ECON 116 Final

research: expansionary fiscal consolidations

(Alesina and Ardagna) cross-country data on large fiscal consolidations, i.e. surplus improves by at least 1.5% over 4 years *expansionary* adjustments: episodes where the country grows faster than the int'l average successful and expansionary adjustments mostly occur when the improvement in the government budget occurred via a *fall in spending, rather than an increase in taxes* (additional work by Alesina et al repeats analysis with only *exogenous* tax and spending changes, finds similar results)

research: consumption and GDP disasters

(Barro and Ursua) C disaster starts with probability 3.6% per year, conditional on not being in a disaster. --ends with probability 28% per year probability of disaster is higher when there is a stock market crash (22%), but stock market crashes usually accompany C crises, with probability 67%

research: asymmetric information

(Nobel prize for Akerlof, Spence, Stiglitz) *Akerlof*: first to model adverse selection, and how it could lead to the collapse of a market such as the market for used cars. *Spence*: emphasized how the presence of adverse selection would lead agents to undertake costly actions to signal their "type" (e.g. college degree). *Stiglitz*: showed how uninformed buyers can design contracts to screen out the "bad" types of agents with which they do not wish to trade. (e.g. investment banks ask new associates to work inefficiently long hours to screen out those unwilling to work hard)

research: banking crises

(Reinhart and Rogoff) *after a banking crisis, the resulting recession is large and protracted* -- 35.5% fall in house prices -- 56% fall in stock prices -- 7 point increase in unemployment -- 9 point drop in GDP -- 86 point increase in debt-to-GDP ratio Recovery from 2007-2009 recession should have been expected to be sluggish. Regulations that could reduce the frequency of banking crises would be tremendously valuable

research: *growth in a time of debt*

(Reinhart and Rogoff) *growth was significantly lower in countries at times when the debt-to-GDP rate exceeds 90%* (both public debt and negative net foreign asset position matter) -- numerical errors in paper, so 90% threshold is disputed, but general idea seems correct the implication that *austerity can be expansionary if debt is high enough* is *not* consistent with the Keynesian model, in which government spending would stimulate the economy no matter what the business cycle state it which it occurs.

deficit measurement problem: *inflation*

(suppose real debt is constant, which implies a zero real deficit.) in this case, the nominal debt *D* grows at the rate of inflation. thus the reported nominal deficit is ΔD = *πD* even though the real deficit is zero. as such, we should subtract *πD* from the reported deficit to correct for inflation.

examples of time inconsistency

*1.* to encourage investment, gov't announces it will not tax income from capital, but once the factories are built, the gov't reneges in order to raise more tax revenue. *2.* to reduce expected inflation, the central bank announces it will tighten monetary policy, but faced with high unemployment, the central bank may be tempted to cut interest rates. *3.* Aid is given to poor countries contingent on fiscal reforms. The reforms do not occur, but aid is given anyway because the donor countries to not want to poor countries' citizens to starve.

climate change: economic model

*C* + *K* = *Y* *Y* = F(K, L, E, S) -- *K* is capital -- *L* is labor -- *E* is energy inputs -- *S* is a climate variable that affects output ("damage") there is a possibility of technological change (e.g. productivity) people like consuming today more than tomorrow

government debt: *traditional view*

*Consider a tax cut with corresponding increase in the government debt.*

What the financial system does: *Fostering Financial Growth*

*In the Solow model, there is one type of capital; in reality there are many* firms with lucrative investment projects are willing to pay higher interest rates to attract funds than firms with less desirable projects the financial system helps channel fund to projects with the *highest expected returns relative to their risk* government helps facilitate this function by providing quality legal institutions -- *e.g.* prosecuting fraud to reduce moral hazard, -- *e.g.* enforcing disclosure requirements to reduce adverse selection

Wedges

*labor wedge* hinders allocation of labor from agriculture to manufacturing *capital wedge* skews allocation of capital in agriculture vs. industry *savings/investment wedge* tax/subsidy of allocation of capital across time

forecasting the macroeconomy

*leading economic indicators (LEI)*: data series that fluctuate in advance of the economy *macroeconometric models*: large-scale models with estimated parameters that can be used to forecast the response of endogenous variables to shocks and policies. (forecasts are very often wrong, which is a reason why some oppose active policy)

problems with Ricardian equivalence

*myopia* not all consumers think so far ahead; some see the tax cut as a windfall *borrowing constraints* some consumers cannot borrow enough to achieve their optimal consumption, so they spend a tax cut *future generations* if consumers expect that the burden of repaying a tax cut will fall on future generations, then a tax cut now makes them feel better off, so they increase spending.

automatic stabilizers

*policies that stimulate or depress the economy when necessary without any deliberate policy change* designed to reduce the lags associated with stabilization policy. (*e.g.* income tax, unemployment insurance, welfare)

policy by *rule* vs. *discretion*

*policy conducted by rule*: policymakers announce in advance how policy will respond in various situation and commit themselves to following through. *policy conducted by discretion*: as events occur and circumstances change, policymakers use their judgment and apply whatever policies seem appropriate at the time.

*The Lucas Critique*: an example

*prediction based on past experience*: an increase in the money growth rate will reduce unemployment. The Lucas Critique points out that increasing the money growth rate may raise expected inflation, in which case unemployment would not necessarily fall.

policies to prevent crises: *focusing on shadow banks*

*shadow banks* engage in *financial intermediation* and include investment banks, hedge funds, private equity firms, and insurance companies deposits are *not federally insured* and thus not heavily regulated and can take on more risk their failures can hurt the broader economy, so many policymakers suggest limiting the risk they can take, increasing capital requirements for them, allowing more government oversight

debt and politics

*some do not trust policymakers with deficit spending, arguing that*: -- policymakers do not worry about the true costs of their spending, since the burden falls on future taxpayers. -- since future taxpayers cannot participate in the decision process, their interests may not be taken into account. *this is another reason for the proposals for a balanced budget amendment*

deficit measurement problem: *uncounted liabilities*

*the current measure of deficit omits important liabilities of the government:* -- future pension payments owed to current government employees -- future Social Security payments -- contingent liabilities (e.g. covering federally insured deposits when banks fail) *it is hard to attach a dollar value to contingent liabilities due to uncertainty*

open economy: *trade surpluses and deficits*

*trade surplus* output > spending exports > imports size of trade surplus = *NX* *trade deficit* spending > output imports > output size of trade deficit = *-NX*

Model of China's economy

*two sectors* agriculture and non-agriculture *production functions* capital, labor, total-factor productivity (TFP, i.e. the *A* in the Cobb-Douglas production function) *capital and labor is allocated across two sectors* but distortions may hinder allocations

open economy: *real exchange rate*

*ε* = real exchange rate, the relative price of domestic goods in terms of foreign goods (*e.g.* Japanese Big Macs per US Big Mac)

solution to time inconsistency: *central bank independence*

a policy rule announced by the central bank will work only if the announcement is credible. (credibility depends in part on the degree of independence of the central bank) *central bank independence is key to low inflation*

quality of healthcare in the US

breast cancer survival rate is highest in the US quicker access to specialists and elective surgery but lower life expectancy compared to other OECD countries rates of mortality amenable to healthcare are very high in the US premiums in the US have far outpaced inflation in their growth

policy responses to a crisis: *conventional monetary policy*

central bank can *expand the money supply* to lower interest rates and encourage spending (*in 2008*: Fed reduced federal funds rate to nearly zero, but this was insufficient)

deficit measurement problem: *capital assets*

currently, *deficit = change in debt* it is better to use *capital budgeting*: deficit = (change in debt) - (change in assets) *e.g.* suppose the gov't sells an office building and uses the proceeds to pay down the debt -- under the current system, deficit would fall. -- under capital budgeting, the deficit is unchanged because the fall in debt is offset by a fall in assets. *the problem with capital budgeting is determining which gov't expenditures count as capital expenditures*

open economy: *demand for loanable funds*

demand = investment

research: subprime mortgages

during the pre-2008 crisis, subprime mortgages became easier to securitize (i.e. to trade rather than keep on the books) an important ingredient in making a mortgage tradeable was for the borrower's credit score (FICO score) to exceed a threshold of 620 mortgage loans for which the FICO was just above 620 were *more* likely to default than those just below (borrowers were screened less well when the loan could be sold on)

climate change: production of energy services

each type of *E* is produced with its own technology -- that uses capital, labor, and energy itself some energy sources are in finite supply (e.g. oil) -- have to add decumulation equation for this two types of energy: -- *dirty*: emit pollution -- *clean*: do not emit

climate change: natural science

effects of climate change can reasonably well by approximated by one variable: *carbon dioxide in the atmosphere* all damages here are on the production -- but easy to reinterpret as damages to well-being, consumption, capital, etc.

common features of financial crises: *insolvencies at financial institutions*

falling asset prices cause defaults on bank loans since banks are highly leveraged, defaults greatly reduce their capital, increasing the risk of insolvencies (*e.g.* in 2008, many banks held mortgages and assets backed by mortgages. Falling house prices sharply increased mortgage defaults, pushing many financial institutions toward bankruptcy)

common features of financial crises: *asset-price booms and busts*

financial crises often follow a period of optimism and a *speculative asset-price bubble* when the optimism turns to pessimism, the bubble "bursts", causing asset prices to plummet. (*e.g.* in the 2008 crisis, the crucial asset was housing)

The Lucas Critique

forecasting the effects of policy changes has often been done using models estimated with historical data. Lucas pointed out that such predictions would not be valid if the *policy change alters expectations in a way that changes the fundamental relationships between variables.*

common features of financial crises: *credit crunch*

frequent defaults and insolvencies make it hard for investors to get loans, even those with good credit and lucrative projects (*e.g.* in 2008, banks sharply reduced lending to consumers for buying homes and to businesses for expanding operations or buying inventories)

fiscal effects on monetary policy

government deficits may be financed by printing money- thus a *high government debt may be an incentive for policymakers to create inflation*, reducing the real value of debt at the expense of bond holders. *fortunately*: -- little evidence that link between fiscal and monetary policy is important. -- most governments know the folly of creating inflation -- most central banks have some political independence from fiscal policymakers

climate change: technological progress

green technology reduces social costs *should we have special incentives for clean energy?* -- No, if carbon tax is set optimally -- Yes, in the absence of the carbon tax, but evaluate the cost/benefit

healthcare: summary

healthcare costs are hte largest fiscal challenge facing the US we spend more than any other nation without evidence of better care this is inefficient- better public and private uses of these money healthcare costs are what is driving debts and deficit out spending is primarily driven by the advent of new, marginally efficacious technology.

climate change: tradeoff

how much to produce? -- use economic inputs (capital/labor) -- and energy (but some is "dirty") -- *energy is good for output* *externality* -- past, current, and future use of "dirty" energy damages the economy

common features of financial crises: *falling confidence*

insolvencies at some banks reduce confidence in other,s and individuals with uninsured deposits withdraw their funds to replace their shrinking reserves, banks must sell assets. Selling by many banks causes steep price declines, called a *fire sale* (*e.g.* in 2008 the collapse of Bear Stearns and Lehman Brothers reduced confidence in other large institutions, many of which were interdependent)

policies to prevent crises: *restricting size*

institutions deemed "too big to fail" have a *moral hazard* problem some proposals would limit the size of financial institutions to reduce the harm their failures would cause to the rest of the financial system proposals include *limiting mergers* and *increasing capital requirements for larger banks*

open economy: *determining NX graphically*

interest rate does *not* adjust to equilibrate savings and investment, as it would in a closed economy.

What the financial system does: *Sharing Risk*

many people are *risk averse* and dislike uncertainty. the financial system allows people to share risks: -- investors can share the risk that their projects will fail with the savers who provide the funds. -- savers may be willing to accept these risks for the prospect of a higher return than they could earn otherwise. -- savers can reduce risk through *diversification*: providing funds to many different investors with uncorrelated assets. diversification can reduce *idiosyncratic risks* (risks that differ across individual businesses) but not *systematic risks*, which affect most/all businesses.

policies to prevent crises: *making regulation work better*

the regulatory apparatus overseeing the financial system is *highly fragmented* Dodd-Frank and other measures seek to coordinate the various regulatory agencies and improve the effectiveness of financial industry oversight

open economy: *how ε is determined*

this graph shows the *supply and demand in the foreign exchange market.* *demand*: foreigners need dollars to buy US net exports *supply*: net capital outflow (*S* - *I*) is the supply of dollars to be invested abroad

policies to prevent crises: *taking a macro view of regulation*

traditionally, financial regulation has been *microprudential*, aiming to reduce the risk of distress in individual financial institutions today, financial regulation is also *macroprudential*, aiming to reduce system-wide distress to protect against declines in production and employment

research: China

what accounted for China's rapid growth since 1953? -- unique model of state capitalism? -- govt interventions? -- very high savings? -- trade? -- effect of the low start? -- foreign direct investment (FDI)? Chinese economy grew rapidly both before and after market-oriented reforms in 1978 -- before 1978, TFP grew slowly, but reductions in wedges delivered rapid growth -- after 1978, TFP grew much faster in the manufacturing sector, also reduction in labor mobility barriers between agriculture and non-agriculture

common features of financial crises: *recession*

with less credit available, consumer and business spending declines, reducing aggregate demand. *result*: output falls, unemployment rise

research: *time inconsistency*

*Kydland and Prescott* -- especially important in fighting inflation -- if agents in the economy anticipate time inconsistency, economy could end up with high inflation but output growth no higher than usual (lose-lose!) -- Barro and Gordon propose a *conservative central banker* who dislikes inflation and so will not be tempted to generate surprise inflation -- second solution: central banks given *independent oversight* of monetary policy, so they can establish credibility -- third solution: policymakers impose a *rule for inflation targeting* -- Zandeweghe and Wolman: time-inconsistency raise inflation by several percentage points in the US -- effect of independent central bank on decreasing inflation is larger in countries with weaker institutions -- time inconsistency issues also arise with deciding whether or not to tax capital

when regulations are needed according to economic theory

*Monopoly* to constrain the use of monopoly power and the prevention of serious distortions to competition and the maintenance of market integrity (*solutions*: antitrust laws and tougher regulations for systemic banks) *Costly info/small consumer* to protect the essential needs of ordinary people in cases where information is hard or costly to obtain, and mistakes could devastate welfare (*solutions*: FDIC deposit insurance, although this then creates a potential moral hazard problem with banks making riskier choices) *Externalities* where there are sufficient externalities that the social, and overall, costs of market failure exceed both the private costs of failure and the extra costs of regulation. informational contagion (due to trade interconnectedness) and informational asymmetry mean that when one bank fails, others are negatively impacted (inter-holdings of assets is high)

government debt: *Ricardian view*

*Ricardian Equivalence*: a debt-financed tax cut has *no effect* on consumption, national saving, the real interest rate, investment, net exports, or real GDP, *even in the short run*. *HOW?* consumers are forward-looking, and thus know that a debt-financed tax cut today implies an increase in future taxes that is equal (in present value) to the tax cut. the tax cut does not make consumers better off, so they do not increase consumption spending; instead they *save the full tax cut in order to repay the future tax liability*. *result*: private saving rises by the amount public saving falls, leaving national saving unchanged.

healthcare spending: global trends

*US spends more than any other country at 17.8% of GDP* -- healthcare spending is very correlated with wealth (i.e. GDP per capita) -- but the US spends $700 billion more per year than can be explained by our wealth

open economy: *national income identity*

*Y* = *C* + *I* + *G* + *NX*

What the financial system does: *Dealing with Asymmetric Information*

*asymmetric information* occurs when one party to a transaction has more information about it than the other party *adverse selection* when people with hidden knowledge about attributes sort themselves in a way that disadvantages people with less information. (*e.g.* investors who know that their projects are less likely to succeed are more eager to finance the projects with other people's funds) *moral hazard* arise from hidden knowledge about actions, occurs when imperfectly monitored agents act in dishonest or inappropriate ways (*e.g.* entrepreneurs investing other people's money are not as careful as if they were investing their own funds) *Banks help mitigate the effects of asymmetric information* -- address *adverse selection* by screening borrowers for adverse hidden attributes that savers might not detect -- address *moral hazard* by restricting how loan proceeds are spent or by monitoring the borrowers

climate change: role of policy

*correct the externality* -- markets do not value the extra cost of climate change -- increase the cost of using energy to *make the private cost equal the social cost*. *one policy: carbon tax* -- per unit tax on energy inputs -- in competitive markets, firms will still maximize profit but now it "costs more" to take into account the social cost -- theoretically equivalent to cap and trade, restrictions, etc.

research: *predicting crises*

*crises are difficult to predict* -- all "early warning systems" failed -- some performed very well in sample but poorly out-of-sample -- crises may be intrinsically difficult to predict because they arise out of a coordination game with multiple equilibria (e.g. I want to run on the bank if I think everyone else does too, but not if I believe that they also do not)

climate change: externality formula

*damages as a proportion of GDP depend on*: -- future expected path of damages -- how you discount the future (more discount = lower externality) -- carbon cycle (longer CO2 stays in atmosphere = higher externality)

arguments for policy by rule

*distrust of policymakers and the political process* -- misinformed politicians -- politicians' interests sometimes not the same as the interests of society *time inconsistency of discretionary policy* -- a scenario in which policymakers have an incentive to renege on a previously announced policy once others have acted on that announcement. -- destroys policymakers' credibility, thereby reducing effectiveness of their policies

open economy: *nominal exchange rate*

*e* = the relative price of domestic currency in terms of foreign currency (*e.g.* yen per dollar)

solution to time inconsistency: *rules*

*e.g.* inflation targeting

open economy: *how NX depends on ε*

*if ε rises*: -- US goods become more expensive relative to foreign goods -- exports fall, imports rise -- *net exports fall*

arguments against active policy

*inside lag*: the time between the shock and the policy response (it takes time to recognize the shock and to implement policy, especially fiscal policy) *outside lag*: the time it takes for policy to affect economy *if conditions change before a policy's impact is felt, the policy may destabilize the economy*

why is healthcare spending so high?

*it is not because of*: -- more hospitalizations (we have fewer) -- more doctors visits (we have fewer) -- length of stay (we have shorter visits) -- more doctors (we have fewer) -- smoking and disease (we smoke less and have less diseases) *healthcare spending is so high because*: -- higher intensity (more done per visit) -- administrative costs are higher -- prices are substantially higher (high physician salaries) *healthcare dollars are not being spent efficiently; this means that we make tradeoffs in education, policing, etc.* *advances in technology are driving up healthcare costs but minimally improving care*

What the financial system does: *overview*

1. Financing Investment 2. Sharing risk 3. Dealing with asymmetric information 4. Fostering financial growth

common features of financial crises: *overview*

1. asset-price booms and busts 2. insolvencies at financial institutions 3. falling confidence 4. credit crunch 5. recession 6. vicious circle

policy responses to a crisis: *overview*

1. conventional monetary policy 2. conventional fiscal policy 3. lender of last resort 4. injections of government funds

open economy: *assumptions about capital flows*

1. domestic and foreign bonds are *perfect substitutes* (same risk, maturity, etc.) 2. *perfect capital mobility*: no restrictions on international trade in assets 3. economy is *small*: cannot affect the world interest rate, denoted *r** #1 and #2 imply r = r*. #3 implies r* is exogenous

policies to prevent crises: *overview*

1. focusing on shadow banks 2. restricting size 3. reducing excessive risk taking 4. making regulation work better 5. taking a macro view of regulation

problems measuring the deficit

1. inflation 2. capital assets 3. uncounted liabilities 4. the business cycle

open economy: *net capital outflow*

= *S* - *I* = net outflow of *loanable funds* = net purchases of foreign assets (domestic purchases of foreign assets minus foreign purchases of domestic assets) when *S > I*, country is a *net lender* when *S < I*, country is a *net borrower*

research: burgernomics

Big Mac price can be used as a basket of goods to indicate price level in each country can also be used to calculate PPP adjustments for comparing real wages across countries

policies to prevent crises: *reducing excessive risk taking*

Dodd-Frank Act of 2010 includes the *Volcker Rule*, which prohibits commercial banks from making certain types of speculative investments

research: climate change

optimal carbon taxes should depend on: -- how fast CO2 emissions get absorbed into the oceans and biosphere -- how much we care about future generations -- how catastrophic climate change will be if we are *uncertain* about the effects of climate change and discount the future at *1.5% per year (like markets), the optimal carbon tax is around $80 per ton

arguments for active policy

recessions cause economic hardship for millions of people AD-AS model shows how fiscal and monetary policy can respond to shocks and stabilize the economy

policy responses to a crisis: *lender of last resort*

runs on banks can create a *liquidity crisis* in which solvent banks have insufficient funds to satisfy depositors' withdrawals the central bank can make direct loans to these banks, acting as a *lender of last resort* (*in 2008*: the Fed acted as a lender of last resort to many banks and *shadow banks*)

balanced budgets vs. optimal fiscal policy

some politicians have proposed amending the Constitution to require a balanced federal gov't budget many economists reject this proposal, arguing that deficit should be used to: -- stabilize output and employment -- smooth taxes in the face of fluctuating outcome -- redistribute income across generations when appropriate

open economy: *supply of loanable funds*

supply = national saving

deficit measurement problem: *business cycle*

the deficit varies over the business cycle due to automatic stabilizers (e.g. unemployment insurance, income tax) these are not measurement errors, but they do make it *harder to isolate the effects of fiscal policy* (e.g. is an observed increase in deficit due to a downturn or an expansionary shift in fiscal policy?) *solution: cyclically-adjusted budget deficit* based on estimates of what gov't spending and revenues would be if economy were at the natural rates of output and unemployment.

purchasing power parity (PPP)

the doctrine that states that goods must sell at the same (currency-adjusted) price in all countries the nominal exchange rate adjusts to equalize the cost of a basket of goods across countries *Why PPP doesn't hold in the real world* -- international arbitrage not possible due to nontraded goods and traded costs -- different countries' goods not perfect substitutes

What the financial system does: *Financing Investment*

the financial system helps channel funds from *savers* (i.e. households with income they do not need to spend immediately) to *investors* (i.e. firms that need funds to finance investment projects) *financial markets* households *directly* provide funds for investment (*e.g.* stock market) *financial intermediaries* households *indirectly* provide funds for investment (*e.g.* banks, mutual funds) *debt finance* selling bonds to raise funds for investment (a *bond* represents a loan from the bondholder to the firm) *equity finance* selling stock to raise funds for investment (a share of *stock* represents an ownership claim by the shareholder in the firm)

policy responses to a crisis: *conventional fiscal policy*

the government can *increase spending* and *cut taxes* (*in 2008*: fiscal policymakers enacted huge stimulus, but the large and growing government debt limited further stimulus measures)

policy responses to a crisis: *injections of government funds*

the government can use public funds to prop up the financial system -- give funds to those who have experienced losses (e.g. FDIC) -- make risky loans -- inject capital into ailing institutions, taking an ownership stake *Using public funds to prop up ailing institutions is controversial and may increase moral hazard*

common features of financial crises: *vicious circle*

the recession reduces profits, asset values, and household incomes, which increases defaults, bankruptcies, and stress on financial institutions.