; several European countries are in serious trouble 
with their public debt and after the most recent events such as the Greek bailout and the election 
that took place in the same country, even the Euro itself has been brought into question (The 
Guardian, 2012). It is interesting to understand the main mistakes that have been made during the 
Great Depression and notice how we have learned from the past, avoiding dangerous behaviours 
that could have made the plummet even worse. Some argue that the crisis that hit the United 
States in 1929 brought the entire economy to its knees because of several errors made by the 
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Lehman Brothers HLD  
Figure 4: LEHMQ historical stock prices pointing out the plummet from 
October 2007 to its bankruptcy.  
Source: Yahoo! Finance