210 summer
default premium
x = r' - r x = _____ to compensate for borrowers who default x is an interest rate spread that reflects the severity of the asymmetric information problem for firms that borrow to invest: MP'_K - d - x = r the ____ acts to REDUCE the NET MARGINAL PRODUCT OF CAPITAL given r
interest rate spread
x = r^l - r
surplus to a vacancy
y - w - (-cy𝜭)
Impulse Response: Simplest Model
yt = γyt-1 + εσ - yt: econ variables - ε: econ shock - σ: econ model of transmission - γ: economic model of propagation Shock gets worse and worse due to propagation
Flexible Inflation Targeting
λκ + π* + λ(ut - uN) - Inflation deviates from ultimate target to respond to state of business cycle Gap - business cycle only, long-run monetary neutrality Measurable - unemployment, output gaps Feasible - as long as there is a phillips curve Independent from other goal: supply shocks Constrained activism: transparent and accountable Communication: goal and performance clear
Adaptive Expectations
π = π-1 - β(u-un) + ε given correlation between pi = pi-1 is 0.7 and 0.9 NAIRU: non-acceleration inflation rate of unemployment or un Inflation inertia: past inflation raises inflation today Demand-pull and cost push: causes for rising and falling inflation, names for u-un and epsilon terms
Aggregate Supply
π = π-e + ((a(1-s)/s)(Y-Y-bar) + ((1-s)/s)ε π = π-e + a(Y-Y-bar) + ε Prediction 1: If average inflation is very high and/or very volatile, firms will want to update their prices more often. Expect s to get smaller, steeper AS if inflation higher/more variable Prediction 2: Sticky prices, sticky info
Aggregate Supply: Upward sloping (medium term?)
π = π-e + α(Y - Y-bar) + ε Why medium term: - Firm have market power, price setters - Price rises with PL and output gap, increasing MC and rising wage p* = P + a(Y-Y-bar) + epsilon-wavey - Nominal rigidities: fraction s of firms don't know current price level, must form a forecast of Pe (Menu costs, sticky prices, inattention - people don't know price changes)
growth rate of money stock
𝛍
long run growth rate expectations
𝛍 = 𝛑bar + gbar 𝛍 = ibar - rbar + gbar
one to one
𝛍 related to 𝛑 almost ___
average probability that a worker finds a vacancy
𝛍M(u,v)/u = 𝛍M(1, 𝜭) where 𝜭 ≡ v/u = TIGHTNESS OF LABOUR MARKET EQUIVALENT TO THE JOB FINDING RATE: f = uM(1, 𝜭) ≡ f(𝜭)
penalty for chairman of CB
𝛑 = 𝛌k - 𝛚 + 𝛌𝛆/(1 + 𝛌) If choose _____ adequately ==> CAN REACH OPTIMUM: 𝛚 = 𝛌k
aggregate supply curve
𝛑 = 𝛑 + [a(1 _ s)/s](Y - Ybar) + 𝛆til(1-s)/s ⟺ 𝛑 = 𝛑^e + 𝜶(Y - Ybar) + 𝛆
upward sloping AS
𝛑 = 𝛑^e + 𝜶(Y - Ybar) + 𝛆 depends on 𝛑^e AND what drives 𝜶 positive or negative
Phillips curve
𝛑 = 𝛑^e - 𝛃(u - u^n) + 𝛆 a curve that shows the short-run trade-off between inflation and unemployment went and measured unemployment, changes in prices through nominal wages and plotted them ==> sloped down INFLATION DEPENDS NEGATIVELY ON UNEMPLOYMENT combo of slope of AS (stickiness) AND amount of AD shifted (= size of shock and crowding out) ==> shifts how much Y INCREASES 1. says business cycle is mostly about AD 2. if want to stabilise use MP 3. forget stabilising just pick point **INFLATION DEPENDS ON***: 1. EXPECTED INFLATION 2. CYCLICAL UNEMPLOYMENT 3. SUPPLY SHOCKS
inflation in short run equation
𝛑 = 𝛑bar + (rhat - ihat)/(𝛘 +𝜶) + (1 + 𝜶)/(𝛘 + 𝜶) × 𝛑^(as)
Inflation
𝛑_t = P_t/P_t-1 - 1 ≈ ∆log(P_t) the change in the PRICE LEVEL aka the change in overall prices ____ is: 1. change in the amount of money you must give to get in return the overall set of goods in the economy 2. loss of real value of the unit of account measure of change of value of unit of account
optimal contract
𝛚 = 𝛌k
link nominal to real exchange rates
𝜖 = (E × P_US)/P_Euro = EP/P* * = price in foreign land
bargaining power of hte power
𝜸
affect consumption
ricardian equivalence breaks down in pay as you go system because of the redistributive aspects ==> ____
increases; decreases
rightward shifts of N^s due to wealth effect (of increase in G) ==> increase in r ==> N ____ ==> w ____
Taylor principle
says 𝛘 > 1 = if 𝛑 is HIGHER THAN target 𝛘 says how much to raise interest rates follow _____ otherwise, spirits would be enhanced by policy, justifying them, leading to instability if 𝛘 = 1 ==> if expect 1% higher 𝛑 ==> 𝛑 = 2% ==> justified whatever expect happens
Repurchase Agreements (repos)
security is temporarily sold to be later repurchased at pre agreed price. Have three features: 1. Haircuts margins: sell for less than market value so that lender has cushion for changes in value of collateral 2. Senior claims over interbank loans and depositors. 3. Very short duration, rolled over frequently
job creation condition
setting EXPECTED REVENUE = EXPECTED COST OF OPENING VACANCY gives rise to the ____ describes a NEGATIVE RELATIONSHIP between WAGES and TIGHTNESS EQUATION: (y - w)/(r + s) = cy/[q(𝜭)] where q(𝜭) = m/v = [𝛍M(u,v)]/v = 𝛍M(1/𝜭 , 1) = probability that vacancy is filled r = real interest rate
shifts in monetary policy rule
shift UP/LEFT IF: 1. tighter monetary policy 2. expected deflation 𝛑 or 𝛑^e move or shock to MP "tighter" = HIGH ihat ==> for same Y, r is BIGGER
demand pull and cost push
shocks causes for rising and falling inflation names for the u - u^n and 𝛆 terms
Business cycles
short-run fluctuations of output and employment around trend Y = Y^(trend) + Y^(cycle) where Y = log output PROPERTIES: 1. small cycles relative to trend, but not minor. Depression is very large 2. recurrent but not predictable: sin-cosine modeling on waves was a failure
Central bank
solution to problem of many banks clearing house for banks with power to issue reserves owned by banks and government to serve as a clearing house for banks bank of banks main job isn't to print currency, but to be a clearing house for banks ADVANTAGE = regulatory power over members
commitment
solution to the salience of the presence / procrastination EX: assignment due in 3 days, costs more to do it day before costs less to do it today OPTION 1: force your tomorrow self to do it raise the cost of doing it in the last day may seem irrational: makes things harder on yourself but actually just a way for you to commit OPTION 2: do it today. realise the actual choice is between today that costs less than at the last minute ==> SOLUTION: _____
limiting payout
solve the problem of BANKS RUNS by _____ 𝜭 = fraction of people get paid
opportunity cost of currency
some forms of money pay 0 interest (cash) whereas holding savings in bonds pay an i ==> HIGHER THE INTEREST RATE ==> FASTER you want to GET RID OF CASH and BUY BONDS to earn interest rate (talking in terms of nominal interest rates) HIGHER nominal interest rate ==> HIGHER velocity
give independence to central bank
source of problem are: k and 𝛌 = the desire to lower unemployment often a political problem because politicians are very responsive to unemployment rate SOLUTION: _________ MEANING: institutional relationship between executive and CB procedure to nominate and dismiss head of CB and length of appointments role of government officials in CB board whether CB must finance government deficits must CB get government approval for actions METAPHOR: child is trustworth, it is the people he/she/they hangs out with that are the problem ==> teach child to be independent and stand up for him/her/their self
normalization of balance sheet
stick with floor system
Nominal rigidities
sticky prices and wages The slow adjustment of nominal wages and prices to changes in economic activity.
uses of dynamic macro model
study the effects of: 1. a temporary increase in government spending 2. a temporary increase in TFP 3. news about a future rise in TFP 4. An (exogenous) fall in the capital stock, e.g. because of a natural disaster 5. an increase in credit-market risk
uses of the two period model
study the effects of: an increase in current income an increase in future income temporary vs. permanent increase in income an increase in real interest rate
horizontally
substitution effect in a graph moves ____
generations have a hard time trading with each other
subtle distortion in pay-as-you-go system: _____
non-tradable sector
taking all the factors together ==> very common that ____ is favoured by politicians etc. because NO COMPETITION
increase; no change; shift
tax cut from an INCREASE IN GOVERNMENT BONDS:==> ==> _____ S^P ==> r ____ (unless substitution effect outweighs) ==> ____ D curve (private savings) by EXACTLY THE SAME AMOUNT as S curve of bonds
defaults
tax-advantaged savings plans. Should max this out, tax savings return beats any other investment
Automatic stabilisers
taxes go up automatically when Y increases Steepens IS and it shifts by less after a shock, shift in MP now has smaller effect on Y
stock price
tells firms how much the stock market values each unit of capital already in place ==> it is a signal of the market's willingness to pay for one more unit
transitory income
temporary deviations from average income
deposit contract
terms of _____ offered by bank: give me your 1 unit of income at t = 0 i will give you y1 at date 1 if you show up and want it get paid according to your place in the line outside my bank otherwise i give you y2 at date 2 IN PERFECT COMPETITION: BECAUSE there are MANY BANKS ==> COMPETITION drives PROFITS = 0 ==> choose y1 and y2 to maximise expected utility of consumers
Must χ be high enough, or low enough, to ensure that the animal spirits on inflation get attenuated?
the condition to attenuate animal spirits is that χ > 1. This is the standard Taylor principle: since higher inflation expectations via animal spirits raise inflation, the central bank needs to respond by raising nominal interest rates sufficiently aggressively to ensure that actual inflation rises by less than expected inflation, thus preventing inflation expectations (and therefore inflation) from becoming unanchored.
Seigniorage
the difference between the face value of money and the cost of supplying it; the "profit" from issuing money CB prints currency, cost 0 ==> buys goods with it gives goods out ==> level of ____ = amount of money printed / price level of goods = number of goods it buys in _____ _______ = ∆M/P = NET INCOME OF CB very easy to raise in the SHORT RUN
Seigniorage
the difference between the face value of money and the cost of supplying it; the "profit" from issuing money Change in M / P
mandates a higher level of saving than the consumer would choose
the fully funded pension system MATTERS ONLY IF ____ where y - c1 = current saving ASSUME: consumer cannot borrow in anticipation of the benefits CASE WHERE MOVEMENT OF ENDOWMENT IS DOWN / LEFT OF ORIGINAL CONSUMPTION POINT: Ricardian equivalence logic says people's DISPOSABLE INCOME GOES DOWN TO y - contributions today to such a point that to keep on consuming at the original consumption point, they'd need to borrow against benefits paid in future ==> not plausible IF GOVERNMENT FORCES THEM TO SAVE: ==> may be forced to consume at a different point where they are worse off (on a lower indifference curve) CONCLUSION: fully-funded pension plans in this context either MAKE NO DIFFERENCE or if government forces them to save too much and can't borrow against future pension benefits ==> may be made worse off by being forced to save ==> no rationale in this context to set up this system
if a person is a saver or a borrower
the income effect RELIES HEAVILY on _____
term spread
the interest rate on a long-term debt security minus the interest rate on a short-term debt security
f
the more important variable between f and s
loss spiral
the more prices fall, the higher the losses to banks.
The great moderation
the period from 1985 to 2007 when the US economy experienced relatively small fluctuations and low inflation + longer expansions HOWEVER, the business cycle isn't dead - not predictable - still intense contractions (2007-9) - still co-movement across sectors, industries, aggregate variables - impulse responses haven't changed
The Great Moderation
the period from 1985 to 2007 when the US economy experienced relatively small fluctuations and low inflation volatility fell 1984-2002 WHY?: better at managing inventory ==> make exactly amount needed and smoothed production ==> smother business cycle LENGTH OF BOOMS INCREASED
paternalism
the policy or practice on the part of people in positions of authority of restricting the freedom and responsibilities of those subordinate to them in the subordinates' supposed best interest. THIRD SOLUTION TO OVERSPENDING very difficult philosophical/economic debate: if you're making bad choices, should I impose the 'right' choices on you? use NUDGES: raise minimum payment on credit card balances Save More Tomorrow program: firms offer employees the option of joining a program in which their saving rates automatically increase when they get a raise
efficient markets hypothesis
the price of a stock = the present value of future expected dividends (related to the firm's profits)
maturity transformation
the process by which banks take short-maturity liabilities and invest in long-maturity assets (long-term investments) -they offer a contract that is 'on demand' or 'demand deposit contract' i.e. anyone could show up in period 1, even though the bank is investing in products that only come to fruition in period 2 -only via maturity transformation can the bank provide liquidity insurance -same contract given to all - to be able to withdraw period 1 if they want, not dependent on having a liquidity shock, as this is private info -y2>y1 is a must
arbitrage
the process of buying a currency low and selling it high
tax multiplier
the ratio of change in the equilibrium level of output to a change in taxes start with: Y = c + 𝜸(Y - T) + a - 𝛿r + g IF INCREASE t: ==> C DECREASES ==> Y DECREASES ==> C decreases more ==> pushes Y further down so on and so on ∆Y = 𝜸(∆Y - ∆t) ==> ∆Y = -∆t × 𝜸/(1 - 𝜸) which is the _____
Effects of an increase in capital stock on the SOE with production and investment model
the rightward shift of the output supply curve should cause the real interest to fall. The output demand curve then shifts to the right as the excess supply of output is exported and net exports rise.
business cycles
the short run fluctuations of output and employment around trend -small relative to trend but not minor -recurrent but not predictable
Classical economics
the theory that free markets will restore full employment without government intervention Y and r fixed by production function deal with nominal variables
adaptive expectations
the theory that people look at past experience and gradually adapt their beliefs and behavior as circumstances change MODEL OF EXPECTATIONS 3 CONCEPTS FOLLOW FROM THIS: 1. the NAIRU 2. Inflation inertia 3. Demand-pull and cost-push
Inventory investment
the value of the change in inventories of finished goods, materials, and supplies
current income
theories of consumption ==> _____ SHOULD affect CURRENT CONSUMPTION only through affecting life-time wealth BUT empirical studies suggest that _____ may have a DIRECT EFFECT ON CURRENT CONSUMPTION
Quantity theory
theory that too much money in the economy causes inflation M × V = P × Y where M = money stock V = velocity = number of transactions, changing hands Y = number of goods in economy P = price level P × Y = nominal GDP LHS: transaction equal the stock of currency times the number of times it changes hands RHS: nominal GDP, all sales in economy EQUAL INTERPRETED AS PROPORTIONAL ==> KEEP r FIXED, and use Fisher equation and semi-elasticity of velocity that says : 𝛏 = ∆V/(V∆𝛑^e) ==> GROWTH RATES OF THE EQUATION HOLD 𝛍 + 𝛏∆𝛑^e = 𝛑 + g g = growth rate of economy
sticky market wage
there is a _____ in the case that POSITIVE UNEMPLOYMENT persists labour supply > labour demand and wage is above the intersection
cost push
this cause of inflation occurs when producers raise prices to cover higher resource costs IF INFLATION DECREASES OR INCREASES: and its because 𝛆 because change in MC ==> shift in Phillips curve
pro discretion
time inconsistency problem is greatly exaggerated and can be taken care of by institutional design discretion allows me to respond to unexpected shocks if i can use money and the price system and to improve the real side of the economy, why not?
what is the difference between time and dynamic inconsistency?
time inconsistency: when decision makers discount the future- salience of the present -dynamic inconsistency: even though decision makers planned their consumption in period 1, when period 2 comes, they change it again- hyperbolic discounting
pay as you go pension system
transfers between the young and the old people make contributions which go straight away to the old taxes on the working population pay for transfers to those who have retired each period suppose two generation are alive at each date: young and old young pay contributions t old receive benefits b population growth: N' = (1 + n)N where each period, there are N' young, N old alive total pension benefits must equal total contributions from the young: Nb = N't ==> t = b/(1 + n)
sustainable debt
tricky BUT DEPENDS ON: interest rates future growth i = interest rate B = government debt S = spending T = tax revenues D = deficit PY = nominal GDP ∆B_t = i_tB_t + S_t - T_t where D_t = S_t - T_t debt over nominal GDP: b = B/PY ∆b_t/b_t = ∆B_t/B_t - ∆P_t/P_t - ∆Y_t/Y_t = i_t + D_t/B_t - 𝛑_t - g_t
Unemployment rate
u = U/L those who are not employed but actively searching for work
steady state unemployment rate
u = s/[s + f(𝜭)] = s/[s + f(v/u)] (BC) ==> model can explain Beveridge curve
first order condition of two period model
u'(c) = 𝛃Ru'(c')
increases; decreases
u* INCREASES when: s ____ OR f ____
steady state unemployment rate
u_t+1 = u_t = u* DETERMINES FOR LR s(1 - u*) = fu* ==> u* = s/(s + f) adjustment to u* is quick
U
unemployed population variable
decreases
unemployment INCREASES in recessions because f ____
expectations argument
unemployment only changes if unexpected inflation if expected inflation rises, then PC shifts, stops being useful once expectations adjust, unemployment at LR 'natural level' NEED: how inflation expectations formed
pin down E
use definition of nominal exchange rate: 𝜖 = EP/P* ==> E = 𝜖P*/P take logs ==> ∆E/E = x + 𝛑* - 𝛑 where x = change in real exchange rate 𝛑* = change in price abraod 𝛑 = change in price at home
prevent float
use same currency, same central bank ==> no foreign reserves, no individual central banks ==> fix exchanges rates forever and share a common monetary policy 1st get rid of CB's ability to raise i ==> can't bet against more costly to bet against peg ==> get rid of own currency ==> create one such as the euro
price
value of good in terms of that unit of account. How much money you give to get a good.
Acyclical
variable has approximately 0 CORRELATION with output EXs: real wages government spending
countercyclical
variable moves in the OPPOSITE DIRECTION of cyclical output NEGATIVE CORRELATION with cyclical output EXs: unemployment
Procyclical
variable moves together WITH OUTPUT POSITIVE CORRELATION with cyclical output EXs: consumption investment imports inflation
promote trade
volatility of exchange rate = impediment ==> peg to _____
surplus to an unemployed worker
w - b given 𝜸 = worker's bargaining power ==> according to Nash bargaining ==> _____ should be a fraction 𝜸 of the total surplus ==> w - b = 𝜸(y + cy𝜭 - b) ==> w = (1 - 𝜸)b + 𝜸(y + cy𝜭) (WC) WC = wage curve
Wage Curve
w = (1-γ)b + γy + γcθ - Positive relationship between tightness and bargained wage - Shifts upward b or y increase (unemployment benefits raise outside option, higher productivity increases gains from deal)
conclusion of equilibrium search model
wage curve (WC) and job creation curve (JC) together ==> equilibrium wages and market tightness (w, 𝜭) GIVEN equilibrium tightness 𝜭, from Beveridge curve (BC) ==> equilibrium unemployment u is determined GIVEN equilibrium tightness 𝜭 ==> find job finding rate f(𝜭) ==> use f(𝜭) to find steady state unemployment rate u ==> given u and 𝜭 ==> vacancy rate v is known
tie to the mast and commitment
ways to limit your options so you don't overspend
real exchange rate; inflation differentials
what determines how many dollars I pay to get one Euro? ________ and ________
focus of equilibrium search model
what gives rise to the Beveridge curve relationship? what could have caused the Beveridge curve to shift? what determines equilibrium unemployment?
euro crisis
what happens if have huge capital inflow that shifts the production function and production function shifts out
Balanced budget multiplier
what if G and T rise by the same amount? combine government purchases multiplier with tax multiplier: ∆g = ∆t = ∆ ==> ∆Y = ∆g × 1/(1 - 𝜸) - ∆t × 𝜸/(1 - 𝜸) = ∆ ______ = 1
term spread is negative
what if ______ ? ==> must mean that i_t^{1} are HIGHER THAN EXPECTED to be in future ==> policy is TIGHT and tight policy is often associated with recessions
greater than 1; less than 1
what if sell share in project at date 1 once know my type? say selling destroys possible additional yield EARLY TYPE: only sell at price _____ LATE TYPE: only buy at price _____ ==> NO MUTUALLY BENEFICIAL TRADE ==> NO MARKET
unconventional monetary policy
what was _______? forward guidance and ______ to move LONG rates
change interest rate
when _____ (in isolation), income is EXOGENOUS it changes the GRADIENT of the budget line ==> budget line PIVOTS when there is a _____
inflation increases
when ______ ==> MP curve shifts UP ==> i INCREASES ==> expected inflation is FIXED ==> r INCREASES OUTPUT DECREASES INVESTMENT DECREASES
pecuniary externality
when a bank sells assets they push asset prices down and cause losses of other banks - this leads to systemic risk where losses in one bank can lead to losses across the system -amplification in modern banks - modern banks have greater systemic risk due to new features of securitisation and wholesale funding
Diaibolical loop
when banks hold a significant number of domestic sovereign bonds as assets. When there is a shock to perceptions of default risk on these sovereign bonds, the value of these bonds decreases. the banks holding these bonds suffer losses on their assets. This in turn has two effects: (1) these banks have lower equity and are therefore more likely to need a government bailout (2) these banks cut lending to the real economy, lowering economic activity and government tax revenues. Both of these channels imply a higher probability of government default, thus creating a feedback loop and potentially a self-fulfilling cycle in terms of expectations of default.
Solvent but illiquid
when its debt is not unsustainable but it has large amounts of this debt coming to maturity (i.e. short term debt) and it is not able to roll it over (this creates liquidity crisis, rollover/run crisis). Illiquidity can lead to insolvency as illiquidity can trigger default. In a liquidity crisis, international institutions may step in to provide emergency funds as a "lender of last resort".
boom
when output is ABOVE TREND OR when cyclical output is POSITIVE
recession
when output is BELOW TREND OR when cyclical output is NEGATIVE
total surplus of a match
when they (firm and worker) are together ==> they can produce y when they are apart ==> firm gets the value of another vacancy and the workers gets the value of unemployment unemployed worker enjoys unemployment benefit = b ASSUME: vacancy costs cy to maintain ==> total hiring cost in the economy = cyv ==> average hiring cost for each unemployed worker = cy𝜭 ______ = y - b + cy𝜭 the sum of the surplus to an unemployed worker and the surplus to a firm with a vacancy
yield curve; expectations
why do central bank speeches move markets so much? _____ and _____ of future short rates
salience of present, temptations, dynamic inconsistency
why do people have regrets and governments overspend
greater than or equal to
worker accepts offer w IF: V_e (w) _____ V_u
efficiency wages
worker effort tends to increase with the real wage rate that the worker receives can produce stickiness in the real wage because the wage is set by firms to provide incentives for workers to exert effort In contrast, in the COMPETITIVE MODEL: equilibrium wages clear there labour market i.e. bring labour demand into line with labour supply
growth dividend
%∆(debt/GDP) = D_t/B_t - (g_t + 𝛑_t - i_t)
Corridor System
- CB controls i buy buying/selling bonds from banks in order to inc/dec their deposits/ credit - floor = CB interest rate iv - ceiling CB lending rate
Term Spread
- Difference shows whether investors expect the IR to increase or fall - If 2 year rate > 1, people expect next year's 1 year rate to be higher - Positive spread - short term rates rise in the near future.
central bank reserves
- Money held by the central bank and used by commercial banks to make payments between themselves - min requirements - free of default - Iv
Central bank intervention in bank runs
- are they bailing out bad banks w bad assets? = ineffeciency?
requirements for Ricardian equivalence
- lump sum taxes - tax burden shared equally among households - no credit market imperfections
violations of PPP
1. Law of one price does not hold very well 2. basket of goods in one country to another is NOT THE SAME 3. many goods are NON-TRADED 4. there are TRANSPORTATION COSTS 5. BARRIERS TO TRADE
Co-Movement
One shock effects both variables, and both variables effect each other.
M x V
P x Y
public saving
T - G
Public debt increases, and tax revenues decrease. Do these two developments raise/lower/leave unchanged your assessment of whether the State might be insolvent?
The two developments mean that the blue vertical line shifts to the right (higher debt), while the green parabola shrinks towards the vertical axis (lower tax revenues).
Current bank balance sheet
Use Reserve satiation and quantitative easing 1. ASSETS: long-term government bonds 2. LIABILITIES: currency and reserves 3. TOTAL SIZE: very large
marginal product of capital; taxes
What two things determine the ADDITIONAL EXPECTED FUTURE PROFIT of buying a machine? ____ and _____
Contraction
When cyclical output is falling. Starts with a peak, ends in a trough.
MP
____ is reason why crowding out
saving
____ is used to achieve smooth consumption
vacancy rate
____ = v measures the fraction of jobs that are vacant i.e. the total number of vacancies divided by vacancies plus "filled jobs" (employment)
Keynesian consumption function
____ states that CONSUMPTION DEPENDS ON CURRENT INCOME: C = a + bY where a>0 and 0<b<1 where C = aggregate consumption (stable) Y = aggregate income a,b are parameters
simple bond
_____ has x = 1 ==> y = 1 + i
Income effect
_____ of real wage and real interest rate change on representative household response to the hypothetical income transfer used to find the substitution effect with the price held constant
threat of bank runs
_____ useful to discipline banks _____ ARE NEVER A BAD EQUILIBRIUM
higher long run nominal rate
______ ==> higher inflation target ==> higher inflation
arbitrage conclusion
______ ==> 2 times LR yield approximation = sum of sequence of short rates taking into account future ones are based on expectations
Net Income in the past
______ = i^(Assets) × Assets - i^v × Reserves - 0 × Currency
loan rate
______ = r2 at banks
investment line
______ ==> goes down the lower the 2 year rate the more you invest HIGHER investment pushes inflation UP
reason for stagflation
______ in 1970s: supply shock + abuse of the Phillips curve
Money
a unit of account a social convention: convenient to use same units; indifferent to units because government coordinates all people into 1 unit
substitution effect
isolates pure incentive effect of something changing like r, holding constant may be better off or worse off
i
opportunity cost of holding reserves as opposed to lending
midpoint of budget constraint
optimal place for E in two period model
N year bonds
pay q^{n} today, get £1 in N years expected return on N one year bonds and one _____ MUST BE THE SAME 1/q_t^{n} = (1/q_t^{1}]) × (1/q_t+1^{1}e) .... × (1/q_t+n-1^{1}e in terms of yields i_t^{N} = (i_t^{1} + i_t+1^{1}e + .... + i_t+N-1^{1}e) / N
0
peg exchange rate: set (∆E/E)^e = _____
myopic argument for fully funded pension systems
people are short-sighted ==> maybe need to be forced in order to make yourself better off PATERNALISTIC ARGUMENT
Policy in Short Run
pi^e = pi-bar + pi^as "Animal Spirits" Higher real interest rate means less consumption and investment today, firms want to lower their prices so lower inflation: r = r-bar - α(pi - pi^e) + r-hat (shocks - productivity, taxes etc.)
steeper
smaller s ==> ______ AS
propagation
the CHANNELS through which shocks transmit to economic outcomes over time ⟺ different macroeconomic models
modesty
what can stabilisation policy achieve? ____ is best
Comovement
Links across industries -they seem to move together up and down in spite of the idiosyncrasies/all industries' value added goes up together (where some go up and some go down) of each industry Across components of GDP (corr with cyclical output) -Procyclical: C, I, M, inflation -Countercyclical: Unemployment -Acyclical: real wages, G
The interest rate falls. This will be a permanent change. How does this affect the nominal interest rate on long-term bonds in this economy, as well as the term spread on these bonds?
Long-term interest rates are the average of current and expected future short-term interest rates. A permanent change in i will cause all of these short-term rates to fall, so the long-term rate will also fall. The term spread is the difference between the short- and long-term yields. Since the current short-term rate and the expected future short-term rate will change by the same amount, the short-term and long-term yields also change by the same amount, so the term spread does not change.
Why does PPP not hold?
Many goods are non traded The basket of goods in different regions not the same Transportation costs Barriers to trade
Tobin's Q
Market Value of Firm / Replacement cost of capital Firms increase investment until Tobin's Q ratio is equal 1, try to maximise the present value of dividends by maximising stock market value
suspension of convertibility
SOLUTION TO BANK RUNS: 1 ______ announcement that ONLY FIRST 𝜭 fraction of DEPOSIT will be paid at date 1 ==> others will be turned down PAYOFFS TO LATE CONSUMER: if go to bank at date 1 ==> receive LESS THAN y1 because change that will not be at the start of the line if go at date 2 ==> investment is INTACT so can receive y2 RECALL: y2 = (1 - 𝜭y1)(1 + r) / (1 - 𝜭) ==> y2 > y1 PROBLEM: do not know 𝜭 ==> if suspend too early, hurt the people hit by liquidity shock incentive for bank to close early and keep money
Nash Bargaining
Surplus will be solved by 'Nash bargaining' where constant bargaining powers of γ (0 to 1) and 1 - γ for workers and firms w - b = γ(y-b+cθ) w = (1-γ)b + γy + γcθ - Higher gamma, worker gains more from the job
fiscal reform
TO END A HYPERINFLATION: not enough to cut money growth now, if people expect you to print money in the future ==> expect inflation to accelerate ==> second term rises need to also promise to not print more money in credible way = _____
forward guidance
announce future short-term interest rate plans through ARBITRAGE, this affects expected returns, and so affect long-term yields today 2i_t^{2} ≈ i_t^{1} + i_t+1^{1}e even though CB only sets short-term rates, because it can control WHOLE PATH of these short-term rates ==> can influence long-term rates: [i_t^{1}, i_t+1^{1}e] ⇒ [i_t^{1}, i_t^{2}]
permanent or life time income
both Friedman's theory of permanent income theory of consumption and Modigliani's life-cycle theory of consuMption HIGHLIGHT THE ROLE OF _____ in DETERMINING CONSUMPTION
Business fixed investment
businesses' spending on equipment and structures for use in production
lifetime budget constraint of limited commitment
c + c'/(1 + r) = y - t + (y' - t' + pH)/(1 + r)
lifetime budget constraint for a saver (lender)
c + c'/(1 + r1) = y + y'/(1 + r1) - [t + t'/(1 + r1)] = we1
ABC recovery
1. v large fall in DP 2. Immediate bounce back as gov runs a deficit 3. less steep recovery
return on short one-year bond
1/q_t^{1}
probability of being re-elected
1/𝛿 in consumption with temptation model for government
tax cut in market with no imperfections
==> consumer will save entire tax cut to pay the higher future taxes
reduce welfare (less generous welfare state)
Corollary of situation of an increase in the unemployment benefit b if want to REDUCE UNEMPLOYMENT ==> ____ explains difference in unemployment across countries still be able to pay for c at this point
higher tightness
FOR ANY GIVEN u: HIGHER vacancy rate v ==> ______ (v/u) ==> HIGHER job finding rate f ==> LOWER steady state unemployment rate u
government's present value budget constraint
G + G'/(1 + r) = T + T'/(1 + r) says government must collect enough taxes in present value over the whole future horizon sufficient to pay for the government's spending it plans to do LHS: the present value of all the government's expenditure (no transfer payments, provision of goods and services directly) RHS: present discounted value of all taxes, STRICTLY NET TAXES any transfers would be deducted
Fisher equation
From NO ARBITRAGE CONDITION: get measure of expected inflation and 3 concepts linked: 1 + r = (1 + i)/(1 + 𝛑^e) <=> from taking logs 𝛑^e = i - r nominal rate = real rate + expected inflation
government's future period budget constraint
G' + (1 + r)B = T' where T = tax revenue collected in real terms (if negative = transfer) B = money borrowed = how many bonds issues, start from blank
positive
GIVEN NO ARBITRAGE: from investor's perspective, if buy currency today, question is whether it is EXPECTED TO APPRECIATE: THAT IS WHETHER: (∆E/E)^e = (E_t+1^e - E_t)/E_t is _____
Fisher Equation
Take logs of everything since they're so low that 1 + r = r etc. Nominal rate = real rate + expected inflation
Which policies should be delegated to technocrats?
Technically complex decisions Goal is clear and consensual Providing a stable framework is more important than quick reactions Redistribution issues are not first order Accountability and transparency can be enforced
dynamic inconsistency
Tendency of 'optimal' policy to be different at different points in time
solvency
The ability of a company to pay interest + debt due use present and future cashflows
shock amplification
The amplification comes from the fact that modern banks amplify asset-price cycles through the loss and margin spirals
consumer's indifference curves
individual's consumption vs. future consumption show people's preferences spending done by households basket of goods would like more of both every point is a consumption plan
Exchange rate volatility
Varies with -future interest rates in both countries at far away horizons -proportionally with future exchange rate, and so real exchange rate as well -expectations changes on these Usually v volatile bc LOP only holds in the long run
The Great Moderation
Volatility of the business cycle fell 1984-2002. The length of booms increased
Boom
When output is about trend cyclical output is positive
aggregate demand curve
shows the relationship between the aggregate price level and the quantity of aggregate output demanded by households, businesses, the government, and the rest of the world variables = Y, 𝛑
Phillips Curve
shows the short-run trade-off between unemployment and change in inflation -negative relationship -uses nominal wages
steeper
slope of IS curve is ________ IF: 𝛿 SMALL OR 𝜸 SMALL if investment is interest-rate inelastic OR if lower marginal propensity to consume
tying yourself to the mast
solution to not overspending when have consumption with temptation force yourself to split savings of 1/2 into liquid savings available at date 2 and illiquid savings that can only touch at date 3 ==> utility is higher here than if had no limitations
a < 1
ZERO PROFITS of banks 0 profits ==> 𝛑 = 0 because banks are COMPETITIVE L = deposits what would you receive from loans made? ==> oblige borrowers to pay r2 𝛑 = aL(1 + r2) - L(1 + r1) = 0 ==> 1 + r2 = (1 + r1)/a ==> there is a DEFAULT PREMIUM (r2 > r1) WHEN _____
ASAD after MP expansion
_______ leads to AD shift to the right ==> INCREASE in g ==> INCREASE in Y ==> INCREASE in disposable income multiplier / crowding out effect flexible firms raise their price due to the INCREASE IN Y as they do AND 𝛑 INCREASES: ==> MP shifts LEFT ==> INCREASE in i ==> INCREASE in r ==> CUTS I ==> DECREASE in Y SR: MONETARY POLICY EFFECTIVE a cut in interest rates raises both 𝛑 and Y LONG RUN: MONETARY POLICY NEUTRAL given higher 𝛑 people adjust 𝛑^e ==> sticky guys adjust 𝛑^e UP ==> AS shifts UP = LR point to where output returns to original output point EXPECTED INFLATION INCREASES FURTHER
real exchange rate
_____ = 𝜖 relative price of goods of two countries EX: how many European baskets must give to get one American basket
DECREASE real interest rate
_____ ==> DECREASES relative price of current consumption ==> FLATTEN SLOPE of lifetime budget line
transitory changes in income
_____ ==> PREDICT smoothing of AGGREGATE CONSUMPTION
flatter IS
_____ ==> less impact to fiscal policy ==> depended on 𝛿 ==> large 𝛿 = how sensitive is investment to the INTEREST RATE ==> A LOT OF CROWDING OUT
larger T
_____ ==> smaller the effect of CURRENT INCOME y on wealth ==> smaller effect of y on c
LHS of E1 (midpoint of L.B.C)
_____ ==> tax cut would have NO EFFECT because not borrowing ==> save tax cut to pay higher future taxes BREAK RICARDIAN EQUIVALENCE
current consumption
_____ DEPENDS ON lifetime wealth
s
_____ DEPENDS ON: 1. firms' decision to lay off workers 2. workers' decision to quit
f
_____ DEPENDS ON: 1. how many vacancies are available 2. how many vacancies are filled by workers
second hand market sales
_____ DO NOT count for GDP neither do trades in financial assets
Public pension systems
_____ can be rationalised by a CREDIT-MARKET FAILURE: the inability of the unborn to trade with those currently alive 2 TYPES: 1. PAY AS YOU GO 2. FULLY FUNDED
sequential service constraint
_____ dictates that only the first N/y1 people in line will get paid, others get 0 either wait, get 0, or go to bank maybe on time (uncertainty)
higher real interest rate
_______ ==> LESS consumption ==> LESS investment ==> firms want to lower their prices ==> LOWER inflation r = rbar - 𝜶(𝛑 - 𝛑^e) + rhat
increase in government spending
_______ (ignoring the tax burden) ==> Y^d shifts RIGHT
increase in labour productivity
_______ = INCREASE (exogenously) in: TFP or capital stock ==> Y^s shifts RIGHT
term spread
_______ = slope of yield curve
fixed rule
_______ ==> no-response and appointing a conservative central bank chairman a distorted response
level of equilibrium employment (N*)
_______ DEPENDS ON: 1. level of w* 2. labour DEMAND curve
level of equilibrium unemployment
_______ DEPENDS ON: 1. level of w* 2. labour supply curve 3. labour demand curve
substitution effect
_____ of real wage and real interest rate change on representative household response to price change with hypothetical income transfer to ensure household remains on original indifference curve
increase in TFP
______ ==> SHIFTS OUT labour DEMAND curve BECAUSE it INCREASES MARGINAL PRODUCT OF LABOUR
increase in current TFP (z)
______ ==> marginal product of labour INCREASES ==> SHIFTS labour demand curve to the RIGHT ==> HIGHER current capital stock ==> INCREASES marginal product of labour ==> SHIFTS N^d to the RIGHT
Yield to maturity
______ (or interest rate) : constant annual rate that equation return on the bond EX: _____ on 1 period bond = 1 period interest rate simple approximation for a 2 period bond: 2i_t^{2} ≈ i_t^{1} + i_t+1^{1}e
INCREASE real interest rate
______ ==> INCREASES the relative price of CURRENT CONSUMPTION ==> STEEPER SLOPE of lifetime budget line ==> leads to BOTH income and substitution effects
decision to buy capital
______ DEPENDS ON: 1. the present discounted value of the additional expected profits from having the capital 2. the cost of buying it
decrease in capital stock
______ EXOGENOUS e.g. natural disaster DIRECT EFFECT: Y^s shifts LEFT ==> MP_N DECREASES ==> N^d shifts to the LEFT ==> MP_K' INCREASES ==> I^d INCREASES ==> Y^d shifts to the RIGHT
linear penalty
______ ONLY affects MEAN INFLATION, NOT VARIABLE RESPONSE
high unemployment
______ during the recessions of 1974-1975, 1981-1982m 1991-1992, 2001, and 2008-2009
second equilibrium condition
______ for (w, 𝜭) given by firm's decision to open vacanies IN EQUILIBRIUM (due to free entry of firms): expected profit from opening a vacancy = 0 IF EXPECTED PROFIT IS POSITIVE ==> more vacancies open
interbank credit
______ is an imperfect substitute for reserves pays i could have a deposit at CB ==> earns an interest rate i^v, v = notation for reserves
specific skills
______ needed in entrepreneurship and in loan monitoring/collection
positive wealth effect
______ on households 1. SHIFTS C^d ==> Y^d SHIFTS RIGHT 2. SHIFTS N^s ==> Y^s SHIFTS LEFT
long run inflation
_______ is determined by LONG RUN NOMINAL INTEREST RATE set by CB 𝛑bar = ibar + rbar
output supply curve
an INCREASE in the real interest rate r labour supply SHIFTS to the RIGHT employment RISES real wage FALLS HIGHER EMPLOYMENT ==> a LARGER ____ ==> _______ is UPWARD SLOPING
expanding
an economy RECOVERING FROM A RECESSION will still be in a recession and YET be _____
at the level of the efficiency wage
unemployment is POSITIVE if L^s > L^d _______
stock variable
unemployment is a ____ that adjusts slowly as a result of this job finding process
entry in a spreadsheet
unit of account is _____ in your bank focus on using cards, not cash ==> no physical unit
How we know that the AD curve is downward slowing
when inflation rises, the MP curve shifts left thus causing output to fall therefore, in the graph as inflation increases, Y decreases so a downward sloping line
increases; shifts down; negative
when the asymmetric information problem worsens ==> x ______ ==> INVESTMENT DEMAND ____ ==> firm chooses to invest less at any r ==> theory predicts a _____ relationship between investment and the default premium
Government budget constraint
where B is T'-G'/1+r
unpredictable
which shock hits and of which size is _____ ==> why business cycles are irregular and hard to forecast
volatile
why are countries always trying to peg exchange rate? because it can be very ____, hurt trade, and law of one price
expecting high inflation
why fear that people start ________ ? ==> becomes SELF-FULFILLING, with fiscal problems
uncovered interest parity with default
with probability d_t, the domestic bond does not pay at all, but default ==> equating expected returns ==> i - i* ≈ d - (∆E/E)^e _____ = expected appreciation + default risk
P
working age population variable
assumptions of ricardian equivalence
1. tax burden SHARED EQUALLY, no redistribution 2. the taxes we are considering are of the LUMP SUM FORM
Kuznets consumption puzzle
What is the empirical relationship between consumption and current income? Studies did not find a consistent and stable relationship across households at a point in time, they found that APC was falling but within a country over time, APC was constant <=> ____
deficit financed tax cut
____ ==> CONSUMER WELATH remains SAME ==> CONSUMPTION CHOICE (c, c') remains SAME start from E1 suppose government wants to stimulate deficit by CUTTING PEOPLE'S TAXES ==> REDUCE t ==> y - t INCREASES ==> EXPECT E1 to move TO THE RIGHT ==> SHIFT OUT BUDGET CONSTRAINT NOT ACTUALLY WHAT HAPPENS!!! can't cut taxes today means more debt ==> if don't raise t' and keep same level of spending ==> can't repay debt ==> MUST INCREASE t' ==> y - t INCREASES ==> y' - t' DECREASES ==> E MOVES RIGHT AND DOWN remains on same lifetime budget c ==> LIFETIME BUDGET CONSTRAINT DOESN'T CHANGE ==> people go on consuming at midpoint ==> would not want to change their consumption plans ==> consumers don't respond to this tax cut
current income
____ is the sum of 1. PERMANENT INCOME 2. TRANSITORY INCOME
current income
if changes in ____ have a SMALL IMPACT on lifetime income ==> SMALL IMPACT ON CONSUMPTION
negative transitory shock
implies dis-saving or borrowing
vertically
income effect in a graph moves ____
saving increases
when current income = c increases ==> ____
Keynes claims
1. amount of aggregate consumption mainly depends on AMOUNT OF AGGREGATE INCOME: 2. higher absolute level of income will lead, as a rule, to a greater proportion of income BEING SAVED
government can borrow more easily than individuals
CONSIDERATION OF ASSUMPTIONS OF RICARDIAN EQUIVALENCE: say want to BORROW MORE but can't because HIGHER r if government cuts taxes ==> spend today debt needs to be paid eventually but ______
future generation pays debt
CONSIDERATION OF ASSUMPTIONS OF RICARDIAN EQUIVALENCE: when government gives tax cut today, debt goes up, and in future debt will need to be paid off ==> may be after a time when you care ==> _____ say care about future generation ==> still save
increase in the real interest rate for a borrower
CURRENT CONSUMPTION: DECREASES FUTURE CONSUMPTION: ??? (unsure) CURRENT SAVINGS: INCREASES incentivise people to go out and save
government's current period budget constraint
G = T + B where T = tax revenue collected in real terms (if negative = transfer) B = money borrowed = how many bonds issues, start from blank
n < r
IF _____ in PAY AS YOU GO for YOUNG GENERATIONS: gradient of E1E2 will be <<< gradient of budget constraint ==> E2 is below original budget constraint ==> SUBSEQUENT GENERATIONS MADE WORSE OFF
consumer's wealth equation
IN RICARDIAN EQUIVALENCE: G + G'/(1 + r) = N[t+ t'/(1+r)] <=> we = y + y'/(1 + r) - [t + t'/(1 + r)] = y + y'/(1 + r) - 1/N*[G + G'/(1 + r)] TO UNDERSTAND THIS EQUATION: what is income, interest rate only way fiscal policy impinges on that wealth is through G and G' don't need to say anything about t or T, irrelevant can be summarised as 1/Nth of present discounted value of government's expenditure ==> HOLDING G AND G' FIXED ==> any change in TAX POLICY is not going to to have any impact whatsoever on this lifetime wealth
borrow
___ when income is low aka when young or (dis-save) in retirement
R
____ = 1 + r
aggregate economy
_____ : variation source in AGGREGATE INCOME: reflects LONG RUN GROWTH i.e. permanent increases in ____ 's resources, because transitory components across households cancel out
endowment point
_____ is ALWAYS on the lifetime budget constraint
across households
______ : much of the VARIATION in INCOME reflects: 1. FACTORS such as UNEMPLOYMENT, and 2. fact that ____ are at DIFFERENT LIFE CYCLES
permanent increase in income; temporary increase in income
______ >>>> _____ in terms of effect on CURRENT CONSUMPTION
consumption of durables
______ is MORE VOLATILE than INCOME more like investment than consumption
aggregate consumption of non-durables
______ is SMOOTH relative to AGGREGATE INCOME
contraction
when cyclical output is FALLING starts with PEAK ends with TROUGH
Expansion
when cyclical output is GROWING: it starts with a TROUGH ends with a PEAK
saving decreases
when future income = c' increases ==> ___
slope of IS curve
-(1 - 𝜸)/𝛿 < 0
Keynsian Economics
Keep P and pi fixed
private savings
Y - T - C
Acyclical
approximately zero correlation with output
overcome moral hazard problem
justification for such forced savings program: ____
Residential investment
purchases of new housing units
flatter
the bigger the Supply ==> ____ AS will be
one to one
↑ 𝛑bar ⟺ ↑i ____
strength of the Okun law relation
𝛃 = 𝜶𝛈 = slope of AS curve × _____
markets in dynamic macro model
1. Goods market 2. Labour market 3. Financial market
benefits of currency pegs
1. PROMOTE TRADE: by removing exchange rate variability 2. COMMIT PUBLICLY TO AN INFLATION TARGET = to other countries' inflation
continue searching
ACCEPT JOB if offers at least reservation wage OR ELSE: ___
unchanged; increases
AFTER COMBINING GOVERNMENT PURCHASES MULTIPLIER AND TAX MULTIPLIER: private output ______ total output ______
c; a; c + a
ANIMAL SPIRITS SHOCK ___ INCREASE = people for no reason want to consume more ____ INCREASE = people want to invest more for no reason ==> Y increase ==> IS shifts up by _____ and multiplier ==> r INCREASES (2nd round effects) CROWDING OUT EFFECTS
intertemporal exchange
ANY loan contract represents an _____: borrower receives goods and services in the present in exchange for a promise to repay in the future borrowers need incentives NOT TO DEFAULT on their debts - these incentives typically provided by COLLATERAL REQUIREMENTS EXs: a house is collateral for a mortgage loan or for financing consumption through equity withdrawal, a car is collateral for a car loan
Modern Banks: new features
Assets - Securitisation -combine loans in a pool to remove idiosyncratic risk -sell revenue stream from future payments for a payment today -traded continuously, marked to market Liabilities - Wholesale funding -Short term unsecured credit from other banks in interbank market -Repurchase agreements 1)haircuts/margins - sold for less than market value for changes in collateral 2)senior claims over interbank loans and depositors 3)very short duration, rolled over frequently
normal goods
Assumption of consumer's indifference curves: both current and future consumption are ____
heterogeneity
BASIC IDEA OF JOB SEARCH THEORY: ____ differences in jobs and in workers ==> time needed to match these i.e. takes time for a worker to find an "acceptable" job and similarly for a job to find an "acceptable" worker
automatic stabilizers
Because of the automatic stabilisers, the impact of a shift in the MP curve due to higher inflation has a smaller effect on output in the IS-MP model. This implies that the AD curve is steeper.
downward sloping
Beveridge curve is ____
consumer is a borrower if didn't face credit market imperfections
CASE: _____ want to consume a point G (very far right) because highest utility on highest IC ==> not on actual budget constraint ==> best point you can get to is E1 (midpoint) when government changes timing of taxes ==> move E along budget constraint ==> to E2 ==> no impact on consumption ==> move along lifetime budget constraint as if no borrowing constraints MUST ALWAYS BE ON L.B.C. given government spending ==> NEW KINK at E2 ==> now after tax cut, lifetime budget constraint extends to the region couldn't reach before and section of borrowing is further to the right ==> better off as a consumer ==> SPEND TAX CUT fiscal stimulus works ==> higher taxes in future
depreciated and is expected to appreciate
CONFUSION IN NO ARBITRAGE: if E FALLS today TEMPORARILY with future E the same ==> today it ____
Short/Long AS
Classical case: Vertical AS, output fixed, g expansion raises inflation Keynesian case: Horizontal AS, inflation is fixed, g expansion raises Y Going from short to long run, horizontal AS shifts as inflation adjusts
Why is productivity (output per hr) procyclical?
Employment and hours worked (ppl go part time or lose jobs) are both procyclical -If worker is kept in recession even with less sales, then this is labour hoarding -as it is expensive to go and find labour again -even though the worker is less productive as they are making and selling less per hour, they are kept around -productivity tends to be procyclical as a result - the same person is more productive in expansion
low; high
Endowment point E is TO THE LEFT of tangency point A: reflects ____ current after tax income, anticipates ____ future after tax income closer to student position promising career may spend more and run up debts
high; low
Endowment point is quite far TO THE RIGHT of the tangency point: ==> current income after tax is relatively ____ future income after tax is relatively ____
Give two reasons why r might fall
Examples: "Maybe MPK fell (secular stagnation), maybe population ageing has increased demand for savings."
Arbitrage
For real return to give same return as a nominal asset, these two must be equated. It must be that 1 + r = (expected return on nominal bond) = (interest rate) x (1/1+ pie)
Repurchase agreement/Repo (demand deposit type that is not regulated, offered by shadow banks)
I give you an asset, you give me a loan. I sign contract today stating I will buy back the asset tomorrow for an amount = the loan + interest. Rolled over every night, means court can be avoided as the loaner would just keep collateral. These repo contracts became like checking accounts because they were constantly and constantly rolled over. Banks were borrowing in repos and investing in long term projects (meaning they would need the repo to keep on rolling over over this time)
Friedman Rule
I-Iv =0
greater than
IF MPK' is _____ use cost of capital (r + d) ==> profit rate is HIGH, ==> drives up the stock market value of the firm ==> HIGH VALUE OF Q
less than
IF MPK' is _____ user cost of capital (r + d) ==> firm is incurring losses ==> stock market value falls ==> LOW VALUE OF Q
current profits are low
IF _____ ==> firm must finance the investment through loans, bonds, or issuing shares
change shift expectations
IF _________ : ==> change expectations => end up with LESS u ==> ACHIEVE 𝛑 GOAL
crowding out
INCREASE IN G: output Y increases by LESS than government spending G this is a reflection of Y = C + I + G and that consumption C and investment I fall CONSUMPTION FALLS: negative wealth effect, substitution effect of higher interest rate INVESTMENT FALLS: higher interest rate implies an increase in the cost of capital THIS DISPLACEMENT EFFECT OF HIGHER GOVERNMENT SPENDING IS KNOWN AS ____
Investment savings market
INVESTMENT = SAVINGS I = (Y - T - C) + (T - G)
AD: shift in AD
Increase in G, higher Y, higher C, multiplier Higher Y means CB increases interest rates and r increases I crowded out, Y reduces slightly Overall increase in IS Increase in AD and Y
AD: higher inflation
Increase/Left shift in MP when inflation rises, Y falls
slope down
Inflation INCREASES ==> MP curve shifts UP ==> output DECREASES ==> AD _____
Rational expectations revolution
Macroeconomics movement that occurred in the 1970s, introducing more microeconomics into macroeconomics.
Give one criticism of the rational expectations model
It precisely requires that the agents perfectly understand the model and know all the parameters.
we doesn't depend on the timing of taxes
KEY POINT: LIFETIME BUDGET CONSTRAINT DOES NOT CHANGE WITH A DECREASE IN TAXES BECAUSE ____
give CB governor a contract
METAPHOR: $10 off your allowance per minute late
Exchange rates
Nominal exchange rate: how much foreign currency we get in exchange for a unit of domestic currency Real exchange rate: how much foreign basket we can buy for one domestic basket
What are nominal rigidities in the assumption of the Aggregate Supply curve
Nominal rigidities: fraction s of firms don't know current price level, they must form a forecast of it Pe. Why? • Menu costs, sticky prices. • Inattention, sticky information.
Vertical LRAS
ONLY for LR because hard to believe that prices adjust instantly so that all of K and L are exactly used always there is a level of output that is determined by Michaelmas term materials (production functions)
capital misallocation
Portugal's slump in productivity can be partly explain by ______ after euro in 1999
Investment: financed by borrowing + PDV
Production - wages + (Future Prod - Future wages + future capital - borrowing needed for new capital)
decreases; decreases
REASON 1 WHY IS CURVE HAS A NEGATIVE SLOPE: HIGHER interest rates ==> _____ investment ==> ______ output then second round effect further ____ it
lender of last resort
SOLUTION TO BANK RUNS: 2 ______ central bank can LEND RESERVES to banks ==> depositors can be paid IF 𝜭 TURNS OUT TO BE HIGH if 𝜭 is HIGH ==> CB comes to the rescue ==> bank won't close early ==> no run CONCERNS: 1. why aren't other banks LENDING via INTERBANK MARKET? ==> probably moral hazard 2. what if instead BAD BANK, BAD ASSETS? ==> bail out is TRANSFER TO FAILING BUSINESS 3. BAGEHOT DOCTRINE: lend safely at penalty rate against good collateral ==> BUT STILL RUNS if bank shows up because late people showed up early and need to borrow: give at HIGH INTEREST RATE to make them feel it get < y2 because need to pay off CB for stopping the bank run NOT A PERFECT ANSWER
IS
Steeper if investment is interest rate inelastic/if MPC lower Shifts right when G increases (govt purchases multiplier) and shifts left if T increases (tax multiplier)
interest parity
The difference between any pair of countries' interest rates is approximately equal to the expected change in the exchange rate.
fire sale
The precipitous fall in the price of assets that takes place when financial institutions must sell their assets quickly in the midst of a crisis
Purchasing Power Parity
Where EP is price of US goods in pounds and P* is price of UK goods in pounds Can show difference in inflation π* - π = difference in exchange rates (when there is purchasing power parity)
minimise expectations errors
Why are central banks worried about transparency?
lower
Why are expectations low now? CB kept i close to 0 in recent years ('temporarily') ==> people think 𝛑hat is lower
T
__ = Nt tax revenue paid by by N similar households / consumers in period t
APC
___ = C/Y = a/Y + b what fraction of total income to consume
value of being unemployed
___ = V_u = E[wage you will get after search] NOT A FUNCTION OF THE WAGE OFFER some weighted average of: 1. NON-MARKET INCOME: such as unemployment benefits, value of leisures, etc.) 2. EXPECTED MARKET INCOME: that depends on the DISTRIBUTION OF WAGE OFFERS
W
___ = y - t + (y' - t')/R
falling APC
___ ==> RISING APS
aggregate consumption
___ is NOT much smoother than income, even for short-lived business cycle episodes
beta
___ shows that the consumer cares about future consumption but is impatient ___ = impatience
transitory
if changes in current income are MAINLY ____ ==> they have LITTLE IMPACT on CONSUMPTION
funding liquidity
ability to borrow money to buy securities or make loans
multiplier
about high 𝜸
tax smoothing
achieve consumption the same in all periods via _____ 𝝉1 = 𝝉2 = 𝝉3
lenders face lower interest rate than borrowers
another type of credit-market imperfection government borrows and lends at the interest rate that lenders face ==> Ricardian equivalence DOES NOT HOLD IN GENERAL suppose a world where consumer saves at one interest rate (low one) borrow at high interest rate there are government such that when save as consumer --> put into government bonds government pays savings r at all times
money
arbitrary unit of account
asymmetric information
bank lending is subject to _____ because many potential borrowers banks cannot tell the good borrowers from the bad ones
household budget constraint shifts
income effects occur directly when _____ e.g. higher productivity boosts income increased lump-sum taxes reduce disposable income
Intertemporal Budget Constraint (3 periods - hard v)
c1 + (c2/1+r) + (c3/(1+r)^2) = W W = y1 + y2/(1+r) + y3/(1+r)^2 Given W is wealth, replace c3 out of objective to solve unconstrained maximisation
properties of solution to consumption problem
c1 = c2 = c3 = W/3 1. ONLY TOTAL WEALTH MATTERS: time profile of income {y1, y2, y3} DOES NOT MATTER can borrow/lend no matter how it changes so, only permanent income matters for consumption, not current income 2. CONSUMPTION SMOOTHING: people want to smooth consumption over time use borrowing/lending to achieve it
long run
can't fool people all the time so 𝛑^e = 𝛑bar
co-movement model
conditioned on a shock: do the variables move up and down together? Two variables, two shocks y^(a)_t = 𝜭_a×y^(b)_t + 𝜸_aa×y^(a)_t-1 + 𝜸_ab×y^(b)_t-1 + 𝛔^(a)𝛆^(a)_t y^(b)_t = 𝜭_b×y^(a)_t + 𝜸_ba×y^(a)_t-1 + 𝜸_bb×y^(b)_t-1 + 𝛔^(b)𝛆^(b)_t y^(a / b)_t = two economic variables 𝛆 = two economic shocks 𝛔 = economic model of transmission 𝜭 = ECONOMIC MODEL OF _____ 𝜸 = model of propagation can write using MATRICES IMPULSE RESPONSES: Y_t = 𝜭^(-1)𝚪Y_t-1 + 𝜭^(-1)⅀𝛆_t write A = 𝜭^(-1)𝚪 B = 𝜭^(-1)⅀
maximise lifetime utility
consumer CHOOSES (c, c') to _____ use the consumer's lifetime utility function = u(c) + 𝛃u(c') SUBJECT TO: lifetime budget constraint: c + c'/R = W R = (1 + r) W = lifetime wealth = y - t + (y' - t')/R
kinked
consumer's budget constraint is ____ in a credit-market with imperfections
keep banker's human capital
demand deposits _____ to the financing because disintermediation is not inefficient it only shifts rents allow for more credit and create liquidity
reserves
deposits of banks at the central bank
Wage curve
describes a positive relationship between WAGE and TIGHTNESS
appreciation
increase in E
Oken's Law
during recessions, unemployment increases
currency peg
fixes exchange rate of currency to another currency Tying the value of one currency to fluctuations in the value of a different currency. because nature of theory over short period ==> change in exchange rate could be large
one sided search theory
focus on the search behaviour of workers assume exogenou arrival of job vacancies and an exogenous wage distribution mostly used in microeconomics IMPORTANT FOR identifying supply-side influences on equilibrium employment
nominal return
give x today, get y back next year
special features of banks
have ILLIQUID FINANCIAL ASSETS funded by liquid demandable liabilities real assets are ILLIQUID financial intermediaries are special BECAUSE: demandable deposits make bank's assets more 'liquid' LIQUIDITY IS MOST CRUCIAL
Floor system
have a lot of reserves ==> S is high but S is also perfectly INELASTIC shifts DEMAND of reserves to hit i target intersects the Demand Curve at the horizontal bit ==> if change deposit rate (with no change in the supply of reserves) ==> D curve lower horizontal bit SHIFTS UP ==> i instantaneously SHIFTS UP by the same amount because no one wants to borrow or lend at different than CB they choose their official price (deposit rate) ==> markets adjust around them
high nominal interest rates
high inflation countries print a lot of money and therefore have ____
crowding out
high 𝛈 , high ∆
lower inflation
higher rates TEMPORARILY ______ ==> squash spirits
get rid of temptation
how can CB have so much power and not respond to government? ____
carry trade
if domestic interest rates are LOW and foreign interest rates are HIGH ==> the ____ borrows in dollars and invests in Euros
flexible inflation targeting
inflation deviated from ultimate target to response to STATE OF BUSINESS CYCLE 𝛑 = 𝛌k + 𝛑* + 𝛌(u_t - u^N_t) DUAL MANDATE ON REAL ACITIVITY: 1. GAPS: business cycle only, LR monetary neutrality 2. MEASURABLE: unemployment, output gaps 3. FEASIBLE: yes, as long as there is a PHILLIPS CURVE 4. INDEPENDENT FROM OTHER GOAL: supply shocks 5. CONSTRAINED ACTIVISM: transparent, accountable 6. COMMUNICATION: goal and performance clear
Giving independence to central bank
institutional relationship between executive and cb procedure to nominate/dismiss head of cb and appointment length role of govt officials in cb bard whether cb must finance govt deficits ?do cb have to get govt approval for actions
Demand for reserves
interbank rate i minus rate on reserves iv is the opportunity cost of reserves -demand for reserves falls with i - iv -Friedman Rule: i - iv = 0 -interbank credit is an imperfect substitute for reserves, less liquid less safe -the interest rate on reserves is always lower than or equal to the interbank rate -at a high quantity of reserves, demand saturation is reached, same interest rate in either
opportunity cost of reserves
interbank rate minus rate on reserves = _____ i - i^v
borrowing constraint
lifetime budget constraint of the form: c1 ≤ y1 where c1 = current consumption y1 = current income
Taylor rule
most central banks choose short-run interest rates according to the following POLICY RULE: i = rbat + 𝛑bar + 𝛘(𝛑 - 𝛑bar) + ihat In LR, it is CONSISTENT with LR target THIS POLICY DEVIATES FROM LONG RUN INTEREST RATE IF: 1. Current inflation is not at long-run target 2. Discretionary policy 'shock' = "**** the rules" LR interest rate = policy rule either because 𝛑 is high or feel like it (ihat)
off-equilibrium threats
must be credible i. must be able to do it AND ii. must want to do it if it happens mere threat of government bail-out enough to make sure it never happens people will always call you on your bluff
Fisher equation
nominal interest rate r = real interest rate r + expected inflation pi e
left of endowment point
portion of the budget constraint where the consumer chooses to save
right of endowment point
portions of the lifetime budget constraint where the consumer chooses to borrow
slope of monetary policy rule
positive 𝛈 high 𝛈 ==> CB debts stabilise output ==> stabilise prices STEEPER if monetary policy RESPONDS MORE to OUTPUT
asset-price cycles
price of housing rises, assets rise in value, bank can borrow more, banks lend more, house prices rise further
Sector N
produces GOODS FOR DOMESTIC MARKET, protected from foreign competition by natural and political barriers EX:construction and real estate
effect of misallocation between sectors
ratio of output in T to output in N DECREASES ==> economy is WORSE OFF
Fisher equation
real interest rate = nominal interest rate - inflation rate
r
return on real bond
marginal cost; marginal benefit
the OPTIMAL CHOICE of consumption today EQUATES _______ AND _______
higher
the ____ is i relative to i^v ==> LESS DEPOSITS a bank wants to have at CB BECAUSE: can lend them out instead at a profit
intersection
the ____ of the value of being employed and the value of being unemployed graphs = reservation wage don't want to be too fussy and never find a job don't want to accept the first job you get
open market operations
the buying and selling of government securities to alter the supply of money - this is how the CB changed the supply of reserves
maturity transformation
the conversion of short-term liabilities into long-term assets
rules vs discretion
the debate between those who believe that policy intervention in reaction to economic and financial crises may improve the economy contrasted with those who believe such policy interventions tend to lengthen or exacerbate crises
Quantitative easing
use newly issued reserves to buy government bonds of longer maturities use both ==> LOWER interest rates and push up inflation INCREASE demand for longer-maturity bonds ==> INCREASE their price ==> LOWERS the compensation for liquidity or risk ==> LOWERS tp_t combines with forward guidance go out and buy 2 year bonds ==> raise their r and lower their sik ==> savings shifts down
stimulus packages in recession
using G, T to stabilise Y against other shocks
price
value of good in terms of that unit of account how much money you give to get a good
two period model of investment
production function: Y = zF(K, N) future output: Y' = z'F(K', N') Future capital stock: K' = (1 - d)K + I Current profits: 𝛑 = Y - wN - I Future profits: 𝛑' = Y' - w'N' + (1 - d)K' Present value of profits for the firm: V = 𝛑 + 𝛑'/(1 + r) investment is financed from retained earnings, or issuance of new shares absent financial frictions, the results would be the same if firms issues bonds to invest INTUITIVELY: OPTIMAL EMPLOYMENT DECISION: MPN = w OPTIMAL INVESTMENT DECISION: MB(I) = MC(I) MARGINAL COST: MC(I) = 1 MARGINAL BENEFIT: MB(I) = [MPK' + 1 - d]/(1 + r) OPTIMAL INVESTMENT DECISION: [MPK' + 1 - d]/(1 + r) = 1 ==> MPK' - d = r CAPITAL ACCUMULATION EQUATION: I = K' - (1 - d)K FIRM MAXIMISES: Y - wN - [K' - (1 - d)K] + [Y' - w'N' + (1 - d)K']/(1 + r) MPN' = w'
steeper
crowding out is more powerful the ____ is MP because MP responds more to output in this case
i = 0
current net income close to 0 of CB digital currency because ___
two period model of consumption
provides a simple way to illustrate the key features of dynamic theories on consumption CAPTURES: 1. idea of "DYNAMIC OPTIMISATION' = maximise utility over lifetime 2. difference between "permanent/lifetime" income and "current" income period 1 = present period 2 = future
inflation bias
public expects policy to be biased towards higher inflation raise their expectations accordingly up to the point where benefit of lowering unemployment by surprising people is just offset by the cost of higher inflation because of CB's temptation, end up with higher inflation and unemployment unchanged
pecuniary externality
pushing asset prices down and causing losses of other banks through market prices
search theories of unemployment
put forward hypotheses about the factors that determine s and f derive the dynamic path for u by developing theories about flows of unemployment
r + d
q > 1 <==> MPK' + 1 - d > 1 + r <==> MPK' > ____
decreasing in 𝜭
q(𝜭) = probability that a vacancy is filled is ____ part of job creation condition
market value of installed capital
q-THEORY OF INVESTMENT: ____ = [Y' - w'N' + (1 - d)K'] / (1 + r) GIVEN: MPN' = w' and constant returns to scale property ==> ____ = [(MPK')K' + (1 - d)K'] / (1 + r)
state of the economy
r
Share Prices
r = (1+r)v/p + (p' - p)/p Given that rate of return is PDV of present dividends + profits from share sale in future.
Historically, what is r usually?
r=MPK, historically around 2%
new inflation target
raising rates permanently is EQUIVALENT TO having a _____ ==> RAISES inflation
assumptions of labour market equilibrium
real interest rate r is given slope of N^s(r) represents ONLY the substitution effect of changes in the real wage real wage w adjusts to ensure labour supply is equal to labour demand capital stock K is given production function reveals how much output Y firms supply
demand pull
relating to or denoting inflation caused by an excess of demand over supply IF 𝛑 INCREASES OR DECREASES and its because u > u^n because moving along Phillips curve because AD shifts
K'
replacement cost of installed capital
structure of efficiency wages model
represent the idea that higher wages make workers more keen to do well ASSUME: worker exerts effort that is an increasing function of the wage e(w) where e'(w) > 0 PRODUCTION FUNCTION: Y = F(K, E) where E = e(w)N = effective units of labour ASSUME: competitive environment ==> firm takes market wage as given and chooses employment
Post-1980s and post-Ch8 model of expectations
deviation of inflation from expected inflation comes with deviation of output from long run level of output
different kinds of money
differ anonymity, creation, recording, acceptance as medium of exchange
interest rates
difference between budget constraints for saver and borrower: 2 different ____
market's expected path for short rate
difference between long and short rates tells you _______
durables
don't have consumption smoothing with ___ EXs: car, dishwasher, no need to smooth spending on them consumption is MORE VOLATILE than GDP smoother graph is smoothing than the GDP smoother but not by much temporary variations in income don't count much towards your lifetime wealth Reason for less smoothing: all else is not equal (change income, holding all else constant)
floats
double counted money a paid sum which, due to delays in processing, appears simultaneously in the accounts of the payer and the payee
consumer's lifetime budget constraint
downward sloping linear line E = endowment = consuming income after tax whenever you receive it LHS of E: consuming less of income today = you are a SAVER ==> can spend more than income after tax in future RHS of E: consuming more income today = you are a BORROWER ==> repay debt in future means consume less of future disposable income
effort equation
e(w) where e'(w) > 0
increase in expected future TFP
e.g. discovery of new technology that is not immediately available for use in production OR rise in stock prices
1 + r
each unit you save in consumer's lifetime budget constraint
dividends
earnings distributed to stockholders stocks pay ____ from firms' profits NOT PREDETERMINED
identification problem
econometricians can estimate vector autoregressions (VARs) but can't separate comovement from transmission and propagation
impulse
economy growing steadily ==> hit by a _____ = shock = disturbance ==> economy REACTS ⟺ propagation of shock spreads across industries ==> economy gets back on track the SOURCE of the shocks EXs: interest rates, technology, energy price LIKE a rock hitting water: ripples more than a cycle
wealth
effects of a change in INCOME on c DEPEND ON how y affects ____
connection between Okun and Phillips laws
empirical co-movement regularities
E
employed population variable
good outcome
everyone gets paid regardless of when they show up depended on late consumers waiting for period 2 to withdraw
euro
example of currency union eliminated e-risk aka default risk was 0
theory of exchange rates
expect appreciation if foreign interest rate ABOVE domestic interest rate (∆E/E)^e = i*_t - i_t if i* is HIGHER than i ==> it must be that i is expected to appreciate over the next year or two
Theory of exchange rates
expect domestic appreciation if foreign interest rate is above domestic interest rate -bc if E falls today temporarily with future E the same then today it is depreciated and is expected to appreciate
Rational expectations model
expected changes in monetary policy have no effect on unemployment and output and only affect the price level UNCONTROVERSIAL PART: people optimally use the available information to make best forecast possible. People do not make systematic forecast errors aka make the best forecast you can, on average you get it right CONTROVERSIAL PART: people have very good information, and especially understand the AD-AS model exactly as perceived by the economic theorist and policy maker. Model-consistend expectations. This requires that people and the government have the same information and that people are not locked into old contracts aka silly to assume extreme rational expectations
Tobin's q
expected value of a corporation (value of stocks and bonds) divided by the value of its capital stock at replacement cost q = Market value of Installed Capital / Replacement cost of installed capital gives the expected value of a unit of capital relative to its current purchase price
being in power right now
extra discounting comes from probability that will not be in power ==> salience of present comes from _____
exogenous
f = job finding rate is a ___ variable FOCUS ON f: if took u* = s/(s + f) equation, you change when s and f most changes explained by f changing as s is quite stable
increasing in theta
f(𝜭) is _____ given the properties of the matching function i.e. HIGHER the TIGHTNESSS ==> HIGHER JOB FINDING RATE
depreciation
fall in E
entrepreneur
financier cannot trust _____ to deploy production skills and get full output potential
wholesale funding
financing through the issuance of short term debt than through deposits A. Short-term unsecured credit from other banks in interbank market. Well informed, uninsured, quick to run B repo market - security temporarily sold and then repurchased at a pre-agreed price
equity finance
firm can raise funds through ____ issue stocks and shares
output demand curve
for each interest rate r sum up the components of demand this gives us the _____
goods market equilibrium
found by putting the output supply and output demand curves together real interest rate adjusts to clear this market
government's role with money
require that all transactions with money are stated in this unit of account given indifference between many units, usually this serves as a COORDINATION DEVICE
Current exchange rate varies with
future interest rates in both countries at far away horizons proportionally 1:1 with future exchange rate and so real exchange rate as well expectations changes as well
job finding rate equation
given that we find the reservation wage w* from the values of being employed / unemployed the ______ : f = pH(w*) where p = exogenous fraction of unemployed workers receiving a job offer = probability of getting a job H(w*) = 1 - F(w*) where F(.) is the CDF for the exogenous distribution of wages
one sided search model of unemployment
gives us a theory of what f is STRUCTURE: unemployed worker receives job offers to work at a particular wage must decide whether to accept/reject offers and continue searching for work KEY DECISION VARIABLE: reservation wage ASSUMPTION(s): all differences in jobs collapsed to just wage they pay
Consumption/saving decision
giving up a unit of consumption today allows an extra 1 + r units of consumption to be purchased in the future Households requires MRS_C,C' units of future consumption to compensate for the loss of a unit of current consumption OPTIMALITY CONDITION: MRS _C, C' = 1 + r
Consumption/leisure decision
giving up an hour of leisure for work INCREASES INCOME by w ==> budget constraint has slope = - w Household requires MRS_l,C units to consumption to compensate for loss of one hour of leisure OPTIMALITY CONDITION: (tangency between budget line and indifference curve): MRS_l,C = w
positive transitory shock
goes into saving
L
good borrowers are identical but can be differentiated from identical bad borrowers ALL borrow ____
taxation problem
government has some spending {g1, g2, g3} HOW SHOULD GOVERNMENT FINANCE IT OVER TIME? if lump-sum taxes ==> Ricardian equivalence says it does not matter DISTORTIONARY TAXES: only behaviour in our simple model is CONSUMPTION, ==> consider SALES TAXES Extreme version like FINANCING A WAR: {0, g, 0} CONSUMER AND GOVERNMENT BUDGET CONSTRAINT: (1 + 𝝉1)c1 + (1 + 𝝉2)c2 + (1 + 𝝉3)c3 = W g = 𝝉1c1 + 𝝉2c2 + 𝝉3c3
q^{2}
government zero-coupon 2-year bonds price of bond superscript = duration of bond
Deposit insurance
guarantees from a government to pay depositors even if the bank can't come up with the funds HOWEVER could induce moral hazard
set market rates
how do central banks _____ ? today by choosing the interest on reserves. in the past, through choosing the quantity of reserves
Nash Bargaining
how does a meeting between a firm and worker result in a worker being hired when a worker meets a firm with a vacancy, they have to decide at what wage to form a match and start production ____ is one way to DETERMINE WAGE Intuitively: wage is set such that the TOTAL SURPLUS from a match is divided between the firm and the worker according to their bargaining power
Matching function
how easy it is for firms and workers to find each other m = 𝛍M(u, v) where 𝛍 = match efficiency parameter, same role as TFP in production function u, v = inputs m = output PROPERTIES: (similar to neoclassical production function) constant returns to scale positive marginal products diminishing marginal products EX: m = 𝛍u^(𝛈)n^(1 - 𝛈)
The price level
how much money you must give to get the overall set of goods in the economy. Pt
fiscal roots
hyperinflation is a monetary phenomenon with _____ people not doing their jobs
interbank rate
i if banks want to lend other banks money ==> get interest on those money in return that = i market clears AT THIS RATE
Friedman rule
i - i^v = 0 indifference between lending or keeping at CB optimal point for CB
reserve satiation
i = i^v deposit rate = policy rate have a lot of reserves
lending rate
i CANNOT BE ABOVE CB _____ is a horizontal line in demand for reserve CB can decide how many reserves to have = CB's supply
Old CB Net income
i x currency
rate on reserves
i^v
interest parity condition
i_t ≈ i*_t - (E_t+1^e - E_t)/E_t
lower interest rates
if EXCHANGE RATE is HIGHER than desired ==> _____ , print money and buy foreign currency with it
raise interest rates
if EXCHANGE RATE is lOWER than desired: ==> ______ , sell foreign currency to lower money growth
mathematical expectation operator
if X is a random variable a,b known scalors ==> _______ is LINEAR E[aX + b] + aE[X] + b if write: 𝛆 ~ (0, 𝛔^2) then: E[𝛆] = 0 and E[𝛆^2] = 𝛔^2 Linear rules then: E[a𝛆 + b] = b and E[a^2𝛆^2] = a^2𝛔^2
q > 1
if ____ ==> firm should buy more capital
inflation is higher
if ______ than expected ==> interest rate r is LOWER
only people with liquidity shock
if ________ go to the bank at t = 1 bank must pay N𝜭y1 in total ==> must liquidate fraction x of projects to get xN ==> equate the two: N𝜭y1 = Nx at t = 2 N(1 - 𝜭)y2 = (1 - x)(1 + r)N ==> y2/y1 = √(1 + r) < 1 + r
Why firm runs wont work
if bankers ran them they get x therefore there is no commitment device this doesn't disintermediate - doesn't remove the entrepreneur
moral hazard argument for fully funded pension systems
if didn't have this system ==> in people's interest to save and make private provisions for themselves expect if you don't save because can't that government will always bail out old because group is politically influential ==> would do this by taxing the young ==> set up a pay as you go system (PAYG) which may not be optimal ==> force people to save
expectations of the future
if firms are FORWARD THINKING: ==> investment decisions DEPEND ON ____
less incentive; de facto pay as you go system
if government face irresistible pressures to support those who have not made adequate provision for old age ==> individuals have ____ to save for themselves ==> creases a ________ if this system is not optimal then government must force individuals to save to sustain fully funded pensions
borrowing in current period
if know that FUTURE INCOME will INCREASE ==> SPREAD C over lifetime BY ____
Purchasing power parity
if law of one price applies to ALL GOODS, benchmark for real exchange rate: 𝜖 = 1 ==> E = P*/P
greater than; less than
if on MP but NOT ON IS ==> on LHS I ____ S ==> on RHS I ____ S
costs of currency pegs
if overvalued, trying to STOP DEPRECIATION ==> can run out of international currency to sell FLOATS can occur ==> rather let the peg go to be able to cut nominal interest rates
PC view
if policymakers perfectly controls AD by fiscal and monetary policy ==> Phillips curve gives the achievable outcomes and maps equilibrium PC = menu of possibilities for both u and 𝛑
AD shocks
if recessions are caused by ____ ==> economy should move ALONG the Phillips curve
higher return
if risk-adverse, require a ______ ==> p of 1 year strategy needs to be lower
Walras' law
if the goods and labour markets are in equilibrium then the only remaining market in the economy (the financial market) is also in equilibrium
Riccardian Equivalence
if the government increases households' current disposable income by cutting taxes, households will not spend the extra income budget deficit increases, more government debt, higher future taxes because a consumer's
Flexible market wage
if there is a _____ in a situation where there is POSITIVE UNEMPLOYMENT ==> the ____ will fall to CLEAR THE LABOUR MARKET and therefore result in no unemployment
marginal product of capital
if there is an improvement in technology than ____ will be higher and profits will be larger
decreases
if w* is HIGHER ==> CDF INCREASES ==> H(w*) DECREASES ==> f ____
self-fulfilling equilibrium
if you want to run, so does everyone else who is a late consumer BUT, if ALL RUN, then you want to run ==> confirms your initial belief ==> bank run = ______ multiple equilibrium as well
Dual problem
imagine that government could dictate consumption to people ==> it solves max log(c1) + log(c2) + log(c3) s.t. c1 + c2 + c3 = W - g EASY SOLUTION: consumption is THE SAME IN ALL PERIODS WHY: want to help people smooth consumption HOW: subtract consumption every period to pay for the government spending, use deficits to smooth DO THIS VIA: 𝝉1 = 𝝉2 = 𝝉3
equilibrium in financial market
imperfect markets 2i_t^{2} ≈ i_t^{1} + i_t+1^{1}e + tp_t the more you invest in the two year bond the higher is going to be the gap in risk between two year bond and roll over strategy more you go into and investment ==> HIGHER THE RISK
investment savings relation
in (Y, r) space Y = c + 𝜸(Y - T) + a - 𝛿r + g ⟺ r = (1/𝛿) × [a + c - (1 - 𝜸)Y + g - 𝜸t]
core to periphery
in EU, enormous FLOW OF CAPITAL from ______ NO CAPITAL OUTFLOW from Europe to the outsiders, but WITHIN EUROPE, BIG CAPITAL FLOWS
explosive
in Taylor principle: 𝛘 < 1 ==> more than unanchored ==> ____
law of one price
in competitive markets free of transportation costs and barriers to trade, identical products sold in different countries must sell for the same price when their price is expressed in the same currency pi * = E pi
wealth effects
in macro, refer to income effects as _____ terms are interchangeable
decreases; increases
in recessions: revenue ____ as TAX BASE decreases spending _____ = social insurance
negative
in steady state of matching function there is a ____ relationship between UNEMPLOYMENT and VACANCY RATES ==> explains beveridge curve (BC)
optimal choice is to the right of the borrowing constraint
in the case where _____ : people would like to borrow but must settle for a point E highest utility they can possibly attain is at E not their choice D subject to standard lifetime budget constraint BINDING BORROWING CONSTRAINT: ==> ultimately current consumption and income matters if current y fell, you'd cut back c 1 for 1 with drop in y ONLY VARIABLE THAT MATTERS IS Y
income effects
in the dynamic macro model, ______ from wage and interest rate changes (all else equal) SHOULD BE IGNORED ARGUMENT: representative household, as the owner of firms, and as the taxpayer, ultimately faces offsetting gains and losses from any change in market prices
real return
in units of goods, today gave x/p_t, next year get y/p_t+1 ==> ______ is ret = (y/p_t+1)/(x/p_t) - 1
current and future consumption increase
increase in current and increase in future income both have positive income effects: ____ as the consumer acts to smooth consumption over time
higher spread
increase in risk could explain ____ and ==> fall in investment and output
deposit rate
interest on reserves NOT POSSIBLE FOR i TO BE BELOW THIS because CB is the safest place and takes unlimited reserves no i below i^v because CB controls i, can always add #s to cell they create money
r^l
interest rate paid by borrowers
r
interest rate received by savers
countercyclical
interest rate spread is ____ rises in recessions
fluctuations in current profiles
investment models so far suggest that investment decisions depend primarily on expected future profits EMPIRICALLY HOWEVER: investment moves with _____ as well some firms with highly profitable investment projects but low current profits appear to invest too little current profits appear to affect investment even after controlling for the expected present value of profits
financier
investors cannot trust _____ to deploy his collection skills on the loan BUT can tie ____ to assets
term premium
investors require _____ = tp_t to compensate for the risk of holding two period bonds deviation between returns on the long strategy and roll over strategy _____ ==> there is differing RISKS of different strategies
Carry-trade
involves borrowing in one currency where interest rates are low and then using the proceeds to invest in another currency where interest rates are high
independence
is a currency union harmless? NO, trade up some ____
allocation
is more credit and capital ALWAYS good? NO, ______ is crucial
Bagehot Doctrine issues
issues: banks can willy-nilly come to CB and say they miscalculated theta -moral hazard where only unreliable banks use LoLR, why don't banks borrow in interbank market? Maybe they didn't have a run and just are a bad bank - they will default after borrowing from CB -LoLR would be bailing out, transferring money to failing businesses (as assets of banks) -If CB seizes whole project so it does not suffer loss, the late types will still run and nothing will have improved (they know there will be nothing left for them)
term structure of interest rates (yield curve)
it(1), It(2)... It(N) CB only sets short-term rates, but because it can control whole path of these (aka forward curve) it can influence the entire yield curve
Classical economics
keep Y and r fixed
Optimal debt management
keep tax rate constant if spending more than average, run a deficit (and vv) if higher revenue than average, run surplus (vv) use deficits and surpluses to smooth tax rates in the face of shocks
wars
large surge in spending run deficits, let debt accumulate during peace, pay it off
shock multiplicity
larger drop in credit as all banks start expecting all other banks to cut lending significantly after the shock.
Effects of an increase in interest-rate spread on the dynamic macroeconomic model (Graphically)
(correction) Reduces demand for investment, shifting output DEMAND to the left
New CB Net income
(i2 - i)Assets + i x Currency
Keynesian ASAD model
**HORIZONTAL AS** output is fixed After g expansion, OUTPUT RISES **INFLATION FIXED Y CHANGES**
classical ASAD model
**VERTICAL AS** output is FIXED After g expansion ==> INFLATION RISES (MT): g INCREASE ==> AD shifts UP ==> INCREASE in Y all it led to was firms raising prices ==> yet to a higher 𝛑
Floor System
- Now CB just sets i to whatever it wants - all banks have surplus deposits due to QE so no demand for interbank market - floor iv
Present CB Net Income
- Term spread gives extra positive or negative income to central bank, can be large - CB can make losses, need fiscal backing, treasury letter of indemnity (treasury can cover losses via tax revenue)
Tax Multiplier
- change in t (MPC/1-MPC)
Securitization
- combine loans in a pool to remove idiosyncratic risk - sell the revenue stream from future payments for a payment today - traded continuously, value marked to market ( = risk) - asset backet
durable goods
- consumption fluctuates more than nondurables - no consumption smoothing - as they are bought less frequently
European banks
- large = bank financing is dominant - few large banks in each country - individual country can't bail out banks - regulatory heterogeneity
Modern banking risks
- securitization = little incentive for bankers to be prudent = took on bad loans - wholesale funding = greater risk of runs - amplified asset-price cycles due to loss and margin spirals
When does Ricardian Equivalence not hold
- when there is a BINDING borrowing constraint - when rl>r - when a generation that receives pension etc does not have to pay for it (pay as you go)
margin spiral
lender requires more margin = lends you less = you can loan less = prices fall further
2007-08 crisis
-(Start) Growth in MMF and repo markets, huge part of the economy was running like a shadow bank -Bear Sterns run (they weren't a bank and had no checking accounts so did not get deposit insurance, they were investing in long term projects and borrowing short term). The investment bank suffered losses on how value their mortgage assets were i.e. sub-prime mortgage loans. It had no depositors, but depended on the overnight repo market massively - classic run. -Banks run on banks (TED spread rose i.e. the interest rate on 3 month interbank loans minus that on 3 month govt bonds, rises when banks don't want to lend to other banks). Banks were no longer rolling over repo contracts they had with other banks even with the promise of being paid a higher premium. -MMF run Lehman fails (many MMFs had lent to Lehman), so losses to MMFs, the Reserve Primary Fund 'breaks the buck' - when the MMF investors could lose the principal as the price of the share in MMF has fallen below it. People and firms caught on and also ran. No LoLR for Lehman by Fed, bc they were not a bank. -Northern Rock Run Spread to actual banks from investment banks. NR = a mortgage issuing bank, grew rapidly using wholesale borrowing, borrowing commercial paper (from MMFs) and repos from other banks. Other banks ran on NR when it lost money on its mortgages, first UK bank run since 1866. -Fed = Lender of Last Resort CB stepped in and LoLR to NR and GS. It lent money to the MMFs etc to stop the bank run. Now there was been new regulation so that if institutions look like a bank and offer demand deposits, they will no longer be bailed out and depositors can run on them as a discipling act. (End)
Define the aggregate supply curve
-A steeper AS curve in high inflation since share of firms with nominal rigidities, s, decreases and a increases -Inflation more variable with output
Give one argument for why bank runs are necessary for its efficiency, and against deposit insurance that removes them.
-Bankers need incentives, otherwise they will extract a hold-up rent from depositors. Explain that the threat of bank runs disciplines the banks, and transfers this rent to depositors. Explain why with deposit insurance, bankers would extract a rent, and fewer projects would be funded.
Inflation example of time inconsistency
-CB can only raise output by surprising firms -May as well set 0 inflation -Then firm will keep price fixed -After they are locked into these prices, the CB wants to engage in monetary policy to raise output -If firms realise this, they set upward sloping price path
If the currency is pegged, and a country is facing the risk of capital outflow, what are their two options to prevent this and an advantage or disadvantage to both? How will both options lead to a reduction in output?
-Capital controls: (may cause protectionism and creation of rents in the tradable sector): The production possibility frontier (PPF) shows feasible output combinations in the tradeable (T) and non-tradeable (N) sectors. Capital controls may lead to misallocation across sectors thus lowering output due to lower marginal product of capital- Misallocation could be temporary and overcome with domestic policy -Increase nominal interest rate: Can be shown to reduce output through IS-MP, AS-AD or with reference to the Phillips Curve- if rational expectations, the recession following an increase in short-run nominal interest rates could be relatively short lived as expectations will quickly adjust to ensure that real interest rates do not remain high.
The exports of a country fall sharply, and the interest rate that this country pays to creditors on its foreign debt has spiked up. This country asks other countries to lend to it at a lower interest rate than this new one, but higher than the interest rate paid in the past. It argues that the foreigners will profit from this suggested loan. Make an argument supporting lending to that country, and one against it.
-Expected repayment varies as a function of the promised repayment on debt -A given amount of borrowing can be associated with two different equilibrium interest rates: a low rate (probability of default is considered to be low) and a high rate. -The increase in interest rates reflect a decrease in the country's ability to generate revenue (a decline in solvency, parabola shifts inwards). or it may capture the movement from a good to bad equilibrium (illiquidity). -If insolvent- countries won't lend In this case, the lower interest rate that is being suggested will just represent a transfer of resources from the lending country to the borrower. -In the second case (a liquidity crisis), it is possible for the lender to lower their interest rate and still be repaid in expectation (in fact, the lender may even receive a higher return in expectation by lowering the interest rate but not all the way to the good equilibrium). In addition to not harming (even potentially benefitting) the lender, the lower interest rate will also be a more efficient outcome since it will make socially costly defaults less likely.
Provide one justification for a balanced-budget rule that forbids fiscal deficits and two separate and independent arguments for why instead we would like to allow for fiscal deficits during recessions.
-For a balanced-budget rule: politicians could. be hyperbolic discounters. They will be tempted to spend more today and accumulate large defecits and debt that in the end makes everyone worse off by not smoothing consumption over time. -Against: Counter-cyclical stabilization policy: By cutting taxes or raising government purchases in a recession, policy can stimulate real activity and raise output. This serves to fight the recession and to stabilize the business cycle (Keynes). -Against: Optimal debt management: Policy wants to keep tax rates constant through time, to minimize their distorting effect. In recessions, output falls, and so does the tax base, leading to a fall in tax revenue. Likewise, spending increases with unemployment insurance and other programs. The optimal policy is to let the public deficit rise and not change tax rates, counting on future surpluses in booms to pay for the extra debt.
Capital funding through banks
-German wants to put capital in Spain -puts capital in German bank -German bank does wholesale funding to Spanish bank -Spanish bank lends to Spanish household
What are three institutional designs that can overcome inflation bias
-Give independence to the central bank (technocratic decisions reduce political capture -Appoint a CB chairman that dislikes inflation more than society -Give the CB chairman a contract with strings attached e.g. New Zealand; a lower wage with higher inflation or fired if inflation gets too high
If surprising agents is the only way for a central bank to have an effect on the real activity, should central banks be as secretive as possible? Discuss.
-If the public held constant inflation expectations, as in the 1960s, the central bank could successfully pick points on a static Phillips curve and exploit the trade-off between inflation and unemployment. -Time inconsistency issue can be somewhat mitigated: if CB keeps secrecy from the government, government can't exert pressure for expansionary monetary policy is their time horizon is shorter than the CBs -BUT: The reality is only semi-rational inflation expectations. A fear of surprise inflation may persistently increase inflation expectations. Inflation expectations more volatile -CB can't commit to any policy path so can't directly impact inflation expectations
In one year, governments provide large transfers to households and businesses. A large share of these funds were deposited in banks, which in turn deposited them at the central bank. Plot in a diagram the market for reserves. Show the effect the policies of 2020 might have on the equilibrium interbank rate and then what happens to the equilibrium interest rate if the central bank in response buys large amount of government bonds and credits the deposit account of banks.
-Initial shock is a large shift of the demand to the right -If the supply is unchanged this will (weakly) increase the interest rate -the central bank response consists of shifting the supply to the right, so that the interest rate stays at the previous level.
Dangers from securitisation
-Large share of assets marked to market -Can quickly realize losses -Rely on markets functioning efficiently
Expected Deflation (ISMP)
-MP curve shifts up -high r means lower I and lower Y
What determines real r?
-MPK -desire for consumption vs savings
repo market
like a pawn shop i give you an asset ==> you give me a loan ==> i sign a contract today stating I will buy back the asset tomorrow for an amount = to loan plus interest ==> buy back at payment of loan rolled over every night ==> buy asset back then sell immediately popular because courts: if don't pay you keep stuff, no court costs
A fiscal authority decides to unexpectedly increase transfer payments to households in the form of more generous welfare payments. In the IS-LM-AD-AS model, the effect this has on output depends on (i) the multiplier, (ii) crowding out, and (iii) the fraction of firms that set prices flexibly with full information. State and discuss how each of these factors raises or diminishes the effect of this fiscal policy on output.
-Multiplier effect: The multiplier effect raises the direct impact of the transfer on output. The increase in transfers raises disposable income, which raises consumption and so the aggregate demand for output. As this raises income, it further raises disposable income, and further raises consumption and output. And so on. This is the multiplier, which multiplies the initial effect on output, so it raises the fiscal effect on output. Graphically, the IS shifts to the right by more than the direct effect -Crowding out: The increase in output due to the fiscal transfer raises the demand for real money balances, which raises the real interest rate in the money market. This lowers investment and thus output. Given an upward sloping MP curve, the increase in output is lower than the horizotnal shift in the IS. -Price Flexibility: The more flexible firms there are, the more this increase in aggregate demand raises prices, which by lowering real money balances raises interest rates and lowers investment and output. The more firms with flexible prices there are, the greater this attenuating effect on output will be. Graphically, more flexible prices means a steeper AS, so the shift of the AD to the right has a smaller effect on output .
What were Volker's mistakes as chairman of the fed in the 1970s?
-Not managing inflation expectations -Assuming the phillips curve was stable -Not recognising the 1970s oil shock caused an AS dominant recession, not an AD one. -Estimated sacrifice ratio to be 2.5 but in reality it was closer to 1.5 -Didn't have enough data on the Phillips Curve
Misallocation sources within sectors
-Politics - without foreign competition, firms can more easily lobby for local regulations to erect barriers to entry and constraints on firms growing Politicians are receptive to small firms bc they employ a large share of the population and are seen as income mobility -Finance - banks in underdeveloped financial markets lack managerial talent and tools to diversify their credit portfolio, so they are weary of giving large loans to a few firms
You are faced with three pictures of the macroeconomy of a country over 20 years. The first one contains a time-series plot of GDP changing from year to year. The second shows you time-series plots of consumption, investment, imports, and inflation changing from year to year. The third shows you the impulse response of unemployment and retail sales to a few major shocks and tells you when each of these shocks was large. How would you use these data to identify when the country was in a recession, and what was behind it?
-The GDP plot can be used to determine whether the economy is in a recession in a number of ways. For example, a recession can be defined as periods during which actual GDP is below potential GDP (that is, the long-run GDP trend), which can be estimated using the GDP data. More informally, recessions could also be defined as periods in which the economy experiences at least two consecutive quarters of negative GDP growth. -The time-series plots of consumption, investment, imports, and inflation allow us to analyse comovement in the economy. In particular, since these variables are all pro-cyclical, we could identify recessions as periods in which we see a decline across all of these indicators. -Furthermore, the data on consumption, investment and exports may allow us to identify which sectors are driving the recession, while analysing the inflation data could provide clues as to whether the recession is due to demand-side or supply-side factors. The third piece of data can be used to identify recessions as periods in which (i) the impulse response showed an increase in unemployment and a decrease in retail sales and (ii) the shocks were large
During a deep recession, like the one we have been living through the past year, we want to use all the tools available, including monetary policy, to raise employment. At the same time, during recessions, people are paying more attention than usual to what the central bank is doing and to what is inflation. Explain each of these two considerations, and why they can create a conflict for monetary policy.
-There is a Phillips curve in the economy, that this is driven by nominal rigidities, and that this allows for the use of monetary policy in order to have inflation be higher than expected inflation so that employment is higher than its long-run value. -If people pay more attention to monetary policy, then this reduces the extent of nominal rigidities, and so makes the Phillips curve steeper. -Since a steeper Phillips curve makes it harder for the central bank to reduce unemployment through inflation, in the sense that it requires inflation to be much higher than expected to achieve it. -At the limit, case where everyone is paying attention, the Phillips curve is vertical, and the conflict is extreme as the central bank cannot do anything about employment.
limits to central bank's independence
live in a democracy which policies should be delegated to technocrats? technically complex decisions goal is clear and consensual providing a stable framework is more important that quick reactions redistribution issues are not first order accountability and transparency can be enforced
In the European periphery, when all banks cut lending, an individual bank wanted to cut credit as well. Discuss why this is the case. After a small shock that makes all banks want to lend less, do you expect a large contraction in credit and why?
-When one bank cuts lending (e.g. fewer mortgages), reduces demand for housing, lowers house prive, lowers the value of MBSs held by all banks -Value of tradeable assets held by banks falls, they have less collateral, can obtain less wholesale funding. -Less funding, can lend less -Hence the best response curve is upward sloping. -means that a small shock that makes all banks want to lend less could lead to a large contraction in credit due to amplification and multiplicity -Amplication: amplify asset-price cycles through loss and margin spirals -the fact that best response curves are upward sloping implies that multiple equilibria are possible, meaning that there can be an even larger drop in credit than from just amplification alone if all banks start expecting all other banks to cut lending significantly after the shock.
Liquidity
-With financial frictions, there may be multiple interest rates consistent with the institutions being solvent -For some interest rates, the institution can keep to repayment schedule, but for others doesn't have enough to pay the interest (in this case they are solvent but illiquid) -solvent but illiquid - where under fundamental interest rate, the institution is solvent but if there is a jump in interest rates whereby it is unable to make payments, it is illiquid -Some interest rate spikes can prevent an institution from being able to rollover and keep servicing their debt
Dangers from wholesale funding
-a well informed creditor can run quickly if they sense increased risk -Repos not being rolled over is a new funding risk
How is the idea of rational expectations implemented into the standard modelling of the Phillips Curve?
-approach by Lucas and Sargent in late 1970s and 80s. -argued that it is not consistent to assume people form their inflation expectations using just past inflation rates (adaptive expectations). People do not just 'get used to' higher inflation levels, but they observe long term trends in government policy and make rational guesses about the future inflation rates (rational expectations). Indeed, evidence from hyperinflations points to rational formation of expectations, as stabilisation policies can be immediately successful at reducing inflation when orthodox policies are implemented by the government (fiscal restraint together with tight monetary conditions) - something inconsistent with adaptively formed inflation expectations.
2007 BofE change from corridor to floor system
-banks were not trusting the money they deposited at other banks (could go bust) -afraid to lend to each other -demand for reserves increased massively -this meant (corridor) the interest rates shot up, wanted this to fall if anything in a crisis -CB struggling to shift supply to the right with OMO -so CB shifted to floor system, demand can now change without affecting the supply of reserves
Euro area pre-pandemic
-beginning of 2019, were in an expansion -had been 2 crises; 2008 GFC and 2012 Euroarea debt crisis -slow recovery compared to earlier crises in the last few decades -some countries recovered faster than others
Multiplicity
-can end up with multiple equilibria on the best response function of modern banks -self fulfilling: if i think all will cut lending by a little, i want to cut it by a little as well. if i think all other banks will cut by a lot, i want to cut by a lot as well -DD model's 'you run, I run' idea is a upward sloping best response -superficially will be same equilibrium as old banks, but there is a more volatile credit market -you go to L instead of H and also risk gigantic crashes such as to G
roles of the central bank
-clearing house - owned by banks + gov - regulatory power - monetary policy - bank of the banks
Federal Reserve - ending GFC
-deployed LoLR tools to provide liquidity to the banking system -then expanded its tools to support dealers and funding markets -The Fed + Treasury introduced programs to support the commercial paper market, a key source of funding to financial institutions and businesses -Helped restart the ABS market
Covid recession
-fast recovery -in usual recessions manufacturing falls more than services, but here services fell more than manufacturing (due to lockdown) -sharp recovery at first and then a somewhat delayed recovery -women suffered more as they work more in services, while usually men suffer more.
Why do banks hold national debt (govt bonds)?
-financial regulations forces safe liquid assets, but mistakenly treats govt debt as always safe -monetary policy operations readily exchange govt bonds for reserves (CB is always buying up bonds w OME) -banks are primary dealers of govt bonds (they buy the bonds and find buyers or use auctions) -moral suasion by govt in trouble where they ask bank to lend to them (doesn't happen in UK)
New risk of modern banks
-grow quickly, their incentives for prudence is weaker as they pass on revenue streams to buyers of securities -higher funding liquidity risk (wholesale funders quick to exit, shadow banks face no reg) -amplify asset-price cycles
What affects unemployment?
-higher job separation rate s -lower job finding rate f -higher reservation wage w* -lower rate p of obtaining job offers
Pre-1980s and pre-Ch8 ISMP model of expectations
-horizontal AS for very short run -only in v short run bc hard to believe that in response to large shifts in the AD and therefore large shifts in output, prices would stay fixed -vertical LRAS only for very long run -only in very long run because it is hard to believe that prices adjust quickly so that all of K and L are used exactly
MP Counter G shock (ISMP)
-if the govt wants to spend but not increase output -increase G but simultaneously increasing interest rates -MP shifts left and IS shifts right -the multiplier and the MP both offset change in the output due to higher g -loose fiscal tight money
Increase in G (ISMP)
-increase in G shifts IS right -n is positive -Y increases -CB increases interest rates so then r increases -I lowers -Y lowered -there is an expansionary effect from G increase and a crowding out effect due to the increase in r (either can be larger) -the steeper MP is, the more crowding out
European banks
-large in size (bank financing dominant, firms don't offer corporate bonds) -concentrated within countries (few large banks per countries, assets>GDP, country cannot bail out its banks) -regulatory heterogeneity (different reg)
Why LOP doesn't hold
-many goods are non traded -the baskets in different places are not the same -there are transportation costs -there are barriers to trade
Lender of last resort
-means bank does not have to terminate late projects to pay larger-than-expected volume of early types -late types will not run as they know they will be paid -as long as y2>y1 no run -bad equilibrium eliminated and action is never triggered
type of demand deposits
-money market funds - repo market
Balanced budget expansion (ISMP)
-no multiplier effect as the multiplier effects of G and T together give 1 -all excess income from g gets taxed away -we have crowding out on TOP of this, so increase in output is less than the increase in G and T -an increase in G and T balances budget
Central Bank
-owned by banks and govt, is a clearing house for banks -has regulatory power over members -reserves can only be held by banks recognised by CB, are free of default (can always issue more), are short-term as used to settle claims, can only be issued by CB -has minimum reserve requirement
Liquidity Insurance
-provided by maturity transformation -bank pooling the joint risk of being an early consumer -unlucky early type still gets some good return (over and above the 1 they paid initially) -the lucky late type still gets some of the good returns, but is paying a premium by accepting to receive less ex ante -those with liquidity shock are paid at the expense of the premia that everyone pays -people are happy to receive less at date 2 in exchange for getting at least some return at date 1 if they have a shock.
Modern bank - if others lend less what happens?
-pushes down house prices -lowers value of securitised assets -given small net worth -must sell some securitised assets -all selling at same time, little market liquidity, fire sale -low asset prices mean less collateral value for repo -losses spiral -expectations of further fall means higher margins and haircuts -margins spiral -funding liquidity falls -bank should lend less -upward sloping best response
Phillips curve
-represents relationship between output gap and inflation but output gap is hard to measure.
Collateral constraint
-s(1 + r) ≤ pH GIVEN: s = y - t - c c ≤ y - t + pH/(1 + r) using this can borrow against housing wealth
Animal spirits (ISMP)
-say if people want to spend more, higher a and c -Increased C and I -Increased Y, increased (Y-T), increased C again, multiplier -an increase in a and c is just like an increase in g -IS shifts right (with multiplier) -leads to increased AD and Y
Illustrate AS-AD curves after a monetary policy expansion (e.g. decrease in i)
-shift in output to the right, keeping prices fixed, output increases. - firms respond to higher AD by increasing wither output or prices -BUT the increase in output will increase interest rates (MP) and lead to a crowding out effect -In the long run prices adjust to offset the raise in output. -As we move from short to long run, sticky firms also adjust prices -πe increases and AS moves left -Monetary policy is only effective in the short run (neutral in LR) -SR to LR when expectations change
Fall in T (ISMP)
-shifts IS right -increase in Y smaller than the tax multiplier x change in tax -CB raises nominal rates which raises real rates -there is a fall in I which generates a fall in Y -whether private output in/decreases depends on the relative strength of the effects
Solutions to deal with the risk of bank runs
-suspension of convertibility -lender of last resort -deposit insurance -off-equilibrium threats
Implications of rational expectations
-the sacrifice ratio is 0 for credible policy. Sacrifice ratio should be 0 under R.E to the extreme, we would essentially be on the LRAS
bank vs no bank
1 < y1 < y2 < 1 +r
Aggregate supply : predictions
1) If average inflation is very high/very volatile, then firms will want to update their prices more often. Expect s to get smaller, steeper AS curve if inflation higher/more variable. With a small s, alpha gets higher. --Note a steeper AS means that stimulus programs that change AD have less of an impact than before. -In low inflation is when these policies work better. -a large s means that AS is flat, and that AD shifts have a big impact 2) Sticky prices and sticky information
Assumptions
1) firms have market power and set prices 2)the prices firms set rise with price level and the output gap -because of increasing marginal costs (DRS) and rising wages 3) nominal rigidities: fraction s of firms don't know current price level and forecast it with Pe. -they don't know because of menu costs (sticky prices) and inattention (sticky information)
3 functions of banks
1-participate in the payment system 2-receive short term deposits and make long-term loans: maturity transformation 3-monitor loans Fintechs (narrow banks) do 1. Shadow banks do 2 and 3.
reasons for credit market imperfections
1. ASYMMETRIC INFORMATION: would-be borrowers know more about their characteristics than do lenders e.g. 'market for lemons' = adverse selection problem 2. LIMITED COMMITMENT: borrowers may choose to default ==> lender can overcome limited commitment with collateral quantitative limits on borrowers
types of investment
1. BUSINESS FIXED INVESTMENT 2. RESIDENTIAL INVESTMENT 3. INVENTORY INVESTMENT
What are the three new risks associated with modern banks, securitisation and wholesale funding?
1. Banks are bigger and have less 'skin in the game'- incentives to collect mortgages, and ensure loans are 'good' are much lower 2. Higher funding liquidity risk: wholesale funders are quick to exit if there is increased risk and shadow banks have no deposit insurance or regulations so there is no protection against runs. 3. Amplify asset-price cycles- price of housing increases, value of assets increase, banks can increase borrowing from wholesale funding markets, banks issue more loans/ mortgages, house and asset prices rise further
Optimality conditions of dynamic macro model
1. CONSUMPTION/LEISURE: MRS_l,C = w 2. TIMING OF CONSUMPTION: MRS_C,C' = 1 + r 3. TIMING OF LEISURE: MRS_l,l' = (1 + r)w/w' ==> MRS_l,l' = [MRS_l,C × MRS_C,C']/(MRS_l',C') = w(1 + r)/w'
assumptions of IS market
1. Consumption depends on disposable income 2. Investment depends on interest rate 3. Government is EXOGENOUS
arguments for deficits in recessions
1. Countercyclical stabilisation policy 2. optimal public debt management
horizontal bits of demand for reserves
1. DEPOSIT RATE: 2. LENDING RATE
simplifications of consumption problem
1. DISCOUNTING: 𝛃 = 1 you already know about the role of impatience 2. INTEREST RATE: r = 0 you already know about the role of interest rates 3. UTILITY FUNCTION: u(c) = log(c) you already know about role of MRS max w.r.t. c1,c2 log(c1) + log(c2) + log(W - c1 - c2)
why banks hold bonds
1. Financial regulations forces safe liquid assets, but mistakenly treats government debt as always safe 2. Monetary policy operations readily exchange bonds for reserves 3. Banks are primary dealers of government bonds 4. Moral suasion by government in trouble
steps to general equilibrium of dynamic macro equilibrium
1. Find equilibrium in labour market (with real wage adjusting) for a real interest rate with production function ==> yields supply of output 2. find equilibrium in the goods market (with real interest rate adjusting) using supply of output obtained at the first stage (which is conditional on the interest rate)
assumptions of why AS is upward sloping
1. Firms have MARKET POWER, set prices 2. Desired prices rise with price level and the output gap. BECAUSE of INCREASING MARGINAL COSTS and RISING WAGES p* = P + a(Y - Ybar) + 𝛆til price that a firm sets = p* depends on: 1. higher the price level, higher want to charge for my good 2. as more production happens, need to pay more wages and more technology ==> MC INCREASING ==> raise price (a) 3. there are some shocks = changes in MC 3. NOMINAL RIGIDITIES: fraction s of firms don't know current price level, they must form a forecast of it P^e because a. menu costs, sticky prices b. inattention, sticky information
reasons for efficiency wages
1. HIGHER WAGES ATTRACT BETTER WORKERS: firm does not know which workers are really good and who will apply, so it offers higher wages to attract applications from good workers example of ADVERSE SELECTION 2. HIGHER WAGES RETAIN BETTER WORKERS: good workers get offers from outside, a high wage will stop them from quitting and saves the firm training costs example of ADVERSE SELECTION 3. HIGHER WAGES INCREASE THE VALUE THAT WORKERS ATTACH TO THEIR JOB: ==> more careful not to shirk on the job, be found out and fired example of MORAL HAZARD
Equilibrium conditions of Ricardian equivalence
1. INTEREST RATE ensures TOTAL PRIVATE SAVING = QUANTITY OF GOVERNMENT BONDS issues in the current period S^p = B 2. INCOME EXPENDITURE IDENTITY MUST HOLD: Y = C + G 3.
positive spread
long-term rates are HIGHER than short-term rates 2 (i_t^{2} - i_t^{1}) ⟺ (LR - SR) markets expect short-term rates to RISE in the future i_t+1^{1}e - i_t^{1}
What was the Phillips curve view of the world of the 1960s? Why was it abandoned by the 1980s?
1. Not managing inflation expectations 2.In the 1960s, our understanding of the Phillip's curve was like a machine- a fixed mechanism resulting in a trade-off between inflation and unemployment. This was reflected in the data throughout the 1960s. (Between 1961 and 1969 unemployment fell from 6.8% to 3.4% as inflation rose 1-5.5%). -But contrary to this, the 1970s bought stagflation (high inflation and unemployment). This was largely in line with predictions made by Friedman and Phelps in the 1960s. -They argued that people get used to higher inflation and adjust their inflation expectations. -Led to the formation of the expectations-augmented Phillips Curve -Further critique in the late 1970s and 1980s by Lucas and Sargent led to implementation of rational expectations in the standard modelling of the Phillips Curve
negative spread
long-term rates are LOWER than short-term rates 2(i_t^{2} - i_t^{1}) ⟺ (LR - SR) markets expect short-term rates to FALL in the future i_t+1^{1}e - i_t^{1}
What are two new features of modern banks that increase systematic risk in financial institutions
1. Securitization: combining loans to remove idiosyncratic risk. Banks sell the revenue stream from future payments for a payment today. These revenue streams are then traded continuously and their value is determined by the market e.g. mortgage backed securities 2. Wholesale funding: Through short-term unsecured credit from other banks in the interbank market (uninsured) and Repurchase Agreements (repos)
Discuss two interpretations of the sudden spike in sovereign yields in Greece in 2010. Discuss in which of these two cases an IMF loan can increase social welfare and why.
1. Solvency Crisis: a fundamental change in the ability of the government to raise revenues/cut expenditure and payoff its debts. the Greek government most likely cannot pay off its debts, irrespective of perceptions of default, in which case the IMF loan will probably not be repaid and default will still occur. Since the socially costly outcome of a default is not avoided, there is no gain in social welfare from the IMF loan . 2. Liquidity Crisis: a change in perceptions of the default risk on Greek bonds even with no change in the fundamental solvency of the government. an IMF loan to the Greek government at a lower (but still profitable) interest rate can significantly lower the probability of default, thus increasing social welfare.
properties of reserves
1. can only be held by banks recognised by the central bank 2. can only be issued by the central bank 3. short-term as used to settle claims 4. free of default as CB can always issue more: defines what money is, can always issue
causes of a wealth effect
1. change in current or expected future TFP 2. change in current or future government spending higher tax burden: but no _____ from T without a change in G, by Ricardian equivalence 3. Exogenous change in initial capital stock
How to define recession
1. decline against all procyclical variables 2. consecutive perieds of negative GDP growth 3. judgement by NBER or CEPR 4. cyclical output below trend
detecting turning point of business cycles
1. fancy algorithms detecting maxima and minima 2. simple rules of thumb: contraction is two consecutive periods of falling GDP 3. Judgement: ask the expert
conclusions of efficiency wage model
1. for SMALL TEMPORARY CHANGES in LABOUR DEMAND: adjustment occurs through EMPLOYMENT with the wage rate not reacting to the shock 2. efficiency wage model is slightly Keynesian
optimal debt management
1. keep TAX RATE CONSTANT. satisfy intertemporal budget constraint over time 2. if some times, SPEND MORE THAN AVERAGE ==> RUN A DEFICIT if some times, SPEND LESS THAN AVERAGE ==> RUN A SURPLUS 3. if have: HIGHER revenue than average ==> RUN A SURPLUS LOWER REVENUE than average ==> RUN A DEFICIT 4. use deficits and surpluses like consumers use borrowing and lending: smooth out shocks
assumptions of interbank rate
1. overnight 2. safe 3. nominal rates in money: trust receiver won't default period = deposit at CV = overnight
three functions of banks
1. participate in PAYMENT SYSTEM 2. receive SHORT-TERM DEPOSITS and make LONG TERM LOANS: MATURITY TRANSFORMATION 3. MONITOR LOANS
Three Functions of a Bank
1. participate in the payment system 2. maturity transformation 3. monitor loans
how to finance a war
1. smooth taxes 2. run a deficit 3. pay debt during peacetime
problems with modern banking
1. when one bank's gross debts are high. it wants to default 2. who controls the spreadsheets what stops owner from putting some money aside, since he owns the book (JP Morgan) 3. frequent bank failures and panics
return on long sequence of short bonds
1/q_t^{1} × 1/q_t+1^{1}
return on long two-year bond
1/q_t^{2}
Expectations hypothesis
1/q_t^{2} = (1/q_t^{1}]) × (1/q_t+1^{1}e) second term of RHS: don't know price you'd be sold bond for then
value of commitment
loss with discretion: L^D = 0.5(𝛌k)^2 + 0.5𝛌k^2 = 0.5(𝛌^2 + 𝛌)k^2 alternative, follow a rule: 𝛑 = 0, u = u^N loss with rule is lower than with discretion: L^D = 0.5(0)^2 + 0.5𝛌k^2 = 0.5𝛌k^2 _______ : central bank would like to commit to low inflation, but cannot if inflation is low, because ex post tempted to raise inflation
systemic risk
losses in some financial institutions can lead to losses across the whole financial system
Recessions
1975-1980 Huge oil price increase due to OPEC 1982-1988 Volker recession, tightening monetary policy 1993-1999 Gulf War, invading Iraq, spike in oil prices 2009-2001 GFC 2013-2019 Eurozone debt crises
ISMP model
2 curves: IS curve Y = c + 𝜸(Y - t) + a - 𝛿r + g Monetary Policy curve r = 𝛈Y + 𝛘𝛑 + ihat - 𝛑^e 3 variables: Y, r, 𝛑 (eliminate r) EQUILIBRIUM: intersection of the two curves point at which both I=S AND agents are indifferent between nominal and real assets equilibrium in both goods market and financial market
Bond Yields: 2 period vs Roll Over
2 period yield = 1/2 of the roll-over yield.
changes in bank of england
2001-2015 1. went from corridor to floor system 2. bought a lot of long term bonds
What is the Lucas critique?
: If raise M to get lower u at the expense of higher 𝜋, people adjust 𝜋e, perhaps fully, perhaps partially. Either way, as soon as try to exploit the Phillips curve, it breaks down (shifts) on you
build up inflation
lower rate and expectations ==> ____
reservation wage
lowest wage offer that an unemployed worker is willing to accept
sticky info
main reason why they don't adjust prices to shocks: data on inflation expectations is strongly supportive most people are clueless of 𝛑 is right now ==> not bad, cost of not knowing is small
Cryptocurrencies
A digital currency in which encryption techniques are used to regulate the generation of units of currency and verify the transfer of funds, operating independently of a central bank. It solves the problem of counterfeiting (fake replicates of real products) and double spending (The risk that a digital currency can be spent twice). mechanism to create money, record transactions in way that cannot be falsified anonymous, decentralised, digital
Inflation
A general and progressive increase in prices level 𝜋t = Pt/Pt-1 - 1≈ ∆log(Pt) loss of real value
rational expectations theory
A hypothesized process by which people form their expectations about what will happen in the future based on all relevant information.
adaptive expectations
A hypothesized process by which people form their expectations about what will happen in the future based on what has happened in the past.
Evaluate the case for rules versus discretion in the conduct of monetary policy
A key feature in this debate is that rules are good because they eliminate issues arising from time inconsistency, such as inflation bias. Discretion, on the other hand, introduces problems of time inconsistency, but allows the policy maker some room to respond optimally to unexpected shocks to the economy. If we think about an inflation rule, this will lower average inflation by eliminating the inflation bias associated with discretionary monetary policy (which is a good thing) but the rule will also increase the volatility of unemployment (which is a bad thing).
Repurchase Agreements (repos)
A security is temporarily sold to be later repurchased at a pre agreed price. Has 3 important features: 1. Haircuts/ margins: sell for less than market value so that lender has a cushion for changes in the value of collateral 2. Has senior claims over interbank loans and depositors 3. Generally very short duration, rolled over very frequently
Bank run
A situation in which many depositors simultaneously decide to withdraw money from a bank over concerns of a bank's solvency discipline device, crucial for intermediation function of banks because what gives them commitment
Hyperinflation
A very rapid rise in the price level unit of currency changes so quickly that can't solve the problem of inflation ==> cash is practically worthless as each not is worth so little
co-movement
many aggregate macroeconomic variables grow or contract together during economic booms and recessions modern view of the business cycles DEFINING FEATURE of the business cycle in spite of all the idiosyncrasies of each industry, yet they all seem to share one common factor
higher unemployment benefit (b)
APPLICATION OF EQUILIBRIUM SEARCH MODEL: ______ ==> WC SHIFTS UP ==> HIGHER w ==> LOWER 𝜭 together with BC ==> HIGHER u ==> LOWER v
average propensity to save
APS = 1 - APC
risk neutral
ASSUMPTION OF BONDS: investors are _______ = care only about expected return
N consumers
ASSUMPTION of RICARDIAN EQUIVALENCE: ___ consumers / similar households across which government spreads out tax evenly
ineffective
AT BEST: fully funded pensions are ____ IF: the mandated amount of saving is less than what would otherwise be chosen. If it is greater, then the system can only make things worse for optimising consumers
Inflation Target
Add π* to the loss function of policy makers L policymaker = 0.5[(π - π*)^2 + λ(u-uT)^2] Rearrange for 0.5[π^2 + λ(u-uT)^2 - 2π*π + π*2] Optimal contract will be π* = -λk Institution becomes hawkish and pursues a target below socities, proven to be successful with UK's policy, no country gone back on it since adoption
Consider a bank that builds long-term infrastructure projects that take 10 years to build. It funds itself with short-term commercial bonds: 90-day loans mostly from other financial institutions that get rolled-over often. During a financial panic, this bank finds itself unable to pay its wages and asks the government for credit. Should the government ex ante commit to provide such credit? Provide one argument in favour, and one against doing so.
Although the maturity of the loans may not be overnight or on demand, there can still be a run on this bank every 90 days. One argument in favour of this commitment by the government is that it will prevent a run on this firm by eliminating the bad equilibrium. To the extent that only the good (no run) equilibrium is maintained, this commitment will only function as an off-equilibrium threat that the government will not actually have to pay for. One argument against this commitment is that it can induce moral hazard on the part of the firm, encouraging them to invest in riskier projects than are socially optimal.
illiquidity crisis
An agent is solvent but illiquid when its debt is not unsustainable but it has large amounts of this debt coming to maturity (i.e. short term debt) and it is not able to roll it over (this creates liquidity crisis, rollover/run crisis). Illiquidity can lead to insolvency as illiquidity can trigger a default. In a liquidity crisis, international institutions may step in to provide emergency funds as a "lender of last resort".
supply shock
An event that suddenly changes the price of a commodity or service. It may be caused by a sudden increase or decrease in the supply of a particular good.
clearing house
An institution where interbank indebtedness is computed and offset and net amounts owing are calculated
How does forward guidance affect savings and investment
Announce future short-term interest rate plans. • Through arbitrage this affects expected returns, and so affect long-term yields today 2it(2) ≈ it(1) + it+1(1)e • Even though CB only sets short-term rates, because it can control whole path of these short term rates, it can influence long-term rates: {it (1), it+1(1)e} ⟹ {it (1), it (2)
chairman hates inflation
Appoint a _______ more than society: Has a loss function: L^(policymaker) = 0.5𝛑^2 + 0.5𝛌*(u - u^T)^2 EQUILIBRIUM INFLATION AND UNEMPLOYMENT: 𝛑 = 𝛌*k + 𝛌*𝛆/(1 + 𝛌*) u = u^N + 𝛆/(1 + 𝛌*) choosing 𝛌* SMALLER than 𝛌 can LOWER INFLATION BIAS at the expense of RAISING UNEMPLOYMENT relative to INFLATION VARIABILITY
The good outcome
At date 1: bank pays Nθy1 in total so have to liquidate x fraction of projects so that: Nθy1 = Nx Therefore at date 2: - N(1-θ)y2 = (1-x)(1+r)N
Modern and Old banks' reaction to negative shocks
Attenuation (Old bank) - i want to lend less, but slightly more than others are lending (shown by spiral) Amplification (Modern) - i want to lend less, someone else undercuts, so i lend even less (shown by staircase) Multiplicity (Modern) - i do what i think everyone will do, so there could be multiple equilibria
decreasing
Average Propensity to Consume (APC) is ____ as INCOME INCREASES APC = C/Y = a/Y + b given a>0
vector autoregressions (VARs)
method to calculate impulse responses econometricians can estimate so-called ______ : Y_t = AY_t-1 + B𝛆_t KNOW THAT A = 𝜭^(-1)𝚪 B = 𝜭^(-1)⅀ economic theorist has to provide one of a mix of the following to get the impulse responses {𝜭, ⅀, 𝚪} EX: empirical effects of an increase in the federal funds rate ⟺ ihat shocks shock to i (maybe CB raises i) EFFECT ON UNEMPLOYMENT RATE: u rises transmission is higher interest rate recession positive 𝛔 ==> persists such that effect grows over time, then declines price level starts declining slowly ==> hIGHER interest rates ==> LOWER inflation retail sales: fall sharply, stay down and then gradually recover
expectations change
monetary policy cannot lower unemployment forever because ____
social convention
money is a _____ ==> with hyperinflation, people stopped using it and went back to barter or dollarisation
types of demand deposits
money market funds repo market
capital inflow
more capital available for production ==> production function SHIFTS OUT ==> CLOSE TO EFFICIENCY ECONOMY at the start ==> if efficient economy ==> move to higher indifference curve
more tax
more money growth ==> more inflation ==> ______
little market liquidity
more sellers little buyers
employment is higher
negative wealth effect of increase in G ==> SHIFTS LABOUR SUPPLY CURVE TO THE RIGHT ==> at each real interest rate, _____ ==> output is HIGHER ==> output supply curve shifts RIGHT
intermediation function
Bank runs are NOT BAD because they are a discipline device, crucial for _____ of banks because what gives them commitment
no arbitrage
nominal return and real return 1 + ret = (y/x) × (p_t / p_t+1) = (1 + i) × (p_t / p_t+1) = (1 + i) × [1 / (1 + 𝛑)]
NAIRU
non-accelerating inflation rate of unemployment in the LR at the natural rate of inflation, Phillips curve is vertical
NAIRU
non-accelerating inflation rate of unemployment ⟺ u^n when u = u^n ==> 𝛑 is NOT ACCELERATING
misallocation between and within sectors after a capital inflow boom
non-tradable sector BOOMS at EXPENSE of tradable sector TFP FALLS ON AGGREGATE because very little boom in sector with huge increase in K ==> don't move to a new steady state dispersion of TFP across firms INCREASES as left tail grows debt that funded capital flow must eventually be repaid DON'T JUMP TO SOLOW EQUILIBRIUM BECAUSE MISALLOCATION AND TFP FALLS WHAT HAPPENED IN EURO CRISIS
kensyian dynamic model
not systematically changing with y gives people ability to save and borrow a lot of variation reflects life cycles
solvency crisis
occurs when banks become insolvent fundamental change in the ability of the government to raise revenues/cut expenditure and payoff its debts
consumption smoothing
occurs when people borrow and save in order to smooth consumption over their lifetime not perfect smoothing due to: - credit market imperfections - interest rate incentives
Horizontal AS
only for VERY SHORT RUN because it is hard to believe that in response to large shifts in the AD and thus large shifts in output, prices would remain fixed implicitly, in the ISMP model ____ ==> multipliers and output effects, keeping 𝛑 fixed ⟺ ______
marginal rate of substitution; relative price
optimal consumption level of any two goods MUST EQUATE: _______ and _______ i.e. the indifference curve is tangent to the budget line
keep taxes constant
optimal tax strategy in war times is to _____
C & I
C: less volatile than output (in advanced economies), smaller amplitude I: more volatile than output, higher amplitude
lower; too high
CB CHAIRMAN CONTRACT: WAGE will be ____ THE HIGHER THE INFLATION you will be FIRED if INFLATION is ____ new LOSS FUNCTION for the Central Banker: L^(policymaker) = 0.5[𝛑^2 + 𝛌(u - u^T)^2 + 2𝛚𝛑] WHICH IS DIFFERENT FROM SOCIETY'S LOSS FUNCTION: L = 0.5𝛑^2 + 0.5𝛌(u - u^T)^2 EQUILIBRIUM OUTCOMES: 𝛑 = 𝛌k - 𝛚 + 𝛌𝛆/(1 + 𝛌) u = u^N + 𝛆/(1 + 𝛌)
lower less variable inflation
CB INDEPDENDENCE ==> _____ with NO EFFECT on: growth, or variability of national income
two rates; quantity of reserves
CB chooses the _____ AND _____ GIVEN: demand for reserves by banks
rhat
CB controls ihat BUT DOES NOT CONTROL _____ ==> mirror ihat with ____ when POSITIVE SHOCK in ____ ==> raise ihat Central bank does not know the ____ at best can forecast it. Given these forecasts of ___, can set i to offset them, and the inflation equals target in short run
fiscal backing
CB needs _____ EX: treasury letter of indemnity to combat losses because CB HAS NO TAXATION POWER
influence expectations
CB only sets SR rates (overnight rates now → 10 years) ==> influence expectations of this rate
entire yield curve
CB only sets short-term rates, but because it can control WHOLE PATH of these bonds (aka the FORWARD CURVE) ==> can influence the _______
intertemporal budget constraint
CONSUMPTION PROBLEM SOLUTION: ________ c1 + c2/(1 + r) + c3/(1 + r)^2 = W W = y1 + y2/(1 + r) + y3/(1 + r)^2 W = wealth ==> replace c3 out of objective to solve unconstrained maximisation
dynamic inconsistency
CONSUMPTION WITH TEMPTATION a decision-maker's preferences change over time in such a way that a preference can become inconsistent at another point in time; game theory, dynamic game where a player's best plan for some future period will not be optimal when that future period arrives; Behavioral economics, each different self of a decision-maker may have different preferences over current and future choices want to consume c1 = c2 = c3 BUT end up consuming c1 > c2 > c3
disposable income
CONSUMPTION depends on _______ C = c + 𝜸(Y - T) if richer ==> consume more 𝜸 = parameter, anything you consume not with ______
increase in the real interest rate for a saver (lender)
CURRENT CONSUMPTION: ??? (UNSURE) FUTURE CONSUMPTION: INCREASES CURRENT SAVINGS: ??? (unsure)
Household budget constraint
CURRENT PERIOD: C + S^p = w(h - l) + 𝛑 - T FUTURE PERIOD: C' = w'(h - l') + 𝛑' - T' + (1 + r)S^p COMBINED: C + C'/(1 + r) = w(h - l) + 𝛑 - T + [w'(h- l') + 𝛑' - T']/(1 + r) where C = consumption S^p = household saving w = real wage h = hours available per period l = leisure 𝛑 = profits T = lump-sum taxes r = real interest rate ' = value of a variable in the future time period
right; increase; right
CURRENT TFP INCREASE: ==> shifts N^d to the _____ ==> EMPLOYMENT IS HIGHER at each real interest rate don't include wealth effect here ==> higher employment and TFP both ____ output ==> Y^s shifts ____
wealth effects of decrease in capital stock
C^d DECREASES N^s INCREASES Y^d shifts to the LEFT Y^s shifts to the RIGHT net effects on Y^s and Y^d are ambiguous without further assumptions
substitution effects interest rate
C^d is ALWAYS DOWNWARD SLOPING HIGHER real interest rate r _____ : find point on original indifference curve where tangency condition is satisfied current consumption C DECREASES no income effect so direction of N^s shift is ambiguous RISE in real interest rate r ==> INCREASES slope of budget line ______ : tangency point on original indifference curve moves LEFT current leisure FALLS labour supply RISES labour supply curve N^s SHIFTS TO THE RIGHT
The trilemma
Can only have 2 of the three: 1) Free capital flows (capital can flow freely in search of high interest rates, carry trade) 2) Independent monetary policy (set interest rates however you want) 3) Fixed nominal exchange rates (peg)
The trilemma
Can only have two of the following three: • Free capital flows • Independent monetary policy • Fixed nominal exchange rates
Trilemma
Can only have two of three: - Free capital flows - Independent Monetary policy - Fixed nominal exchange rates (peg) If you have free capital flows, interest parity must hold. Can either fix left hand side or right hand side. Fixex exchane rate and nominal exchange rate, can't have equality for interest parity. Either live with exchange rate volatility, no monetary policy or capital controls?
solution to KPBG
Central bank solves min 0.5𝛑^2 + 0.5𝛌(u - u^T)^2 u = u^N - (𝛑 - 𝛑^e) u^ = u^N - k ==> u - u^T = u^N - (𝛑 - 𝛑^e) - (u^N - k) Substitute in constraints: min w.r.t. 𝛑 0.5𝛑^2 + 0.5𝛌[k - (𝛑 - 𝛑^e)]^2 F.O.C.: 𝛑 = 𝛌[k - (𝛑 - 𝛑^e)] = 𝛌(u - u^T) Public solves: 𝛑^e = E[𝛑] = 𝛌k Outcomes: 𝛑 = 𝛌(k - 𝛑 + 𝛌k) ==> 𝛑(1 + 𝛌) = k(𝛌 + 𝛌^2) ==> 𝛑 = 𝛌k ==> u = u^N
IMF help
Commits to lend at fixed interest rate (above ilow but below ihigh) to help repay F If country insolvent: country should just default and move on because it is a pointless transfer of value from foreign taxpayers. This is like the parabola being left of the borrowing line, IMF lending more than expected repayment. If country illiquid: IMF eliminates liquidity crisis ihigh equilibrium as creditors know IMF will step in, so need not be as concerned about not receving repayment. No value transfer to country
Diamond-Dybvig Model (Utility expected equation)
Consume more = happy, concave so your risk averse
consumer problem
Consumer solves: max w.r.t. c1,c2 log(c1) + log(c2) + log[W - (1 + 𝝉1)c1 - (1 + 𝝉2)c2]/(1 + 𝝉3) F.O.C. w.r.t. c2 and c1 1/c2 = (1/c3) × (1 + 𝝉2)/(1 + 𝝉3) 1/c1 = (1/c3) × (1 + 𝝉1)/(1 + 𝝉3) INTUITION: consumption taxes change the price of consumption in different periods change the relative relative return to saving
Corridor vs Floor system
Corridor, pre-2009: CB shifts supply of reserves to hit i target (open market operations) Floor: CB already has many reserves, it changes the deposit rate and by the force of no arbitrage, the interbank rate moves to match it
Expansion/Contraction
Cylical output growing (falling), it starts with a trough (peak) ends in a peak (trough)
negatively
output demand depends ______ on the real interest rate
flexible prices
p = p* = P + a(Y - Ybar) + 𝛆til
sticky prices
p = p*^e = P^e
salience of the present
pain today gets DOUBLE WEIGHT on your feelings or emotions like extra discounting of the future relative to the present, or extra weight of present relative to future choose / plan to do it TOMORROW when it costs less BUT when tomorrow arrives: you PROCRASTINATE because: PRESENT IS ALWAYS SO COSTLY conflict or DYNAMIC INCONSISTENCY early selves disagree with later selves
weak increase
participation rate trend from 1960 - 2000
liquidity insurance
D-D MODEL WITH ______ AND A BANK PRESENT: ASSUME: bank knows 𝜭 (law of large numbers) bank offers ____: bank is pooling the joint risk of being an early consumer, just like a fire insurance contract does pooling ==> removes some uncertainty unlucky = early type : still gets some of the good returns lucky = late type : paying a premium by accepting to receive less ex ante THIS IS AN EQUILIBRIUM since late type WANTS TO WAIT and early type WANTS to WITHDRAW ==>
inflation inertia
past inflation raises expected inflation today that raises inflation today
forward curve
plot of expected interest rate in N periods know from yield curve
decreases; ambiguous; ambiguous
DECREASE IN CAPITAL STOCK: N^d shifts to the LEFT N^s shifts to the RIGHT ==> w ____ N ____ shifts of Y^d and Y^s are ambiguous ==. Y ______
increases
DECREASE IN CAPITAL STOCK: sum of shifts of Y^d and Y^s due to wealth effect should be SMALLER than sum of Y^s shift from direct effect of lower K and shift of Y^d due to I^d increase ==> r ____
investment
DECREASES in recessions INCREASES in booms PROCYCLICAL variable Y goes up and down in a mechanical way BECAUSE OF _____
decreases
DEFAULT PREMIUM INCREASES as a _____
expected output
DERIVATION OF AS MODEL _____ = expected long run output
0
DERIVATION OF AS MODEL expected shocks are ____
disintermediated
DIAMOND-RAJAN MODEL say banker promises to WITHDRAW HIS HUMAN CAPITAL: after run, loans are in the hands of the DEPOSITORS ==> negotiate directly with entrepreneur, who will over 𝛃X2 ⟺ what depositors could net if they later hired the banker to negotiate on their behalf ==> depositors accept BANKER HAS BEEN _____ AFTER BANK RUN ==> rent = 0 ==> worse off after run ==> banker will not call for renegotiation and will honour X2/n because you can run won't say won't mean you wouldn't be at the back of the line ==> would prefer demand deposit ABILITY TO RUN THREATENS BANK
a bank run
DIAMOND-RAJAN MODEL say banker promises to WITHDRAW HIS HUMAN CAPITAL: ==> depositors RUN on bank ==> seize assets to get 𝛃X2 (TO GET MORE) ==> fraction 𝛃 of them gets paid in full WANT TO BE IN FRONT OF LINE because get paid before no more ==> get ____
funds for real investment
DOWNWARD SLOPING DEMAND for ____
Consequences for Modern Banks
Dangers of securitisation -large share of assets marked to market -can quickly realise losses -rely on markets functioning and ability to sell securities Dangers from wholesale funding on banks -well informed creditor runs -repos not being rolled over is the new funding risk
properties of a currency
Durable Portable Recognized Acceptable Divisible ALSO: transaction handling (centralised vs. decentralised) representation (physical or digital) money creation (monopoly vs. competitive)
effective units of labour
E = e(w)N
Expectations operator
E(aX+b) = aE(X) + b ε, mean 0 and variance square:; - E(ε) = 0 and E(ε^2) = σ^2 E(aε + b) = b and E(a^2ε^2) = a^2ε^2
Employment rate
E/P
lower interest rate
EASY WAY TO STOP HYPERINFLATIONS
optimisation of firm
EFFICIENCY WAGES MODEL firm chooses w and N to maximise profits 𝛑 = F(K, E) - wN ; E = e(w)N F.O.C.s: (N) : e(w) × 𝝏F/𝝏E = w (w) : e'(w)N × 𝝏F/𝝏E = N ==> e'(w) × 𝝏F/𝝏E = 1 (combine two equations) ==> efficiency wage w* SATISFIES: e'(w) = e(w) / w firm MINIMISE COST of inducing effort from each worker / maximise effort from the worker per unit of real wages paid ==> maximise e(w)/w
reserves of foreign currency
ESSENTIAL THING NEEDED TO IMPLEMENT CURRENCY PEG
government purchases multiplier; unresponsive; output
EXAMPLE 1 OF CROWDING OUT G EXPANSION IF UNRESPONSIVE MP 𝛈 = 0 ==> slope = 0 ==> G decreases ==> shift by IS curve by _____ if have fiscal expansion and MP is _____ to output ==> change in ____ = level of government purchasing multiplier
increases; increases; I; increases
EXAMPLE 2 OF CROWDING OUT output INCREASES by LESS THAN GP multiplier when shift right ==> G spending INCREASES ==> output INCREASES BUT WHEN THIS HAPPENS: CB ____ i ==> _____ r ==> I DECREASES ==> Y DECREASES *CROWDING OUT* on ____ because interest rates have ____ (as said) G increasing by ∆g ==> C ___ ==> I DECREASES ==> CROWDING OUT SHIFTS LEFT
right; tax multiplier
EXAMPLE 3 OF CROWDING OUT T DECREASES ==> IS shifts _____ by ______ CROWDED OUT = extra G / cuts in T absorbs some of savings ==> I DECREASES ==> i, r INCREASE private investment to stay the same
Balanced budget expansion
EXAMPLE 4 OF CROWDING OUT ____ shift IS curve RIGHT by ∆ no multiplier scalar positive output INCREASES by < ∆ because change in interest rates ==> I DECREASES overall output goes to Y1 private output fell because I fell NO MULTIPLIER BUT ALL OF THE CROWDING OUT
animal spirits
EXPECTATIONS may deviate from target 𝛑^e = 𝛑bar + 𝛑^(as) due to ______ _____ : expect things with randomness In SR, 𝛑^e ≠ 𝛑 ==> call difference _____
expected inflation decrease
EXPECTED DEFLATION leads to same response in MP as increase in ihat r INCREASES ==> I DECREASES ==> Y DECREASES Why worry?: means CB not hitting inflation target if expect ==> think end up with shock expectation = failure Maybe Y too LOW because CB screw up
Exchange rate volatility
E_t = (1 + i_t)/(1 + i*_t) ..... (1 + i_t+N^e)/(1 + i*^e_t+N) × E^e_t+N+1 VARIES WITH: 1. FUTURE INTEREST RATES: in both countries at far away horizons 2. PROPORTIONALLY WITH FUTURE EXCHANGE RATE: and so real exchange rate as well 3. EXPECTATIONS change on these EXTREME ___
Diamond-Dybvig Model - World without banks
Each individual invests in tech, if liquidity shock terminate investment get c1 = 1, if not then consume at date 2, get c2 = 1 + r Welfare: higher r makes happier, lower theta happier you are
Liquidity insurance equilibrium
Early type need to have the payout early, having it late means nothing to them, so they show up early and get y1 Late type will not want to come early and get money, as y2>y1, so they wait to show up in period 2 As a result, there is equilibrium - even though type is private info, people are better off telling/acting on the truth than deviating
Identification Problem
Econometricians can estimate so-called vector autoregressions (VARs): - Yt = AYt-1 + Bεt where Θ-1Γ = A where Θ-1Σ = B {Θ, Σ, Γ}
Keynesian Economics
Economic theory stating that government spending should increase during business slumps and be curbed during booms P and 𝛑 FIXED very short run window ==> think how monetary policy or austerity change Y and r prices don't change in very short run
control interest on reserves
Economies are becoming cashless is central bank without currency powerless? ==> NO as long as _____ ==> controls unit of account even if not the medium of payment
criticisms of adaptive expectations model
Economists usually thinks of optimal behaviour BUT: OLD DEBATES 1. Stories about Phillips curve using 𝛑^e as a free parameter animal spirits 2. Adaptive expectations is like saying we drive a car looking exclusively at the review mirror 3. End of hyperinflation: inflation and expectations fall very rapidly
effort function(e(.))
Efficiency wages model shows that the efficiency wage w* chosen by the firm DEPENDS ONLY ON ____ ==> 'STICKY' W.R.T. OTHER FACTORS
Public debt increases, and tax revenues decrease. Even if it is not insolvent, explain how the UK could be subject to a liquidity crisis, and what would happen to interest rates on the public debt if so. Would such a crisis be bad for welfare, and what could international organisations do about it?
Even if the State is not insolvent, so the peak of the green parabola is to the right of the blue vertical line, still there are two equilibria. -A liquidity crisis is a move to the top one. The intuition is that bondholders start demanding higher interest on the debt, which raises their payoff if they get paid, but lowers the probability that this happens, so their expected payoff is the same. In the top equilibrium, this comes with an increase in the interest rate in the debt. Finally, Explain that in the top equilibrium, default is more frequent, and that when it happens this comes with a social loss due to the financial frictions, which is the value lost during an insolvency. Organisations like the IMF can promise to lend to the country at an interest rate below i high and in doing so eliminate the top equilibrium.
Theory of Exchange Rates
Expect appreciation if foreign interest rate above domestic interest rate
Classic Bank's balance sheet
FEATURES: 1. ASSETS: mostly short-term government bonds 2. LIABILITIES: reserves and currency 3. TOTAL SIZE: quite small
positive; positive
FIRM SIDE: ____ unemployment on average ___ number of vacancies on average
constants
FIRST ASSUMPTION OF KEYNESIAN CONSUMPTION FUNCTION: a and b are ___
Equilibrium search model
FOCUS: the determination of the job finding rate f in the law of motion for unemployment 3 KEY ELEMENTS 1. MATCHING FUNCTION 2. NASH BARGAINING 3. JOB CREATION CONDITION
Deriving Tobin's Q
First step: S is stoock market value after dividend where S = v' / (1+r) Second step: Firm also has debt of L, so total market value is S + L - Given dividend is v' = pi' + (1-d)K' - (1+r)L - S + L = pi + (1-d)K' / (1+r) - Swap out pi for MPk' x K' so (MPk' + 1-d)K' / (1+r) Then for Tobin's Q: Q = S + L/K', solve for final equation
Derivations of Firms
Flexible: - p = p* = P + a(Y-Y-bar) + ε-wavey (know how to calculate price changes) Sticky: - p = p*e = Pe (set to expectations) P = sPe + (1-s)[P + a(Y - Y-bar)] + (1-s)ε-wavey Subtract P-1 (turns everything to pi) 0 = (s x pi-e) - (s x pi) + (1-s)a(Y-Y-bar) + (1-s)epsilon
Law of one price
For an individual good, if there are no costs to transporting it between two locations, then it must sell for the same price oldest law in economics If p_i is the price of such good then it follows that: p*_i = Ep_i price in foreign land = relative price in our land
inflation targeting
Give central bank a ______ L^(policymaker) = 0.5[(𝛑 -𝛑*)^2 + 𝛌(u - u^T)^2] can rearrange: L^(policymaker) = 0.5[𝛑^2 + 𝛌(u - u^T)^2 - 2𝛑*𝛑 + 𝛑*^2 RECALL OPTIMAL CONTRACT AND PICK: 𝛑* = - 𝛚 = -𝛌k ==> GET NO OPTIMAL SOLUTION
exogenous
Government is _____ Y, C, I = ENDOGENOUS a, c, t, g = shocks 𝜸, 𝛿 = constant parameters LINEARITY for simplicity
ricardian equivalence
Government spending financed through current taxes and government spending financed by selling bonds are equivalent. GOVERNMENT SPENDING: {g1, g2, g3} ==> its intertemporal budget (using government bonds): g1 + g2 + g3 = t1 + t2 + t3 imagine charge lump-sum taxes on income without effect on willingness to earn that income: W = y1 - t1 + y2 - t2 + y3 - t3 = y1 + y2 + y3 - (g1 + g2 + g3) ___________: for CONSUMPTION, ONLY W matter time profile of {t1, t2, t3} does not matter WHAT MATTERS FOR CONSUMPTION: TOTAL GOVERNMENT PURCHASES
0
HARD to set a negative interest rate : BECAUSE currency because could just hold cash because it holds a 0 interest rate ==> ___ IS LOWER BOUND of interest rate can't go past -1% because private companies could come in
welfare state
HAS THE SIZE OF THE GOVERNMENT INCREASED? Yes because of _____, not (Keynesian) government purchases
Fairness argument
HOW TO FINANCE A WAR: Defends the star system as ethically acceptable by claiming that extraordinarily high levels of responsibility merit extraordinarily high levels of compensation. if peace is a DIVIDEND to the future generations ==> they should pay for the war with their taxes ==> PAY FOR WAR WITH DEBT
Solvency of sovereigns
Hard to ascertain solvency for countries bc it depends on fiscal surplus and commitment of politicians to pay their debt Countries therefore prone to liquidity crises as hard to judge the curve or what causes interest rate rises Small negative shock can push a country to insolvency if it was already close to the peak and therefore justify charging a higher interest rate. Also shifts in market sentiment can move economy to high interest rate equilibrium, therefore raising default probability.
Two-period model of consumption: income and borrowing
Household receives incomes of y and y', not yet taxed Saving is s = y - t - c Future consumption: c' = y' + (1+r)s (Divide both sides by (1+r) and substitute s = y - t -c) for intertemporal constraint.
pin down inflation
How do central banks _____ ? by using rates to steer expected and unexpected inflation
collect seniorage
How do hyperinflations come to be? fiscal problems lead to desire to _____ from currency
Seignorage (inflation tax)
How many goods and services the central bank can gain by printing new money - Change in M / P
Investment and Saving (closed economy)
I = (Y -T - C)+ (T-G) - (Private saving + Public savings) - Y = C + I + G Consumption depends on disposable income: - C = c + γ(Y-T) (lil C - consume for sake of consuming, constant, and MPC with income) Investment depends on IR - I = a - δr (delta constant, a is autonomous) Government exogenous - T = t and G = g, will shock these Everything linear, all greek letters constant parameters
Time inconsistency
I announce today I will take action X You choose action Y When tomorrow comes and you have committed to Y, I have an incentive to change my mind I am time inconsistent Yet, if you anticipate this today you act differently today - both of us may end up worse off
greater than
IF the stock market value is _____ the purchase price of new capital ==> firm should buy the machine
Policy Ineffectiveness Proposition
IMPLICATION 1 OF R.E. MODEL: say do fiscal or monetary policy to exploit the Phillips curve then people realise it, raise their inflation expectations, so policy ends up being neutral only unanticipated policy can have effects and there is no role for stabilisation policy PROBLEM: time horizon when tried to go up Phillips curve it shifted on us ended at 0 𝛑^e shifts out against you
role of announcements
IMPLICATION 2 OF RATIONAL EXPECTATIONS sacrifice ratio = 0 for CREDIBLE POLICY 'managing expectations' = integral part of policy All CB manage expectations how 𝛑^e adjusts is important to stop animal spirits and hyperinlation most of what has changed in CB policy is how to manage expectations ____ be transparent shift PC the way you want
role of policy rules
IMPLICATION 3 OF RATIONAL EXPECTATIONS avoid mis-directing agents, creating mistakes, instilling confusion eliminate or minimise the "policy shock" great moderation was result of better policy if shifting Phillips curve is just having 𝛑 different from 𝛑^e ==> may u differs is if trick people as important as policy shocks ==> SHIFT MP Follow Taylor rule: keep 𝛑 = 𝛑^e AND TRY NOT TO SHIFT MP
sources of misallocation within sectors
IN NON-TRADEABLE SECTOR POLITICS: without foreign competition, firms can more easily LOBBY for local regulations to erect barriers to entry and constraints on firms growing politicians are RECEPTIVE TO SMALL FIRMS as entrepreneurship is seen as income mobility and SMALL FIRMS EMPLOY A LARGE SHARE OF THE POPULATION FINANCE: banks in underdeveloped financial markets LACK MANAGERIAL TALENT and tools to diversify their credit portfolio WEARY OF GIVING LARGE LOANS TO A FEW FIRMS ==> favour SPREAD through MANY FIRMS
d + r
IN TWO PERIOD MODEL OF INVESTMENT MPK' = ____
life cycle theory of consumption
INCOME varies SYSTEMATICALLY over the phases of the consumer's "life cycle", so consumers plan over their entire lifetime to achieve smooth consumption ==> CONSUMPTION DEPENDS ON LIFE-TIME INCOME and SAVING is used to achieve SMOOTH CONSUMPTION if changes in CURRENT INCOME have a very SMALL IMPACT on LIFE-TIME INCOME, they have very LITTLE IMPACT on CONSUMPTION LIFE CYCLE PATTERN: borrow when young (income is low), save during middle age (income is high), and dis-save during old age (retirement)
ambiguous; ambiguous
INCREASE IN CREDIT-MARKET RISK with ASYMMETRIC INFORMATION N^s shift to the RIGHT because of HIGHER x and left due to LOWER r ==> no shift in N^d ==> w _____ ==> N _____
ambiguous; decreases
INCREASE IN CREDIT-MARKET RISK with ASYMMETRIC INFORMATION Y^d shifts LEFT Y^s shifts RIGHT ==> Y____ but Y and N likely to fall savers' interest rate r ______
increases
INCREASE IN CREDIT-MARKET RISK with ASYMMETRIC INFORMATION spread x _____ : firms are borrowers so investment demand falls at each level of r ==> Y^d shifts to the LEFT to extent that households are borrowers, C^d falls and N^s increases at each r ==> Y^d shifts left ==> Y^s shifts right
right; increases; decreases
INCREASE IN CURRENT TFP ==> shifts Y^s to the ___ ==> INCREASES MP_N ==> Shifts N^d to the RIGHT effects of higher TFP BOOST INCOME TEMPORARILY ==> WEALTH EFFECTS: 1. C^d _____ ==> Y^d shifts to the RIGHT 2. N^s _____ ==> Y^s shifts to the LEFT by less than original shift 3. future consumption and leisure are normal goods ==> sum of Y^d and Y^s shifts due to wealth effect is SMALLER than the direct shifts in Y^s
increases; ambiguous
INCREASE IN CURRENT TFP: RIGHTWARD SHIFT of N^d LEFTWARD shift of N^s ==> w _____ ==> N _____
increases; decreases
INCREASE IN CURRENT TFP: Y^d shifts to the RIGHT net effect on Y^s is also a rightward shift ==> Y _____ Y^s shift is LARGER ==> r _____
ambiguous; ambiguous
INCREASE IN EXPECTED FUTURE TFP: Net effect on N^s is ambiguous ==> w _____ ==> N _____
increases; decreases
INCREASE IN EXPECTED FUTURE TFP: Positive wealth effect from increase in future output 1. C^d ____ ==> further right right of Y^d 2. N^s ____ ==> Y^s shifts left without further assumptions, cannot draw conclusions about relative sizes of these shifts
increases; ambiguous
INCREASE IN EXPECTED FUTURE TFP: Y^d shifts RIGHT Y^s shifts LEFT ==> r ____ relative size is ambiguous ==> Y ____
increases; increases; positive
INCREASE IN EXPECTED FUTURE TFP: ==> ____ MP_K' ==> increases I^d ==> Y^d shifts RIGHT ==> ____ future output ==> _____ wealth effect
increases; increases
INCREASE IN G both Y^s and Y^d shift RIGHT ==> Y ____ Y^d shift is LARGER than Y^s shift ==> r ____
decreases; increases; increases; no change
INCREASE IN TFP: ==> unemployment ____ ==> employment ____ ==> output _____ ==> wage w* _____
increases; increases; decreases; decreases
INCREASE IN THE UNEMPLOYMENT BENEFIT b: (supposing that V_e (w) doesn't change) ==> INCREASE value of being unemployed, get more leisure CONSEQUENCE: reservation wage ____ w* ____ H(w*) _____ f ____
decreases
INCREASE IN UNEMPLOYMENT BENEFIT b: because f DECREASES ==> with no change to exogenous separation rate s ==> settle at HIGHER RATE OF UNEMPLOYMENT ==> Outflow ____
increase future marginal product of capital
INCREASE in EXPECTED FUTURE TFP OR DECREASE in CURRENT CAPITAL STOCK ==> _______
Discretion model
INTRODUCE SUPPLY SHOCKS: u = u^N - (𝛑 - 𝛑^e) + 𝛆 supply shocks give a trade-off: central bank can react to them public cannot benefit of discretion to stabilise the economy SOLUTION: CB solves min w.r.t. 𝛑 0.5𝛑^2 + 0.5𝛌(u - u^T)^2 u = u^N - (𝛑 - 𝛑^e) + 𝛆 u^T = u^N - k substitute in constraints: min w.r.t. 𝛑 0.5𝛑^2 + 0.5𝛌[k - (𝛑 -𝛑^e) + 𝛆]^2 F.O.C.: 𝛑 = 𝛌[k - (𝛑 - 𝛑^e) + 𝛆] = 𝛌(u - u^T) PUBLIC'S EXPECTATIONS: 𝛑^e = E[𝛑] = 𝛌k RESULTS: 𝛑 = 𝛌k + 𝛌𝛆/(1 + 𝛌) u = u^N + 𝛆/(1 + 𝛌) LOSS UNDER DISCRETION NOW: L^D = 0.5𝛌[(1 + 𝛌)k^2 + 𝛔^2 /(1 + 𝛌)] LOSS UNDER COMMITMENT: L^C = 0.5𝛌(k^2 + 𝛔^2)
negatively
INVESTMENT depends _____ on the interest rate (cost of capital effect) ==> I^d is DOWNWARD SLOPING
interest rate
INVESTMENT depends on ______ I = a - 𝛿r a = investments made that have nothing to do with interest rate if _____ are HIGHER ==> more expensive to borrow ==> people INVEST LESS
equilibrium in the savings market
IS curve is NOT A DEMAND CURVE it represents ______ (I = S market) combos of (Y, r) such that I = s
0
If as CB, want to keep inflation on target ==> ON AVERAGE: 𝛑 = 𝛑bar (as much as possible) ==> want (rhat - ihat)/(𝛘 + 𝜶) = ____
IMF help
If country is insolvent: IMF just transfers value from foreign taxpayers. Country should default, move on. The socially costly outcome of a default is not avoided, there is no gain in social welfare from the IMF loan If country is illiquid: IMF eliminates liquidity crisis equilibrium by promising to loan at a lower rate. No value transfer to country. Country should withstand turbulence, prove it is solvent. can significantly lower the probability of default, thus increasing social welfare.
Keynesian model
If current consumption depends mainly on current income meaning there are BORROWING CONSTRAINTS ==> current consumption may behave according to ____ of consumption even though she is rational and forward thinking
Bailout diabolic loop
If investors think the govt will not pay, price of govt bonds fall, value of bank assets fall, govt must bail them out and/or they cut credit, lowering real activity and tax revenues, which justifies initial investors' belief that govt may not be able to pay
greater than
If market wage rate is ABOVE INTERSECTION of labour demand and labour supply ==> LABOUR SUPPLY IS _____ LABOUR DEMAND ==> POSITIVE UNEMPLOYMENT
Pain of pegs
If overvalued as part of the peg (so on purpose) you may need to stop depreciation, whereby you can run out of international currency reserves to sell. You need to sell foreign currency, sell domestic, and raise nominal interest rate to attract capital to your currency. This is usually why pegs are abandoned, bc the country wants to be able to cut nominal interest rates and avoid recession. It is painful to have to have high interest rates, so abandoning a peg is called a float. To prevent this - same currency, same CB, no foreign reserves, no individual CBs - fix FX rates forever and share a common monetary policy e.g. EURO.
financing constraints
If the firm faces _____ , then its investment might not be feasible SIMILAR TO THE EFFECT OF BORROWING CONSTRAINTS ON CONSUMPTION
Modern Approach to business cycles
Impulse and Propagation approach: -the economy hit by exog shock (can't predict), macroeconomic variables respond by generating business cycles (movement of endog variables) -given a shock, how do variables move conditional on the shock happening? (Impulse response) Impulse: source of shocks e.g. tech, energy prices, rates Propagation: channels through which shocks transmit to economic outcomes over time
Impulse and propagation
Impulse: the source of the shocks. exogenous Propagation: the channels through which shocks transmit to economic outcomes over time.
jointly set a wage
In EQUILIBRIUM OF MATCHING FUNCTION: once a worker and a firm with a vacancy meet, they will ______ that is beneficial to both parties and ==> start production
MPK fell
In current policy debate, r has fallen to 1% BECAUSE ______ through secular stagnation, maybe population ageing has increased demand for savings
Okun's Law
Increase in unemployment associated with negative growth in GDP
labour force equation
L = E + U
Labour force participation rate
L/P
average zero
LESSON 1 FROM TAYLOR RULE: BECAUSE shocks ______ in the long run and there are NO animal spirits in the LR In LR: 𝛑^(as) = 0, rhat = 0, ihat = 0 ==> 𝛑 = 𝛑bar ==> LR = SR target
increases
LESSON 2 FROM TAYLOR RULE: If CB ______ ihat ==> LOWERS inflation in the SR
policy tightening
LESSON 2 FROM TAYLOR RULE: Raising policy rates TEMPORARILY, in the sense of discretionary deviation from the rule, is a ______ ==> LOWERS inflation changing ihat or rhat ==> ↓𝛑
greater than 1
LESSON 4 OF TAYLOR'S RULE: if the central bank raises nominal interest rate MORE THAN ONE-TO-ONE with inflation, ⟺ 𝛘 ______ ==> then animal spirits get attenuated
value of the house
LIMITED CONSTRAINT: the consumer can only borrow up to ____
higher; falls
LINK TO FINANCIAL CRISIS LOWER a ==> _____ r2 = borrower interest rate ==> BUDGET CONSTRAINT SHIFTS IN ==> Consumption ____ for ALL borrowers
increases; decreases; increases; decreases, decreases
LINK TO THE FINANCIAL CRISIS: ASYMMETRIC INFORMATION: when the fraction of good borrowers in the population DECREASES ==> credit market imperfection become more severe ==> there is MORE DEFAULT ==> DEFAULT PREMIUM _____, even good borrowers face higher loan rates ==> CONSUMPTION ___ for ALL borrowers matches observations from the current financial crisis credit market uncertainty ____ lending _____ consumption expenditures ______
down; increases
LOWER i_t+1^e ==> shifts the demand curve _____ ==> _____ investment ==> stimulates economy EFFECT: savings falls i_t^{2} falls quantity of investment ___ inflation INCREASES
Taylor Rule: CB rule
Last two components = 0 in long run (shocks and inflation - expected) Deviate from current inflation being at different long-run target and discretionary policy shock
In a traditional banking system, what is an individual banks best response if other banks lend more?
Lend less: Other banks have captured high MPK projects. Because all banks think similarly there is a unique level of lending where all banks lend the same amount. A downward sloping best response line. If there is a shock, and other banks lend less, best response is to lend more; attenuates the shock
In a modern banking system, what is an individual banks best response if other banks lend less?
Lend less: if others lend less, this pushes house prices down, lowers the value of securitised mortgages, banks must sell some traded assets and since all banks will be selling at the same time there will be little market liquidity- assets will be hard to sell and price will fall leading to fire sales Low asset prices means less collateral value for repo loans- there will be losses and expectations of further falls means higher margins and haircuts- margins spiral and funding liquidity falls. Banks lend less and responses become upward sloping. There is now amplification after a shock. There is also now the danger of multiplicity- if you think all banks will cut lending by a lot, and mirror this, the equilibrium could move to D.
Old bank - if others lend less what happens?
Lend more, other banks are not capturing the high MPK projects, higher return projects available for you -downward sloping best response
Bagehot doctrine
Lend safely to banks with good collateral at a penalty rate
Liquidity crisis model
Low interest rate: borrower likely to be able to pay it back and not default, creditor has high probability of getting a small sum High interest rate: borrower unlikely to be able to pay it back and not default, creditor has low probability of getting a large sum Creditor indifferent Very hard to tell whether insolvent or illiquid, parabola moves in both cases bc it is based on beliefs
Quantity Theory
M x V = P x Y Left-hand side: transactions equal the stock of currency times the number of times it changes hands. V is velocity Right-hand side: nominal GDP, all sales in economy
Oppt Cost of Money
M x V(i) = P x Y - When accepting money, hold it for period - Could instead earn nominal interest rate on it - Higher nominal IR, want to get rid of money, velocity increases - Remember that CB sets i an Fisher i = r + pi^e
What is the Quantity Theory of Money
M xV (i) = P x Y Left-hand side: transactions equal the stock of currency times the number of times it changes hands. V is velocity (a function of i, the opportunity cost of holding currency) Right-hand side: nominal GDP, all sales in economy. Equal interpreted as proportional.
appointing a conservative chairman
METAPHOR: tell her/they/him can only go out if her/they/he goes with the nerdy rule abiding neighvour
favouring N
MISALLOCATION MODEL BETWEEN SECTORS illustrated as a TAX ON SECTOR T over their output ==> LOWER marginal product of capital ==> production frontier is now FLATTER because diverting one unit of capital from N to T gives a LOWER RETURN
rent
MISALLOCATION MODEL BETWEEN SECTORS production function SHIFTS IN assume all of the taxes on T is lost this way ==> lower efficiency in economy
effect of firm size limits
MISALLOCATION MODEL WITHIN SECTORS every extra unit produced in sector N takes more capital ==> more T output is sacrificed for an extra unit of N ==> N production expands PRODUCTION FRONTIER: becomes CONCAVE start at same vertical intercept EFFECT: distribution of firm size is ==> SKEW TO SMALLER FIRMS ==> economy is WORSE OFF
MMFs (demand deposit type that is not regulated, offered by shadow banks)
MMF: deposit your money just like a checking account, they invest it in up to 90 day loans (commercial paper). If there are any losses, it was made law that the depositors should be repaid. Because of this, the first-come-first-served system was created. If the loan borrowers defaulted, the MMF is unable to provide the repayment/withdrawal service. They will only be able to repay the first M% of people. This causes a bank run.
Diamond-Dybvig Model
MODEL FOR MATURITY TRANSFORMATION ASSUMPTIONS: 1. three periods: 0, 1, 2 0-1 = short term, 0-2 = long term 2. N people in the economy each with one unit of a good in period 0 simple economy 3. Investment project such that INVEST 1 at date 0 IF: a. let project run its course ==> get 1 + r >1 at date 2 b. interrupt operations at date 1, get only 1 at date 1 (0 at date 2) everyone wants to stay invested until t = 2 because get the most utility from it 4. All people are identical at date 0 BUT at date 1 can become one of two types, which is PRIVATE INFORMATION probability 𝜭 want to consume at date 1 probability 1 - 𝜭 want to consume at date 2 5. MAXIMISE EXPECTED UTILITY, which is 𝜭u(c1) + (1 - 𝜭)u(c2) = 𝜭(1 - 1/c1) + (1 - 𝜭)(1 - 1/c2) more consumption ⟺ happier have concave, diminishing returns works with any utility function AS LONG AS HAVE: diminishing returns concave Each individual: claims at t=1 ==> get 1 claims at t = 2 ==> get 1 + r WELFARE: U^(no bank) = (1 - 𝜭)[r / (1 + r)]
structure of Diamond-Rajan Model
MODEL FOR MONITORING ENTREPRENEUR: PROJECT: invest one unit at date 1 to get a cash flow at date 2 two periods: t = 1, 2 entrepreneur has project but NEEDS CAPITAL if puts her effort and her human capital into it ==> project gives C2 FOR SURE BUT: may not put in effort and there is no way to force her AND she can THREATEN TO QUIT ==> cash flow = 0 IF SHE QUITS: assets in project have: resale value = X2 < C2 FINANCIER: requires an interest rate of 0 only willing to LEND X2 ==> otherwise entrepreneurs would quit or renegotiate and keep loan - X2 aka a penny more and she won't put in effort project is ILLIQUID because entrepreneur cannot sell his whole claim to the cash flow INEFFICIENCY: If C2 > 1 > X2 ==> project may NEVER get finance INVESTORS: financier has PROJECT SPECIFIC KNOWLEDGE after lending ==> allows him to liquidate for X2 investors are NUMEROUS, less skilled in lending ==> can liquidate only for 𝛃X2, where 𝛃 < 1 INEFFICIENCY: financier can raise only 𝛃X2 against a loan promising to pay X2 WORSE NOW: C2 > 1 > 𝛃X2 RENTS TO HUMAN CAPITAL: rents arise because cannot commit expertise if FINANCIER has NO MONEY==> project will now not get financed if 𝛃X2 < 1 not only assets, but also loan to project is illiquid
autoregression model
MODEL OF IMPULSE AND PROPAGATION y_t = 𝜸y_t-1 + 𝛔𝛆_t where y_t = economic variable (output today) 𝛆_t = economic shock 𝛔 = economic model of transmission = how does 𝛆 transmit into variable y 𝜸 = economic model of propagation = shocks propagates over time one period ahead: y_t+1 = 𝜸(𝜸y_t) + 𝛔𝛆_t+1 ..... IMPULSE RESPONSE: {𝛔, 𝜸𝛔, 𝜸^(2)𝛔, ... , 𝜸^(T)𝛔 ⟺ by how much does variable change given a shock in the past if 𝜸 is SMALL ==> DECREASE impact of 𝛔
ihat increase
MP COUNTER G SHOCK _____ ==> MP shifts UP ==> TIGHTER monetary policy because of extra tightness ==> IS curve shifts too MP controls extent of crowding out in the economy EX: big deficit ==> try to lower unemployment ==> Fed ____ run deficit to increase expansion
crowding
MP affects ____
indifferent to arbitrage
MP curve = equilibrium relation that tells when agents are _____ if not on MP ==> have arbitrage between nominal real investments holding
increasing
MP is ____ BECAUSE: 𝛈 when output INCREASES ==> CB INCREASES i ==> r INCREASES ==> shifts ihat UP ==> 𝛑 shifts UP ==> i INCREASES ==> r INCREASES
slope of indifference curve
MRSc,c' ≡ MUc / MUc' = u'(c) / [𝛃u'(c')]
misallocation between and within sectors
pressure on politicians to make structural reform is relaxed ==> ABUNDANT CREDIT makes it HARDER TO DISTINGUISH PRODUCTIVE PROJECTS ==> some of funds get diverted to assets which are INELASTICALLY SUPPLIED ==> creates CAPITAL GAINS ==> augments future expectations ==> fuels ASSET BUBBLES that spur FURTHER CREDIT in INEFFICIENT SECTORS = unproductive firms
Cryptocurrency
Mechanism to create money, record transactions in away that can't be falsified -anonymous -its creation is decentralised (like banks' creation of deposits) -blockchain database (like database at BofE) -digital (like reserves)
vector autoregressions (VARs)
Method to calculate impulse responses.
Diamond-Dybvig Model
Model of bank runs and related financial crises. The model shows how banks' mix of illiquid assets and liquid liabilities may give rise to self-fulfilling panics among depositors
Impulse and propagation approach
Modern approach to understanding the business cycle the economy gets hit by a shock ==> macroeconomic variables respond to it ==> generating business cycles
Describe two ways in which modern Spanish banks differ from traditional banks. Why do these differences amplify asset-price cycles?
Modern banks hold far more tradable assets (such as MBS) on the asset side of their balance sheets . In addition, they use these tradable assets as collateral to obtain wholesale funding, which is a much more important part of the liability side of these banks' balance sheets than a traditional bank . The existence of tradable assets on the asset side of the balance sheet amplified asset-price cycles in part because these assets are marked to market, so respond very quickly to developments in financial markets. In addition, when these assets increased in value, this tended to mean Spanish banks could borrow more in wholesale funding markets, then lending more, and further pushing up the prices of these assets . Wholesale lenders were willing to provide this additional funding when asset prices were rising as their lending was securitized and very short term. When asset prices started falling, however, lenders were quick to either stop rolling-over these loans or to demand more collateral, forcing Spanish banks to engage in fire sales of their assets and which further pushed down the prices of these assets.
Countercyclical
Moves in the opposite direction of cyclical output, negative correlation
Procyclical
Moves together with output, positive correlation with cyclical output
substitution effects of wage
N^s is UPWARD SLOPING HIGHER REAL WAGE w INCREASES SLOPE of budget line ______ : find new point on original indifference curve where optimality condition is satisfied leisure l DECREASES labour supply = N = h - l INCREASES
fully funded system acting in Ricardian Equivalence
ONE CASE OF ____ ==> almost a mirror image of this here ==> GOVERNMENT BUYS BONDS after taking your money when those bonds pay off ==> give you back your money in the future ==> return you get by government following that strategy ==> exactly return you could get for yourself ==> endowment point moves up along the life budget constraint, in absence of any credit market imperfections ==> if endowment point just moves along budget constraint still consume at the same endowment point as you'd chosen before the system
Corridor system
OPEN MARKET OPERATIONS: shift SUPPLY of reserves to hit i target OBSOLETE SYSTEM OF CB have fewer reserves ==> smaller supply of reserves WANT: to lower i ==> target for i and put money in their bank ==> SHIFT to the RIGHT ==> INCREASE number of reserves ==> i shifts DOWN
Labour demand
OPTIMALITY CONDITION FOR EMPLOYMENT: MP_N = w hiring an extra worker allows an extra MP_N units of output to be produced costs the firm w units of output with a higher wage bill marginal product is diminishing so increased employment requires lower wages
investment
OPTIMALITY CONDITION for ________ : MP'_K - d = r owning an extra unit of capital ==> an extra unit of MP'_K units of output in the future fraction d of capital is lost through depreciation r = opportunity cost of funds financing capital purchase marginal product is diminishing ==> more _____ REQUIRES LOWER INTEREST RATE
1 + r
OPTIMISATION BY CONSUMER: at the optimal point, MRS(c,c') = ____
Job Finding Rate
Offers obtained at p over time and given that an offer is accepted by 1 - F(w*): - f = p(1-F(w*)) where w is offered more than w* - Time to find and accept a job is 1/f
What would you guess the sign on the correlation between output growth and inflation would be?
Okun's law notes that the unemployment rate and output growth are negatively correlated. The Phillips curve notes that the inflation rate and unemployment rate are negatively correlated. Combining the two, it follows that you would expect output growth and the inflation rate to be positively correlated.
Countries in the eurozone voluntarily accept to impose limits on how much they can borrow every year. These prevent them from smoothing tax and spending shocks over time. Why may it be rational to choose to do so?
One response to a dynamic inconsistency problem is to tie yourself to the mast, binding yourself to a rule or commitment that prevents you from yielding to temptation. A deficit ceiling rule prevents the excessive deficits that result from the present bias of politicians, even if it comes with the loss of not allowing from optimal tax smoothing.
budget line just touches the highest indifference curve
Optimal point (c,c') is where ___
Boom/Recession
Output above(below) trend or cyclical output is positive (negative)
dynamic Stackelberg games with uncertainty
PERFECT NASH EQUILIBRIUM 2 agents: A and B choices: x^A and x^B Each wants to MAXIMISE THEIR UTILITY u^A(x^A, x^B, 𝛆) and u^B(x^A, x^B, 𝛆) is a GAME because my utility depends on what you do STAGE 1: agent A makes a choice x^A STAGE 2: we learn about 𝛆 STAGE 3: agent B makes a choice, knowing x^A and 𝛆 STAGE 4: Both agents get their payoffs SOLVE BY WORKING BACKWARDS THROUGH STAGES solution is going to be a function: x^B = f(x^A, 𝛆) max E[u^A(x^A, f(x^A, 𝛆), 𝛆)]
sources of misallocation between sectors
POLITICS: sector N PROTECTED BY LOCAL POLITICIANS given lack of competition can form LOCAL CARTELS coordinate political contribution FINANCE sector N FAVOURED BY LOCAL BANKERS in construction COLLATERAL IS AVAILABLE and easy to price large construction companies often have important SHAREHOLDER STAKES by local banks RENTS favouring N CREATES RENTS effort and resources are diverted to capture these rents directly lowers the economy's resources
long run
PPP holds okay in the ______
inflation is higher or more variable
PREDICTION 1 OF AS MODEL: if average inflation is VERY HIGH and/or very volatile, firms will want to update their price more often Expect s to get SMALLER ==> STEEPER AS CURVE IF ____
sticky prices/info
PREDICTION 2 OF AS MODEL: why have 𝛑^e: the more you expect prices to go up ==> all firms raise price of coefficient of 1 on 𝛑^e: all prices sticky or flexible raise prices when expected prices rise ==> actual prices ris why 𝜶: when output goes up ==> firms want to increase their prices BUT only flexibles can do that ==> 𝜶 depends on a and how much STICKINESS prices change on average every 4 months, BUT if exclude sales, change only every 10-12 months BECAUSE of menu costs and fairness concerns
Representative household
PREFERENCES: over consumption and leisure, now and in the future CONVEX indifference curves ASSUME: both consumption and leisure are NORMAL GOODS SOURCES OF INCOME: labour income dividends paid out by firms interest from bonds Must pay taxes to government
many banks
PROBLEM IN MODERN BANKING WORLD: ______ when use debit card at your shop, your bank must get transfer from my bank spreadsheets are different different banks must clear transactions
representative firm
PRODUCTION FUNCTION: transforming capital and labour inputs into output ASSUME: constant returns to scale, with individual factors having diminishing marginal products firms hires labour from households, uses existing capital, invest by buying new capital firm maximises profits profits paid out as dividends to owner of firm (representative household)
Currency
PROPERTIES: 1. PHYSICAL, hard to seize inconvenient because easy to physically lose or take 2. exchanges one for one with reserves, UNIT OF ACCOUNT 3. pays NO INTEREST, 0 lower bound on interest rates 4. exchanges are ANONYMOUS 5. MONOPOLY ISSUANCE by the state 6. WIDELY ACCEPTED serves as i. MEDIUM OF EXCHANGE: to buy goods as it is legal tender, avoiding double coincidence of wants ii. STORE OF VALUE: into the future as convenient, durable, and homogenous
price level
P_t how much money you must give to get the overall set of goods in the economy how much money to get a basket of goods P_t in the economy
n > r
Pay as you go benefit scheme is ONLY BENEFICIAL IF ____ population growth rate is the implied rate of return for an individual from the social security system, so the system is only worthwhile if the return exceeds what could be obtained in private credit markets
Pegging & inflation
Pegging exchange rate with key trade partners - will promote trade by removing exchange rate volatility. The change in exchange rate is in the long run = to the gap in inflation rates, so that if you peg the exchange rate, inflation in the long run will be the same as where you peg your currency to. It is expensive - you need to hold a lot of foreign capital that earns very little interest and also you are reducing its value as you sell it. Insurance premium.
demand driven
Phillips' evidence in his curve supports ______ cycles
Currency properties
Physical, hard to seize Exchanges 1 for 1 with reserves, unit of account Pays no interest, zero lower bound on interest rates Exchanges are anonymous Monopoly issuance by the state Widely accepted - used as medium of exchange and store of value
The IS curve
Plotting investment = savings relation in (Y,r) space Intuitively: - Higher IR, lower I, and lower output, 2nd round effect lowers it more - Higher income means more savings, raises supply of loanable funds and so lowers their price, the real IR
Policy Ineffectiveness Proposition
Policy cannot systematically manage the levels of output and employment in the economy -fiscal or monetary policy to exploit the PC does not work because people realise this is happening and raise their inflation expectations and the policy ends up being neutral -only unanticipated policy can have effects; there needs to be some difference between inflation and expected inflation for policy; without it there is no role for AD stabilisation policy -the PC curve will keep shifting if people solve the model and know what happens to inflation and expect that, and we end up with no change in employment -in the long run we said all AD policy was ineffective and did not affect unemployment - it is controversial to say this also happens in the short run
Misallocation sources between sectors
Politics - N protected by politicians bc it employes a lot fo people, lack of competition can create cartels, firms are large bc EoS so can coordinate influence over politicians Finance - Sector N favoured by local bankers bc in construction collateral is available and easy to price, large construction companies often have important shareholder stakes in local banks Rents - favouring N creates rents and effort/resources are diverted to capture these rents, directly lowering the economy's resources, return to investing in N is higher bc of the ways it is subsidised.
Investment: financed by retained earnings
Production - wages - Capital accumulated in 1st period + (Future Prod - Future Wages + Depreciation of Future Capital / 1+r)
Pros and Cons of defining a recession as persistent negative deviations in real GDP from its trend.
Pros: Theoretically sounds and empirically easy to use for past data Cons: Deviations from the trend depend on the definition of the trend- an estimate of a trend in real time can be challenging (end point problem)
Pros and Cons of defining a recession as (at least) two consecutive quarters of decline in real GDP.
Pros: simpler given difficulties associated with determining the trend Cons: GDP data subject to considerable revision therefore involves underlying uncertainty Does not provide a good guide to determining the end of a recession
increases; increases; decreases
REASON 2 WHY IS CURVE HAS A NEGATIVE SLOPE: HIGHER income ==> ______ savings ==> ______ supply of loanable funds ==> ______ their price = real interest rate
economic laws; details of economy
RESPONSE to shocks and propagation is governed by ______ and ______
wealth effect on labour supply
RIGHTWARD SHIFT of HOUSEHOLD BUDGET CONSTRAINT ==> GREATER DEMAND for LEISURE (normal good) ==> labour supply SHIFTS LEFT
wealth effect on consumption
RIGHTWARD SHIFT of household budget constraint DEMAND for consumption INCREASES (normal good) consumption demand SHIFTS TO THE RIGHT
contraction
RULE OF THUMB _______ if two consecutive period of falling GPD
greater than; large; large; small
RULES ARE BETTER WHEN: (1 + 𝛌)k^2 ____ 𝛔^2 if k is ______ ==> temptation is LARGE if 𝛌 is ____ ==> MORE TEMPTED if 𝛔 is _____ ==> LITTLE SCOPE for stabilisation
lower; more volatile
RULES _____ average inflation BUT lead to _______ unemployment, as opposed to discretion
Monetary policy rule
Real iR = interest rate - inflation expectation. - Long run IR + inflation target + deviations of shi from long run level + shocks + output response - expected inflation. Response to output: ηY + χpi + i shocks - expected inflation Slope: η positive, steeper if monetary responds more to output Shifts: up and left if tighter policy or if expected deflation
Limited commitment
Refers to situations in which it is impossible for a market participant to commit in advance to some future action introduce collateral into our two-period model for consumption: H = quantity of housing owned by consumer p = price of housing ASSUMPTION: housing is ILLIQUID -- can't be sold in the current period. However, it is possible to BORROW AGAINST housing wealth, with a COLLATERAL CONSTRAINT
Volcker
SECOND FAILURE IN 1970s 𝛑 = 𝛑^e - 𝛃(u - u^n) + 𝛆 SACRIFICE RATIO: to lower inflation by 1%, how much extra unemployment must I tolerate? ⟺ B = slope of Phillips curve in LR, DECREASE 𝛑 means 0 impact on u because impact is temporary NEED TO KNOW 𝛃 AND how long for 𝛑^e to adjust down 𝛑, u accelerate and are high ____ says to LOWER 𝛑
discount near future
SELF-CONTROL PROBLEM: people ______ MORE THAN FAR FUTURE
increases; government purchases multiplier
SHIFT IN IS CURVE: G _____ ==> shifts RIGHT/UP SIZE OF HORIZONTAL SHIFT: _______
increases; tax multiplier
SHIFT IN IS CURVE: if T _____ ==> shifts LEFT/DOWN SIZE OF HORIZONTAL SHIFT: ______
Deposit insurance
SOLUTION TO BANK RUNS: 3 ______ GOVERNMENT will make sure you get y2 even if there is a run at date 1 ==> money is insured up to a point ==> if show up and bank doesn't have it, government gives either y1 or y2 BECAUSE government has power to TAX OTHER TO PAY IT fund by TAXING PEOPLE but then, once I know for sure that by waiting i can get y2 > y1 ==> even if everyone else is running, i won't run BUT same applies to all late consumers ==> NO RUN EVER HAPPENS late guys know not to run because either get y2 or y1 GUARANTEED BUT if never run ==> government doesn't need to tax to bail out ==> THREAT of payout makes people come mere threat of government bail-out enough to make sure it never happens OFF-EQUILIBRIUM THREAT (game theory)
demand deposits
SOLUTION TO PROBLEMS IN DIAMOND-RAJAN MODEL = MODEL FOR MONITORING bank gives depositors a ____ n = in the deal give you X2/n rather than 𝛃X2 VIA FIRST COME FIRST SERVE X2/n < 𝛃X2
clearing houses
SOLUTION to problem of many banks my bank clears your note because trusts the other bank will satisfy their note 1 bank has a house in the other bank
model of inflation expectations
SUBGAME PERFECT NASH EQUILIBRIUM USING DYNAMIC STACKELBERG GAMES VALUE OF RULES: STAGE 1: public's inflation expectations are RATIONAL enter contracts based on them 𝛑^e = E[𝛑] STAGE 2: shocks to economy are realised, say model as supply shocks for simplicity 𝛆 ~ (0, 𝛔^2) STAGE 3: central bank chooses inflation optimally to minimise loss: L = 0.5𝛑^2 + 0.5𝛌(u - u^T)^2 TARGET UNEMPLOYMENT BELOW THE NATURAL RATE: u^T = u^N - k STAGE 4: outcomes are realise according to the model of the economy, via a Phillips curve: u = u^N - (𝛑 - 𝛑^e) + 𝛆
Financial market
SUPPLY: debt issued by government, equity issued by firms DEMAND: household savings
Goods market
SUPPLY: output produced by firms DEMAND: consumption by households, investment (accumulation of capital) by firms, government spending
Labour market
SUPPLY: work done by households DEMAND: hiring by firms
young generations
SUPPOSE: PAY AS YOU GO SYSTEM is introduced in period T, consider welfare of the old and the young: _____ population growth: N' = (1 + n)N THIS CASE:::: n > r = case where GOVERNMENT REDISTRIBUTION makes EVERYONE BETTER OFF ==> lifetime budget constraint SHIFTS OUT TO THE RIGHT ==> consumer better off ==> slope of E1E2 = -(1 + n) STEEPER THAN BUDGET LINE ==> geometrically new endowment point E2 is above B.C. ==> new line B.C. must go through E2, with same slope r ==> shift out to the right ==> consumer gets to CONSUME MORE OVERALL ==> better off CONSUMER'S WEALTH BECOMES: we = y - b/(1 + n) + (y' + b)/(1 + r) beat return available, more people to pay
old generation
SUPPOSE: PAY AS YOU GO SYSTEM is introduced in period T, consider welfare of the old and the young: ______ like it because get benefits and pay no contributions endowment point INCREASES no change in current y huge increase in future consumption SHIFT OUT TO RIGHT of lifetime budget constraint
Allocating capital between
Sector T - goods traded in international markets, subject to competition e.g. manufacturing Sector N - produces goods for the domestic market, protected from foreign barriers by natural and political barriers e.g. construction
How does the expectations hypothesis define the whole yield curve
Sometimes called the term structure {it (1), it (2), ..., it (N)} • Again CB only sets short-term rates, but because it can control whole path of these (aka forward curve) it can influence the entire yield curve {it (1), it+1(1)e, ..., it+N-1(1)e} ⟹ {it (1), it (2), ..., it (N)} • Term spread is slope of yield curve
MP
Steeper if monetary policy responds more to output Shifts up/left if tighter monetary policy (raising interest rates) or if expected deflation
investment with asymmetric information assumptions
Suppose many firms in the economy: some good, some bad bad firms borrow in the credit market, consume the proceeds as executive compensation THEN DEFAULT r = lending rate of interest r' = loan rate ASYMMETRIC INFORMATION: lenders cannot distinguish good from bad firms
bank run
Suppose: N - 1 = everyone shows up at bank and you are a late consumer Bank cannot satisfy all customers BECAUSE: (N - 1)y1 > N FOR LARGE N enter SEQUENTIAL SERVICE CONSTRAINT ==> _______
right; negative wealth effect
TEMPORARY INCREASE IN G: ==> Y^d shifts to the ____ ==> raises tax burden ==> creates ____ = DECREASED demand for all normal goods ==> C^d FALLS by less than G increases ==> Y^d shifts ____ overall ==> N^s INCREASES ==> Y^s shifts to the RIGHT ==> future consumption and leisure are normal goods ==> sum of rightward shift of Y^s and leftward shift of C^d is LESS than change in G
government approach to overspending
TIED TO MAST: balanced budget rules RAISE BORROWING COSTS: constraints on bonds issuance, debt limits PATERNALISM: join EU, blame Brussels sign pacts, troika deals, bypass democracy
Dynamic macro model structure
TWO TIME PERIODS: present and future CLOSED ECONOMY aka no international trade AGENT IN THE ECONOMY: 1. REPRESENTATIVE HOUSEHOLD: makes a consumption vs. leisure decision, and a consumption now vs. saving decision 2. REPRESENTATIVE FIRM: makes a labour hiring decision, and an investment decision 3. THE GOVERNMENT: consumes resources, levies taxes, issues debt
Give one argument for why bank runs are detrimental to the financial system, and in defense of deposit insurance to avoid them.
The argument for why they are detrimental is the Diamond-Dybvig model. Bank runs are a self-fulfilling equilibrium in a model with multiple equilibria. They are detrimental because they force the early liquidation of worthwhile projects. -Deposit insurance removes the bad equilibrium because people no longer have an incentive to run. The argument for why they are necessary is based on the Diamond-Rajan model.
Lucas critique
The argument that traditional policy analysis does not adequately take into account the impact of policy changes on people's expectations. if raise M to get lower u at the expense of a higher 𝛑 ==> people adjust 𝛑^e, maybe fully maybe partially either way as soon as try to exploit the Phillips curve, it SHIFTS on you PC IS NOT STABLE given shock that's unprecedented what happens to 𝛑, u don't try to be good at forecasting LIKE MURPHY'S LAW
Give two reasons why, depsite the great moderation, the business cycle is not dead
The business cycle is not dead for a number of reasons. First, in spite of the long expansions mentioned above, 2007-2009 also saw the second largest contraction in recorded history. Thus, there may be a moderation in the frequency of recessions, but not necessarily in their intensity. Second, much of what we mean when we talk about the business cycle is the co-movement across sectors, industries, and aggregate variables, and that has not changed. Third, the business cycle also relates to the impulse responses of the main aggregate variables to shocks, and this too does not seem to have changed during the Great Moderation.
government purchases multiplier
The change in aggregate income resulting from a one-dollar change in government purchases. Y = c + 𝜸(Y - T) + a - 𝛿r + g keep r FIXED IF INCREASE g: ==> Y INCREASES ==> C INCREASES ==> Y increases more SO ON AND SO ON second round effects ==> Y rises MORE than g ∆Y = 𝜸∆Y + ∆g ==> ∆Y = ∆g × 1/(1 - 𝜸) which is the ____
What is the diabolic loop?
The diabolic loop exists when banks hold a significant number of domestic sovereign bonds as assets. When there is a shock to perceptions of default risk on these sovereign bonds, the value of these bonds decreases . This implies that the banks holding these bonds suffer losses on their assets. This is turn has two effects: (1) these banks have lower equity and are therefore more likely to need a government bailout and (2) these banks cut lending to the real economy, lowering economic activity and government tax revenues . Both of these channels imply a higher probability of government default, thus creating a feedback loop and potentially a self-fulfilling cycle in terms of expectations of default
job finding rate
The fraction of unemployed persons who find a new job during a certain period of time, such as a month rate of accepting new job
Okun's law
The generalization that any 1-percentage-point rise in the unemployment rate above the full-employment unemployment rate will increase the GDP gap by 2 percent of the potential output (GDP) of the economy. whenever we go into a recession UNEMPLOYMENT GOES UP NEGATIVE relationship between output and unemployment
Which is larger- government or tax multiplier?
The government purchases multiplier is larger than the tax multiplier, the former being given by 1/(1 − b), and the latter by b/(1 − b), where b is the marginal propensity to consume.
Effects of a temporary increase in current TFP on the SOE with production and investment model
The increase in TFP does cause the output supply curve to shift to the right though as in the closed economy version of the model. This causes an excess supply of output at the world real interest rate. The output demand curve will then shift right as this extra output is exported and net exports increase.
What were the policy mistakes that led to the Great Depression? What advice would you give to policymakers today to avoid another great depression?
The initial mistake in "Stage 1" (1928-29) was the contractionary monetary policy (raising ˆi) at a time when aggregate demand was falling due to the IS curve shifting left. During "stage 2" (1930-33), as the crisis deepened, the Fed did not respond to the banking panics and expected deflation and allowed the MP curve to shift left. Fiscal policy was also contractionary during this period, further depressing aggregate demand by pushing the IS curve to the left. The "Stage 3" (1933-37) policy stance was more appropriate in that monetary and fiscal policy were both significantly expansionary but a further mistake was made when the expansionary monetary policy was ended prematurely. A further policy mistake during this period were changes in competition policy and labour regulations which shifted LRAS to the left by making the economy less efficient. In "Stage 4" (1939 onwards), the policy mistakes of the previous periods were not repeated - there was large expansionary monetary and fiscal policy for an appropriate period of time and competition policy and labour regulations were reformed. Policymakers should implement appropriately expansionary monetary and/or fiscal policy during recessions to limit their size and duration.
job separation rate
The rate at which workers move from employment to unemployment or outside of the labor force. reasons why may not have a job in t+1
Business cycles:
The short-run fluctuations of output and employment around trend
nominal rigidities
The slow adjustment of nominal wages and prices to changes in economic activity.
Why do central banks put so much emphasis on transparency and communication?
Their objective (usually inflation targets) are announced up- front, thus anchoring inflation expectations and allowing the central bank to gain credibility by achieving the target. This also adds forward guidance to the toolkit of the central banks which, as we learned previously, can be a key policy tool especially when nominal interest rate in the economy reaches its lower bound - it only works if the central bank can make credible promises about its future policy.
A rule that prevents new taxes in the first year a government is in office is proposed to stop governments promising to cut taxes and then increasing them ex post. Discuss one advantage and one disadvantage of this policy, and propose an alternative policy to solve the problem of breaking promises.
This is a time inconsistency problem. -Advantage: Prevents underinvestment bias: with discretion people invest too little in the assumption that politicians will want to tax their investment -Disadvantage: No discretion- there could be a high-value project that would be worth raising taxes for. -Alternatives: (i) assign tax policy to an independent body that dislikes taxation more than society, (ii) adopt a taxation target. These take discretion away from the policymaker.
To deal with dynamic inconsistency
Tie yourself to mast (balanced budget rules) Raise borrowing costs (constraints on bond issuance, debt limits) Paternalism (govt soft force)
The consumption puzzle
Time series data suggest that aggregate consumption is approximately proportional to aggregate income BUT Cross sectional data suggests it follows a Keynesian consumption function. C = a + b(Y-T). Source of variation is from long trends su
Sacrifice Ratio
To lower inflation by 1%, how much extra unemployment must be tolerated
Whats the difference between the balance sheets of traditional vs modern banks?
Traditional banks liabilities: mainly deposits Modern banks liabilities: much more wholesale funds, repos and traded assets
CB needs fiscal backing
Treasury letter of indemnity = treasury will recapitalise them if they make a loss
consumer's lifetime utility function
U(c, c') = u(c) + 𝛃u(c') 0 < 𝛃 < 1
supply of two-period savings
Under efficient financial markets (arbitrage): _______ is the horizontal line at i_t + i_t+1^e
Okun's Law
Unemployment is correlated with the output gap
Investment: Dividends
V = v + v'/(1+r)
The Great Moderation
Volatility fell 1984-2002 Why? -maybe economic policy better, maybe luck, maybe better at teaching firms not to overproduce in booms and underproduce in recession, maybe better at measuring inventory -even including GFC, s.d. is a lot lower than it used to be -less of a business cycle now, length of booms longer -we have a much more stable economy than before, it is just stapled with huge shocks less often
assume effort depends positively on unemployment rate
WAY TO MODIFY EFFICIENCY WAGES MODEL to yield an INCREASE IN WAGES: _____ i.e. the effort function is e(w, u) since u is falling ==> firm has to increase w to maintain effort
Why is there systematic risk amongst financial institutions?
When banks sell assets they exert a pecuniary externality by pushing asset prices down and causing losses to other banks. This is a systematic risk: losses in some financial institutions are amplified and lead to losses across the financial system
Expansion
When cyclical output is growing. It starts with a trough, ends with a peak
Boom
When output is above trend/ cyclical output is positive
Recession
When output is below trend cyclical output is negative
Recession
When output is below trend/ cyclical output is negative
Solvency
Whether the debtor has revenues in the present and in the future with which to repay the debt. If the PV of your revenues > debt, you are economically solvent. An economic institution with future revenues and debt WILL be insolvent for a high enough interest rate With perfect and complete markets, no arbitrage relation linking interest rates, there is a single interest rate relevant to determine solvency -solvent if expected return>the interest payments
Large capital flows from the core to the periphery of Europe in 2000-10 should have allowed income levels in the periphery to catch-up with the core. Instead, productivity in the periphery fell. Discuss how subsidizing non-tradable sectors and imposing size limits on firms within each sector can imply that in spite of the extra capital, the economy's output barely changes.
While large capital flows into the periphery should have, all else equal, caused a significant increase in output in these economies, this did not happen as the additional capital was misallocated across sectors and within sectors across different firms. In terms of misallocation across sectors, certain non-tradable sectors such as construction received a disproportionately large share of the capital inflows due to politicians and underdeveloped financial markets favouring the protection and subsidization of these sectors . This misallocation meant that lots of capital was allocated to the non-tradable sector even when this sector was relatively unproductive compared to the tradable sector. In addition, this system of protection and subsidization created further losses of output through the inefficiencies associated with maintaining these distorted incentives and the wasteful rent seeking behaviour such incentives promoted . In addition to this, there was misallocation within sectors due to size limits on firms. These limits meant that the most productive firms in a given sector were constrained and could not expand to fully absorb the additional capital flowing into their sector . Thus, less efficient firms began to employ more capital, reducing the gains in output of employing this additional capital . These two effects meant that while more capital may have been used in the economy, the efficiency with which it was being used was declining, leading to a much less significant increase in output .
quality is different across countries
Why law of one price does not realistically hold: _____
Fix exchange rates
Why? -to promote trade by removing exchange rate volatility (so that e.g. exchange rate movements do not cancel out cost efficiencies) -to commit publicly to an inflation target equal to the other countries' inflation (keeping exchange rate with trade partners fixed, promoting trade) How? -if exchange rate higher than desired, lower interest rates so that investor money flows out or print money and buy foreign currency with it -if lower than desired, raise interest rates, sell foreign currency to lower money growth (you can't print foreign money, need reserves of foreign currency)
Identification problem
With only knowledge of A and B, co-movement cannot be separated from transmission and propagation. If one of co-movement/transmission/propagation provided, can get the impulse responses. If there is only one variable, then can separate transmission and propagation (once there is co-movement, cannot separate them).
Timing of leisure/labour decision
Working an extra hour today provides extra income w, which has value (1 + r)w in the future extra income allows hours of work to be reduced by (1 + r)w/w' in the future, with the consumption plan remaining affordable household requires MRS_l,l' hours of future leisure to compensate for loss of one hour of current leisure OPTIMALITY CONDITION: MRS_l,l' = (1 + r)w/w'
Okuns Law: Output Gap to Unemployment
Y - Y-bar = -η(u - un) - Output negatively related with unemployment Re-expressing in terms of u Beta = alpha x eta pi = pi-e - beta(u - un) + epsilon = pi-e - beta(u-un) + epsilon Beta is slope of phillips curve
Multiplier. - Govt and Taxes
Y = c + γ(Y-T) + a - δr + g When r fixed, what happens with g rise: - g rises, Y rises, but then C rises, Y rises and so on, therefore Y rises more than g change in Y = change in G x (1/1-γ) If t rises, C falls Y falls, then C falls, pushing Y further down and so on Change in Y = - change in t x (γ / (1-γ))
if Y is log(output) then
Y = log(output) = Ytrend + Ycycle Ycycle is any deviation around the trend
save
___ when income is high
higher w
____ ==> LOWER expected profit from creasing a vacancy ==> v FALLS ==> 𝜭 = v/u FALLS ==> q(𝜭) RISES UNTIL THE EXPECTED PROFIT IS ZERO AGAIN
Odd implication of increase in TFP
____ : causes higher employment but no change in wages CANNOT BE SUSTAINED FOREVER
rbar
____ = MPK
value of employed worker at wage w
____ = V_e(w) an INCREASING FUNCTION of the wage offer related to the concept of an 'asset value' what would be your present discounted value of your utility, the payoffs you make
q
____ = [[(MPK')K' + (1 - d)K']/(1 + r)] / K' = [MPK' + (1 - d)] / (1 + r)
a
____ = fraction of borrowers that NEVER default
inflow to unemployment equation
____ = s(1 - u) DOWNWARD SLOPING: higher the unemployment the fewer people have jobs
tax cut in market with credit imperfections
____ ==> ASSUME s = 0 ==> entire tax cut spend on current consumption
higher i
____ ==> HIGHER 𝛑
without credit market imperfections
____ ==> people can save borrow as much as they want with only constraint being the lifetime budget constraint
Fiscal problems
____ are usually at root of hyperinflations governments printing money to pay for expenses
borrowing constraints
____ explain why current income may DIRECTLY AFFECT current consumption if ___ are present ==> may not be able to increase current consumption EX: credit limit on credit card, or maximum loan to value on mortgage
current income
____ is the only variable that matters in the case of a binding borrowing constraint
firm run
____ leads to change in ownership of claims on the firm can't run on entrepreneur because need the product only she can create
decrease in match efficiency
_____ ==> JC shifts DOWN ==> LOWER w ==> LOWER 𝜭 ==> BC SHIFTS OUT ==> HIGHER u ==> AMBIGUOUS CHANGE in v
nominal exchange rate
_____ = E the relative price of two currencies EX: how many euros must give to get one dollar
fiscal expansion
_____ = G INCREASES ==> IS shifts UP ==> Y INCREASES ==> for fixed 𝛑, when Y INCREASES ==> AD SHIFTS UP BY MULTIPLIER -- crowding out
increase in expected MP_K'
_____ = HIGHER FUTURE TFP or LOWER CURRENT CAPITAL STOCK ==> I^d and Y^d shift RIGHT
arbitrage condition
_____ = NO ____ taking into account that don't know what the price level will be: 1 + r = (1 + ret^e) = (1 + i) × [1 / (1 + 𝛑^e)] best you can do it equate expected return with expected inflation
1 - a
_____ = fraction of borrowers that ALWAYS default
today CB net income
_____ = i^{2} × Assets - i^v × Reserves ≈ Assets × (i^{2} - i) + i × Currency Reserves = Assets - Currency term spread gives EXTRA POSITIVE / NEGATIVE INCOME to central banks, can be large CB is borrowing short and investing long ==> earning difference between long and short rate CB can make losses ==> NEED FISCAL BACKING
assume free capital flows
_____ = no barriers to trade or transportation costs ==> investors can freely invest in euro or dollar bonds
deposit rate
_____ = r1 at banks
interest rate differential
_____ = spread on interest rates
demand for goods
_____ arise from: consumption by households investment by firms spending by the government: Y^d = C^d + I^d + G
government
______ : chooses spending G and lump-sum taxes T must satisfy its budget constraint G + G'/(1 + r) = T + T'/(1 + r) sells bonds: B = G - T to finance its deficit present discounted of spending = present discounted value of taxes in case of an endogenous change in r, we suppose taxes T adjust to satisfy the budget constraint
demand for reserves
______ falls with i - i^v the HIGHER the i ==> fewer deposits you keep the LOWER the i ==> the more reserves you keep at CB
nominal net return
______ on investment is the same as promised rate today: i = y/x - 1
consumption
______ only varies so much a procyclical variable goes up by less than output in a boom and falls less in a recession SMOOTHER than output
Ricardian equivalence does not hold
_______ WHEN: 1. If the tax burden were NOT SHARED EQUALLY among consumers then the government can redistribute wealth through tax 2. If taxes are DISTORTIONARY, e.g. a labour income tax reduces incentives to work 3. If consumers have shorter lifespan than the government ==> there can INTERGENERATIONAL REDISTRIBUTION e.g. public pension systems 4. If there are CREDIT MARKET IMPERFECTIONS, then credit-constrained consumers might benefit from a current tax cut
making splurging expensive
_______ leads to same consumption as tying yourself to the mast APPLICATION: people borrow massively on their credit cards, while having other sources of wealth carry a balance pay huge interest rates EXPLANATION: early self put money in illiquid assets e.g. IRA account or housing, later self wants to splurge, but can only do so by borrowing on credit card at very expensive rate
utility is lower
_______ when have consumption with temptation and dynamic inconsistency
increase in expected future TFP
________ ==> marginal product of capital INCREASES ==> investment demand SHIFTS to the RIGHT if current capital stock would FALL ==> future marginal product of capital INCREASE ==> investment demand SHIFT to the RIGHT
increase in current MP_N
________ = HIGHER TFP or HIGHER capital stock ==> N^d and Y^s shift RIGHT
spread on interest rates
________ DEPENDS ON BOTH 1. default risk 2. exchange rate risk
sharply negative growth dividend and exploding up debt
_________ ==> SOLUTION: LOWER interest rate Grow out of the problem = structural reforms Move to primary surplus = fiscal austerity
gain from discretion
_________ come from being able TO REACTO TO 𝛆
permanent increase in income; temporary increase in income
__________ >>> ________ in terms of effect on LIFETIME WEALTH
Beveridge curve
a NEGATIVE RELATIONSHIP between the UNEMPLOYMENT RATE and the VACANCY RATE also called the UV curve
fall
a ____ in the price of the house ==> the budget constraint SHIFTS IN vertical trunk of the budget constraint shifts left
positive shift
a __________ of the budget constraint INCREASES DEMAND for ALL NORMAL GOODS
balanced budget multiplier
a change in government spending offset by an equal change in taxes results in a multiplier effect equal to one
Ricardian Equivalence
a change in the TIMING of taxes by the government has NO EFFECT ON CONSUMPTION a tax cut is not a free lunch when government has to finance itself, it has a choice between borrowing money or raising taxes BUT borrowing money is not magic ==> debt that needs to be paid in future ==> higher debt burden = HIGHER TAXES ==> government reshuffles timing of taxing
save
a consumer will tend to _____ most of a PURELY TEMPORARY INCOME INCREASE theory behind this: if you had a temporary change in income, you WOULD NOT RAISE c all that much ____ MORE ==> temporary INCREASE temporary DECREASE borrow more if looked at permanent change, get much bigger response of c maybe roughly in proportion to change in income
fixed currency
a currency with an exchange rate that is tied to another currency or to some commodity
Phillips Curve
a curve that shows the short-run trade-off between inflation and unemployment
Phillips curve
a curve that shows the short-run trade-off between inflation and unemployment when unemployment is HIGH ==> inflation FALLS when unemployment is LOW ==> inflation RISES
Tobin's Q ratio
a firm should invest up to Q = 1
fully funded pension system
a government sponsored savings programme where the old receive the payoffs on the assets that were acquired when they were young term-17 contributions used to invest in assets essentially a mandated savings programme where assets are acquired by the young, with these assets sold in retirement BEFORE SYSTEM INTRODUCED: endowment point = E GOVERNMENT SETS UP SYSTEM: you must make contributions put them into assets ==> bond market, makes them into bonds that mature ==> pay those out when people are older IMPACT: contributions REDUCE people's POST-TAX INCOME TODAY
stagflation
a period of slow economic growth and high unemployment (stagnation) while prices rise (inflation) = FAILURE OF PC VIEW
austerity
a set of political-economic policies that aim to reduce government budget deficits through spending cuts, tax increases, or a combination of both
suspension of convertibility
a temporary refusal by banks to convert deposits into cash on demand Announcement that only first 𝜃 fraction of deposit will be paid at date 1
efficiency wage
a wage that is deliberately set above the market rate to increase worker productivity causes unemployment
total government purchases
according to Ricardian equivalence, only thing that matters for consumption is ______
equilibrium search theory
allows for endogenous determination of job vacancies and wages main theory of unemployment in macroeconomics
problems Phillips curve solves
allows to link LR and SR Supply curves reflects that some firms adjust prices behaving as if in the LR some don't (stick) and behave in the SR
currency union
an agreement between a group of countries to share a common currency, and usually to have a single monetary and foreign exchange rate policy political benefit
Kyland prescott barro gordon
application of time inconsistency to game between policymaker and public forming expectations and setting wages/prices:
government problem
assume a BENEVOLENT GOVERNMENT wants to MAXIMISE WELL BEING log(c1) + log(c2) + log(c3) combine budget constraint of consumers and government to get to the overall resource constraint of the economy: c1 + c2 + c3 = W - g
zero profits for the bank
assumption of asymmetric information ____
permanent income
average income, which people expect to persist into the future level of consumption that can be SUSTAINED, and this is what would be chosen by individuals who would like to smooth consumptions
pro rules
avoid temptations DISCRETION n ends up introduction MORE VARIABILITY money and the price system exist to facilitate transactions. always do this BETTER in a STABLE REGIME
Sector T
produces goods that are TRADED IN INTERNATIONAL MARKETS, subject to fierce competition EX: manufacturing
risk of banking sector
bank run is an equilibrium as well, but deposit insurance removes _____
provide liquidity
banks ______ by deposit contract giving insurance against payment needs
x = 0
because of PPP ==> ______ ==> ∆E/E = 𝛑* - 𝛑
welfare is higher
because people do not like uncertainty they prefer to get a little more at date 1 and a little less at date 2 TO THE NO-BANK EQUILIBRIUM ==> ______ with the bank
lifetime wealth
because people want to smooth consumption, the ONLY THING that matters for consumption today is your lifetime wealth
money market funds
big in the 90s you deposit your money, just like a checking account ==> they invest it in up to 90-day loans ==> 'no break the buck' = if any losses, face redemption get back $ guaranteed
sovereign debt
bonds issued by a nation's government in a foreign currency to foreign investors insecure interests spike when there is inc risk of default
c1 < y1
borrowing constraint is NOT BINDING IF: consumer's optimal consumption c1 and current income y1 have the relation : ____ CASE WHERE PEOPLE DO NOT WANT TO BORROW and LIMITING BORROWING HAS NO EFFECT
pass through E
both lifetime budget constraints for savers and borrowers ____
lifetime budget constraint for a borrower
c + c'/(1 + r2) = y + y'/(1 + r2) - [t + t'/(1 + r2)] = we2
lifetime budget constraint
c + c'/R = W where W = lifetime wealth = y - t + (y' - t')/R
The Trilemma
can only have TWO of the following THREE simultaneously: 1. FREE CAPITAL FLOWS 2. INDEPENDENT MONETARY POLICY 3. FIXED NOMINAL EXCHANGE RATES ∆E/E = x + 𝛑* - 𝛑 (∆E/E)^e = i*_t - i_t ==> begs the questions which do you want to live with: 1. exchange rate volatility 2. no use of your monetary policy or 3. capital controls with respect PPP condition if have independent monetary policy ==> not fixed nominal exchange rate EX: United States if fix (∆E/E)^e = 0 ==> no independent monetary policy EX: Hong Kong if set whatever i ==> get whatever 𝛑, can fix nominal exchange rate ==> no free capital flows EX: China
maximise stimulus on inflation
central banks want to LOWER these long-term interest rates in order to _______
PC shifts because of ....
change in expected inflation or supply shocks
no change; no change
change in fiscal policy ==> ==> income _____ ==> interest rates ____
govt purchases multiplier
change in g(1/(1-MPC))
What pins down nominal exchange rates - E ?
change in real exchange rates and inflation levels here and there also impacted by future inflation and exchange rates predictions
Law of motion for unemployment
change in unemployment = inflows - outflows ASSUME: labour force L is constant two adjacent periods t, t+1 U_t+1 - U_t = s(L - U_t) - fU_t s = job separation rate f = job finding rate divide both sides by L and get: u_t+1 - u_t = s(1 - u_t) - fu_t change in u = inflow - outflow
short run effects
changes in Y no changes in 𝛑 HORIZONTAL CASE
automatic stabilizers
changes in fiscal policy that stimulates aggregate demand when the economy goes into a recession without policymakers having to take any deliberate action EX: proportional income tax <=> a smaller 𝜸 ==> IS steeper and shifts by less after shock ==> less multipliers ==> VARs shifts less after shock ==> MP shifts by less ==> Y shifts by less
long run effects
changes in 𝛑 no changes in Y VERTICAL CASE
Monetary policy rule
combining Fisher equation and interest rate rule from LT week 1 r = 𝛈Y + 𝛘𝛑 + ihat - 𝛑^e
off-equilibrium threat
commitment by gov for deposit insurancewill only function as an off-equilibrium threat that the government will not actually have to pay for willing and able to commit
default spread
compensation to investors for possibility bond doesn't pay
real interest rate (r)
consumption demand and investment demand depend on ____
negatively
consumption demands _____ on the interest rate (intertemporal substitution effect) ignoring income effect of interest rate ==> C^d = DOWNWARD SLOPING
lifetime income
consumption depends on _____
non-durables
consumption is less volatile EXs: food, services
types of taxes that affect additional expected future profit
corporate income tax investment tax credits
asymmetric shocks
cost of the trilemma shock to your country and not the others in a currency union ==> your prices need to adjust
