Macroeconomics Midterm 2
What happens to the slop of the IS curve if you change b bar?
*beware of swapped axes* If b bar increases, the IS curve becomes flatter and a given change in the interest rate would be associated with an even larger change in output since investment is more sensitive to interest rates
What factors contributed to the Great Inflation of the 1970s?
- oil price shocks which occurred as OPEC coordinated to raise oil prices -the Fed made mistakes in running a monetary policy that was too loose -Fed didn't have perfect info about the state of the economy and didn't know that there was a prolonged productivity slowdown occurring so they thought the economy was going into a recession. They didn't know that there was a change in potential output rather than something monetary policy could overcome
What is the mission of the Federal Reserve?
-preserve price stability -foster maximum sustainable growth in output and employment -promote a stable and efficient financial system
What is the default value of a bar?
0, however shocks to the economy can push a bar away from 0 in the short run
In what two ways do government purchases affect short-run economic activity?
1. As a shock that can function as a source of fluctuation 2. As a policy instrument that can be used to reduce fluctuations
What are some of the general principles of financial reform after the Great Recession?
1. Reduce possibility of moral hazard: financial instructions were highly leveraged so earned huge returns on investments that paid off but didn't suffer full consequences when they failed since they were deemed too big to fail 2. Gain greater understanding of volatile prices (housing, stocks, bubbles) 3. Possible monetary rule or systemic regulator
What are the three conventional tools for exercising monetary policy?
1. Reserve requirements that require banks to hold a certain fraction of their deposits in special accounts with the central bank itself 2. The federal funds rate 3. Discount rate which is the interest rate charged by the Fed itself if a bank finds itself short of reserves and unable to borrow sufficient amounts in financial markets
How do you avoid a deflationary spiral?
1. Stimulate economy with monetary policy to extent its possible 2. When zero lower bound becomes problem, use unconventional monetary policy like printing money and buying financial securities in order to lower interest rates in those other markets 3. Manage inflation expectations by maintaining strong reputation for keeping inflation stable and close to target level
What are the three building blocks of the IS curve?
1. The IS curve: short run output spends on the real interest rate 2. The MP curve: the central bank sets the real interest rate 3. Phillips curve: inflation rises if the economy is booming and falls if economy is slumping
What three premises is the short-run model based on?
1. The economy is constantly being hit by economic shocks 2. Monetary and fiscal policy affect output 3. There is a dynamic trade off between output and inflation
What are the two main determinants of investment at the firm level?
1. The gap between the real interest rate and the MPK 2. The firms cash flow which is the amount of internal resources the company has on hand after paying its expenses (if firm has high cash flow they find it easy to finance additional investments, while a firm with low cash flow may be forced to borrow in financial markets)
In any given year what two components make up output?
1. The long run component (Y bar) associated with potential output which is given by the combined Romer-Solow model 2. The short run component (Y tilde) associated with economic fluctuations
What are three of the major outcomes of the financial crisis?
1. Total nonfarm employment fell by nearly 8.5 million jobs 2. Short run output fell below potential output by as much as 7% 3. Unemployment increased from 4.5% to 10% in 2009
On average, what is the slope of the Phillips curve?
1/4 so when output exceeds potential by 4%, inflation rate rises by 1%
How long does it take for monetary policy changes to interest rates to have substantial effects?
6 to 18 months
What does a change in a bar mean for the IS curve?
A change in a bar (an aggregate demand shock) changes the amount of investment associated with any given level of the interest rate which means the IS curve will shift
What did the Fed do during the housing bubble and financial crisis?
A collapse in housing prices lead to a decline in household wealth and a fall in consumption which lead to a recession. Recognizing this, the Fed lowered the interest rate to stimulate the economy and push output back to potential However, the collapse in housing prices also lead to a financial crisis that caused a financial friction when borrowing costs to firms rose sharply which caused the real interest rate to increase despite the Feds actions In this case, the economy moved to negative output and higher interest rates
What is a short term debt instrument?
A financial asset on which interest is paid
How does an increase in the real interest rate show up in the IS curve?
A movement along the curve
What does b bar represent in the IS curve?
A parameter that tells us how sensitive investment is to changes in the interest rate. A high value means that small differences between the interest rate and the MPK lead to big changes in investment *changes slope of IS curve*
What are automatic stabilizers?
A policy stimulus that engages automatically when the economy goes into a recession, helping to mitigate the downturn Ex) unemployment insurance and welfare programs
What does the o parameter in the Phillips curve equation represent?
A shock to inflation like oil price shocks or any price shock of an input of production *creates temporary upward shift*
What is a bank run?
A situation in which depositors or creditors worry about a banks solvency and its ability to repay its deposits or short term debt so they withdraw funds simultaneously. To the extent that the bank has illiquid assets, a worry about a bank run could be self-fulfilling Because of this, in 1933 the FDIC set up government insurance for deposits to largely eliminate bank runs
What is a liquidity crisis and explain how it ties into the financial crisis
A situation in which the volume of transactions in some financial markets falls sharply making it difficult to value certain financial assets and thereby raising questions about the overall value of the firms holding those assets 1. During the financial crisis banks sharply increased the interest rates they charged one another because they worried that other banks were backed by a large number of bad mortgages. 2. This caused a flight to safety as banks placed funds in US Treasury bills. 3. As a result the spread between US Treasury bills and interbank lending rose. The amount of lending dropped producing the liquidity crisis.
What is disinflation?
A sustained reduction in inflation to a stable, lower rate
Explain the no-free-lunch principle
A tenet which says that nothing of value comes for free and everything must be paid for Ex) when government spends more money today it must pay it off in the future with additional taxes or reduction in future spending
What is equity?
AKA net worth or capital The difference between total assets and total liabilities and represents the value of the institution to its shareholders or owners which is why it's reported on the liability side
When should you use the AS/AD framework and when should you use the IS/MP-Phillips curve?
AS/AD assumes a well designed monetary policy rule is being implemented so when his is the case it is preferable since the dynamics of the economy can be tracked in a single graph In situations where such a policy rule is not operating such as if there's deflation or if the central bank is not following monetary policy, the IS/MP- Phillips curve is better
Differentiate between adaptive and rational inflation expectations
Adaptive: expected inflation is a function of actual past values of inflation Rational: expected inflation is a function of what firms and consumers expect inflation to be in light of current developments
How did oil prices contribute to the financial crisis?
After decades of relative stability, oil prices rose to never before seen levels in mid 2008 then declined even more sharply ($20 per barrel in 2002 to $140 in summer 2008 to $40 in end of 2008)
What is a time consistency problem?
After firms and workers have formed their expectations about inflation and built these expectations into their contracts and pricing strategies central bankers have an incentive to pursue an expansionary monetary policy so that the economy will boom. Firms and workers however will anticipate this so they'll build it into their prices which will result in higher inflation. Policy makers can overcome these problems by committing themselves to the right policy and maintain credibility and a reputation do making the right long run choices
What essentially does the multiplier on the IS curve do?
Allows for a shock to one part of the economy to be multiplied by affecting other parts of the economy. *IS curve can involve feedback that leads to vicious or virtuous circles
What is a balance sheet?
An accounting representation of an institution's assets and liabilities that is generally organized into two halves that equal each other
What are financial frictions?
An extra amount of money paid by a borrow in credit markets above and beyond what a lender would require to make a loan in normal times. During a financial crisis, such frictions appear to be large and significant and are reflected in risk premiums They lead to liquidity shortages and insolvencies
Why is the IS curve downward sloping?
An increase in the real interest rate raises the cost of borrowing for businesses and households so firms and consumers respond by reducing their investment and this reduction in investment leads firms to produce less which lowers the level of output in the short run
Define what it means for a bank or person to be insolvent?
Another term for bankrupt When assets owned by the bank are no longer large enough to cover the liabilities the bank owns
How can you view actual output in an economy?
As the sum of the long-run trend and short-run fluctuations
Define assets and liabilities
Assets: items of value that the institution owns such as loans, investments, cash and reserves Liabilities: items of value that the institution owes to others such as deposits and short or long term debt
What does it mean for something to be calculated as an annualized rate?
Assume the rate of change would apply if the growth persisted for an entire year i.e. If GDP increased by 1% over a single quarter, we'd say it grew at the annualized rate of 4%
How are balance sheets different from income/expense statements?
Balance sheets are records of stock variables measured at a point in time as opposed to income/expense statements which are records of low variables measured through time
What is the aggregate supply curve?
Based on the Phillips curve and consists of a positive relationship between inflation and short run output Slopes upward because producing output in excess of potential places additional pressure on firms and required economy wide increases in production costs for all economic activity
Explain what systemic risk is
Because financial firms are interlinked through a complex web of loans, insurance contracts, and securities, problems in a few financial institutions can create problems in many others
Why do we refer to Y tilde as determined output?
Because we remove the long run trend associated with economic growth (potential output), what remains are the ups and downs of economic fluctuations
Explain what role leverage had in the financial crisis
Before the financial crisis major investment banks had very high leverage ratios. They also owned complex investment portfolios that included significant quantities of soon-to-be toxic assets. Given this high leverage, banks were soon in a precarious position in which a relatively small aggregate shock could send me into insolvency
Who determines if the economy is in a recession?
Business Cycle Dating Committee of the National Bureau of Economic Research
How does the central bank control the level of the nominal interest rate?
By supplying whatever money is demanded at that rate. Money markets clears through a change in the velocity of money driven by the change in the nominal interest rate which represents the opportunity cost of holding money. If nominal interest rate is higher you put more into your savings account and hold less as currency
What is the global saving glut and how was it created?
Capital markets in advanced countries had an excess of savings and were in search of good investment opportunities which contributed to the rising prices in asset markets in the US Financial crises in the 1990s prompted a number of developing countries increased their saving substantially and curtailed their foreign borrowing, switching from being borrowers to lenders to the rest of the world (especially to the US)
What causes the AS curve to shift?
Changes in expected inflation or inflation shocks
What happens with changes in variables for the AD curve?
Changes in inflation represent movements along AD curve Changes in m bar alter slope (higher m means flatter curve) Changes in a bar and hanged in target rate of inflation cause AD to shift
What are examples economic shocks and what do these shocks do ?
Changes in pick prices, disruptions in financial markets, development of new technologies, changes in military spending, natural disasters Push actual output away from potential output and move inflation away from its long run value
Why would you use securitization in the first place and what went wrong during the financial crisis?
Combining large numbers of assets can diversify the risk associated with any individual asset. However, in the case of the subprime crisis the underlying mortgages proved to be significantly riskier than most investors realized. Since securitization doesn't insulate investors from aggregate risk, when housing prices fell nationwide, large numbers of subprime mortgages went under at the same time
What does the life-cycle model of consumption conclude?
Consumption is based on average lifetime income rather than on income at any given age Ex) when you're young and in college your consumption is higher than your income, as you age your consumption rises more slowly and your you save more as your income rises, then when you retire your income falls but your consumption is stable
What are cost push versus demand pull inflations?
Cost push inflation is caused by the cost increase in the price of an input to production and occurs in o bar Demand pull inflation is caused by an increase in aggregate demand in the economy and occurs in the vYt term of the Phillips curve
What are the two main types of bonds?
Coupon and discount Coupon bond pays the owner of the bond a fixed interest payment each year until the bond matures when the face value of the bond is paid. A coupon is the stated annual interest rate as a percentage of the price at issuance and never changes once the bond is issued A discount bond has no coupon and the return to holding such a bond comes entirely from buying it at a price below its face value
Explain what happens in a deflationary spiral
Deflation may results from a recession that makes inflation negative through the standard short run dynamics. But the deflation then raises the real interest rate which deepens the recession which causes inflation to become even more negative which raises the interest rate even more, making the recession even worse
Describe the money demand and supply curves
Demand for money is decreasing because when interest rates are high we would rather keep our funds in high earning account than carry them around Money supply is vertical because it is set by the Fed
How did the Feds balance sheet change during the Great Recession?
Dramatically resulted 1. More than doubled 2. Composition of assets and liabilities changed: On asset side, Fed expanded its lending through loans and purchases or commercial paper On liability side, Fed began paying interest on excess reserves to control the extent to which its actions translated into additional securities
Why do people prefer a smooth path for consumption?
Due to diminishing marginal utility
Why wouldn't the government use monetary policy to keep actual GDP as high as possible?
Due to the trade off between output and inflation (Phillips Curve). A booming economy today leads to an increase in the inflation rate
What inflation-output loops?
Economy follows counterclockwise looks in a plot with inflation rate on the vertical axis and output on the horizontal axis Intuition: when the economy booms inflation increases and when the inflation rate is high the central bank slows economy, output declines, and inflation falls
Describe the financial friction that occurred during the Great Recession
Even thought the Fed cut the Fed funds rate all the way to zero in an effort to stimulate the economy, the rate at which firms and households borrow to finance investment was rising instead of falling. Interest rates moved in the wrong direction, deepening instead of mitigating the downturn
What are some examples of leading economic indicators?
Fed funds rate, term structure of interest rates, new claims for unemployment insurance, and number of new houses being built
How does an increase in financial friction affect the AS/AD framework?
Financial friction functions like a negative aggregate demand shift and shifts AD curve down to the left
What's a reserve requirement?
Financial regulation that mandates banks keeps a certain percentage of their deposits in a special account with the central bank
What's a capital requirement?
Financial regulation that mandates that the capital (net worth/equity) of the bank be at least a certain fraction of the banks toral assets
What are adaptive expectations of inflation?
Firms expect the rate of inflation in the coming year to equal the rate of inflation that prevailed during the past year. Under this assumption firms adjust their forecasts of inflation slowly
Describe what happens in the AS/AD framework if a price shock raises inflation?
First the shock raises inflation directly. Even though the shock only lasts for a single period, inflation remains high for an extended period because of sticky inflation. The shock raises expected inflation and it takes a prolonged slump in economy to get expectation back to normal so economy suffers stagflation
What are monetary policy rules?
Formal definitions of the central banks reaction to various states of the economy serving to reduce the uncertainty surrounding the central banks responses which aids in achieving economic stability
What is the aggregate demand curve?
Formed from the IS and MP curves Inverse relationship between inflation and short run output on the basis of the inflation rate Downward sloping because at higher inflation rates the central bank increases real interest rates in order to decrease interest sensitive spending thus reducing ouput
Describe the yield curve
Graph of the term structure of interest rates. Shorter term yields are close to zero while bonds with higher maturities have higher yields
What are the axes of the graph of the IS curve and why are they where they are?
Horizontal axis is short run output Y tilde Vertical axis is real interest rate Rt The graph puts the endogenous value on the horizontal output because Rt becomes endogenous in later graphs and there's a long standing tradition in econ to put price on vertical and quantity on horizontal
What shocks to the macroeconomy caused the global financial crisis?
Housing prices, rise in interest rate spreads, decline in the stock market, and movement in oil prices
How does an inflation target help the Fed manage inflation expectations?
If they adopt an explicit target rate of inflation it anchors inflation expectations so when firms are deciding how to set prices the target rate may serve as a focal point and allow firms to coordinate efforts in keeping inflation low and reducing the need for large declines in output
How does negative inflation affect the real interest rate?
If you solve for Rt in the Fisher equation you see that when inflation is negative it raises the real interest rate. When there's deflation, the price level is falling so when it comes time to repay a $100 loan you will be paying it back with dollars that are worth more than when you borrowed them. This rise in the interest rates decreases investment and push output below potential
What is the intuition behind the Phillips curve?
In a booming economy, with output above potential, firms raise prices to cover the higher costs of production as they attempt to meet the higher demand or to take advantage of the high demand to make more profits. As all firms raise prices, inflation rate goes up. Alternatively when output is below potential and the economy is slumping, firms see little demand for their product and lay off workers. They are also restrained in raising prices so when all firms behave this way, inflation falls
Explain what happened with housing prices in the financial crisis
In the decade leading up to 2006, housing prices grew by a factor of 3 due to low interest rates and loose lending standards before collapsing by more than 40% over the next several years.
What is constrained discretion?
In the short run the central bank has flexibility to respond to shocks to the economy in order to ensure stability of output and inflation. Over the long term however it maintains a commitment to a particular rate of inflation
Who does an inflation shock harm?
Increase in inflation harms those on fixed income or who are holding nominal assets Reduced short run output harms those in sales/production
What is core inflation?
Inflation excluding food and energy (which is generally more stable since both of those quantities have volatile prices)
What's the relationship between the interest rate and the price of bonds?
Inverse. As price of the bond decreases, the yield/interest rate increases
Why does the classical dichotomy not hold in the short run?
It would be too costly to change all nominal wages, rental prices and other prices in the economy in the same proportion immediately. Firms have imperfect information and are hit by a range of shocks of their own so monetary policy isn't as important to them and computation is costly. Also many contracts are set in nominal rather than real terms and there are bargaining costs, social norms, and the money illusion which prevent the classical dichotomy from holding
What does the Lucas critique say?
It's inappropriate to build a macroeconomic model based on equations in which expectations are not consistent with the statistical properties of the underlying economy
Why is leverage important?
Leverage magnified any changes in the value of assets and liabilities in terms of the return to shareholders So if an investor is highly leveraged it may it may make large gains or large losses based on small changes in prices
What is the m parameter in the monetary policy rule?
M bar governs how aggressively monetary policy responds to inflation. A high m bar means policy makers are "hawkish" and will aggressively change interest rates if inflation changes
What is the v parameter in the Phillips curve equation?
Measures how sensitive inflation is to demand conditions. If v bar is high then price-setting behavior is very sensitive to the state of the economy. Alternatively if v bar is low then it takes a large recession to reduce the rate of inflation by a percentage point
By how much did the S&P stock price index fall during the Great Recession?
More than 50%
What are the resulting pieces of securitization know as?
Mortgage-backed securities, asset-backed commercial paper, and collateralized debt obligations (CDOs)
What was different in terms of consumption during the Great Recession compared to the average recession in the past fifty years?
On average, recessions were characterized by a relatively stable level of consumption due to smoothing, but the Great Recession was so severe that consumption fell by 3.4%.
What's the relationship between changes in a bar and changes in short run output?
One for one
What is the main way the Fed affects the money supply?
Open market operations in which the central bank trades interest-bearing government bonds in exchange for currency reserves. To reduce the money supply the Fed sells bonds and to expand money supply it will buy bonds
On average how does a recession affect US GDP and include per person and per family
Output falls below potential for sour 2 years adding up to about 6% of foregone GDP. This works out to be about $3000 per person or $12000 per family of four
What does the permanent-income hypothesis conclude?
People will base their consumption on an average of their income rather than on their current income Ex) when you take a vacation or your income falls sharply your consumption generally remains steady
What does the Phillips curve state?
Positive short run output causes inflation to increase because of increased resource demand. Likewise negative short run output leads to decreases in inflation for similar but opposite directions
When is Y tilde negative or positive?
Positive when economy is booming and actual output is above potential Negative when economy is in recession and actual output is less than potential output
In the IS curve, consumption, government purchases, exports, and imports each depend on what?
Potential output Yt bar, which is given exogenously because it had been determined by our long run model
What two variables does the short run model take as exogenous?
Potential output and long run inflation so both of these variables have over bars
What is quantitative easing?
Programs in which the central bank purchases assets other than short term government bonds such as mortgage-backed securities or long-term treasury bonds in an attempt to directly reduce the interest rates in these and other markets
What is a liquidity trap?
Refers to the inability of monetary policy to lower nominal interest rate below zero. Because the real interest rate is high during times of deflation, firms and households don't wish to borrow so the liquidity provided by the monetary policy gets "trapped" inside banks and can't stimulate the economy
Differentiate between Rt and r bar
Rt is the real interest rate which the rate at which firms can save or borrow r bar is the marginal product of capital which is the amount of additional output the firm can produce by investing in one more unit of capital *this is taken as endogenous in the short run model since its constant along a balanced growth path*
What are aggregate demand shocks?
Shocks to the economy that directly influence the short run amount of consumption, investment, government purchase, or net exports. *captured in the a bar parameter* They affect the amount of "demand" in the economy
What do shocks to potential output mean for the IS curve?
Since potential output doesn't enter our IS equation, short run output is unaffected by a change in potential output and the IS curve is left unchanged. This is because shocks to potential output change actual output by the same amount. However a new technology or earthquake for example may change Y bar but also change r bar
Which IS curve is flatter between the original and the multiplier?
Since the multiplier curve makes short run output more sensitive to changes in the other variables it is flatter than the original IS curve *because of the swapped axes!!*
What is stagflation?
Stagnation of economic activity accompanied by inflation. Occurred in the 1970s in response to the oil shocks
How does monetary policy influence real interest rates?
Sticky inflation assumption Since prices don't change immediately, when nominal interest rates change, real interest rates change with them because of the Fisher equation
How did subprime lending contribute to the financial crisis?
Summary: housing prices rose, lending standards deteriorated, more people borrowed to buy houses, and this drove prices even higher 1. Low interest rates caused by the global savings glut, a deterioration in lending standards, and the belief that housing prices could only continue to rise led a large number of borrowers to take out mortgages and purchase homes in the early 2000s. 2. These borrowers included subprime borrowers whose loan applications didn't meet mainstream standards, so when the Fed raised its interest rate, these borrowers went into default which caused a vicious cycle of lower housing prices and more defaults
What gives the AD/AS framework transition dynamics?
The AS curve shifts over time due to its intercept being expected inflation which is the previous year's inflation.
What was the ARRA?
The American Recovery and Reinvestment Act signed into law by Obama in 2009 which was a $787 billion package designed to simulate aggregate demand through tax cuts and increased government spending on things like unemployment benefits, infrastructure, education, and health care
What event marked the beginning of modern macroeconomics and what publication did it stimulate?
The Great Depression which stimulated the development of John Maynard Keynes's "The General Theory of Employment, Interest, and Money"
Define potential output and describe how it functions in the short-run model
The amount the economy would produce if all inputs were utilized at their long-run, sustainable levels Potential output is exogenously given in the short run. It's determined by the long run model, outside the short run model
What's the best way to think about how the yield (interest rate) on a bond is calculated?
The annual return from owning the bond expressed as a percentage of what was paid for the bond. The coupon plus any change in the price of the bond during the year
How do short term rates affect long term rates?
Through the term structure of interest rates. Long term rates are an average of current and expected future short term rates which allows short term rates to affect long term rates
How does the Fed set the federal funds rate?
The central bank states that its willing to borrow or lend any amount at a specified rate. This means no bank can charge more than this rate on its overnight loans or else other banks would just borrow from the central bank and if a bank charged a lower rate the other banks would immediately borrow at that rate and then lend to the central bank at the higher rate until the resources were exhausted
What is the term structure of interest rates?
The different period lengths for interest rates
What does the amount of investment depend on in the IS curve?
The gap between the real interest rate and the marginal product of capital
What is expected inflation?
The inflation rate that firms think will prevail in the rest of the economy over the coming year. We usually assume this is equal to last year's inflation
How does the interest rate adjust?
The interest rate is implicit in the price of bonds. When the Fed sells or buys government bonds the price at which the bond sells determines the nominal interest rate
Why is the federal funds rate?
The interest rate paid by one bank to another for overnight use of excess reserves. Fed controls this by determining the level of reserves in the banking system through purchase and sale of US treasury securities
Define the short run
The length of time over which deviations from potential output occur (~2 years or so)
How do the long run model and short run model fit together?
The long run determines potential output around which actual output may deviate in the short run
Why are aggregate demand shocks temporary?
The long run value of a bar is zero so AD curve will shift back to its original position once shock subsides
What is Ricardian equivalence?
The notion that what matters for consumption is the present value of what the government takes from consumers rather than the specific timing of the taxes Ex) a tax cut today that is financed by higher taxes in the future will have no effect on economic activity since households practice consumption smoothing
What does the MP curve represent?
The policy intentions of the central bank regarding the level of real interest rates
What happens when the Fed cannot lower nominal interest rates any more because they are already low?
The possibility of the zero lower bound is approaches so it makes it difficult for the Fed to lower interest rates. But this means deflation will raise the real interest rate. Since this real interest rate is above the marginal product of capital, investment declines so deflation curtailed conventional monetary policy leading to a liquidity trap
Define securitization
The process of pooling a group of financial instruments such as mortgages, then slicing them up in different ways and selling off the pieces
What typically happens to inflation during a recession?
The rate of inflation falls during a recession
What is leverage and what does a leverage ratio of 9 mean?
The ratio of total liabilities to net worth (or indebtedness to equity) So leverage ratio of 9 means that for every $10 of assets the bank holds, $9 is essential financed by borrowing and only $1 is financed by money put up by the shareholders
What does Okun's law tell us?
There is a right negative relationship between output and unemployment For each percentage point that output is below potential, the unemployment rate exceeds its long-run level by half a percentage point.
Summarize what the Phillips curve tells us
There's a positive relationship between the change in the inflation rate and short run output (Y tilde). This means if output is above potential, Y tilde is positive and the change in inflation will also be positive
Why do calculations of recessions overstate the cost of economic fluctuations?
They don't incorporate gains from periods when the economy is booming since booms and recessions offset each other to some extent
What would an increase in MPK (r bar) mean for the IS curve?
This would lead to an increase in investment demand which would shift the IS curve out and stimulate the economy
How does Fed enact tight or loose monetary policy?
Tight would be a monetary contraction which reduces money supply by selling bonds and leads to an increase in the nominal interest rate Loose would be a monetary expansion which increases the money supply by buying bonds and lowers the nominal interest rate
According to the Phillips curve what is the only way to reduce the rate of inflation?
To reduce output by tightening monetary policy to raise interest rates sharply which will plunge the economy into a recession
Why are expectations so important in conducting monetary policy?
To the extent that banks can coordinate people's expectations of inflation it can maintain low and stable inflation without the need for recession
What was TARP?
Troubled Asset Relief Program which was a $700 billion fund to be used by the Treasury to purchase and insure assets held by financial institutions in an effort to strengthen the financial system and encourage lending As of December 2012, around 97% of the disbursements have been returned to the Treasury
What are rational expectations?
Under rational expectations people use all information at their disposal to make their best forecast of the the coming rate of inflation Incorporate into AS curve by rewriting it with pi e instead of pi(t-1)
Explain the Volcker disinflation
Volcker was appointed chair to the Fed in 1979 and had to bring inflation back under control because excessively loose monetary policy lead inflation to exceed 10 percent by that time. Volcker enacted tight monetary policy by raising nominal interest rates which also raised real interest rates due to sticky inflation. This caused firms and households to invest less which lead the economy into a recession. The recession caused the change in inflation to become negative. Once the rate of inflation had fallen sufficiently the policy makers reduced the real interest rate back to the marginal rate of capital leading output to rise back to potential
What is the sticky inflation assumption?
We assume the rate of inflation displays inertia or stickiness so that it adjusts slowly over time. In he very short run (within 6 months) we assume the rate of inflation doesn't respond directly to changes in monetary policy
How do we specify short run fluctuations in practice?
We specify them in percentage terms rather than in dollars so we express it as the difference between actual and potential output as a percentage of potential output i.e. Actual output is 1% below potential
Describe the IS curve when economy has settled down at its long run values
When Yt = Yt bar, output is at potential so Yt tilde = 0. Since Rt = r bar in the long run, the IS equations reduces to simple statement that a bar = 0. This is why all share parameters must add up to 1
In general, when does a recession begin?
When actual output falls below potential so short run output becomes negative
What's the basic story of the IS curve?
When interest rate increases, investment decreases, which means output decreases
What are agency problems and describe two
When one party in a transaction holds information that the other party does not possess adverse selection: when a firm knows its niche in the industry is particularly vulnerable over the coming year, so it will want to borrow and it knows that if it does well it can pay back the loan but if it fails it can declare bankruptcy moral hazard: after a firm borrows a large sum of money it may engage in particularly risky investments know it can declare bankruptcy if the investments fail
Why can the real interest rate and the MPK differ in the short run?
When the Fed changes the interest rate, the change is instantaneous but the MPK doesn't change until new capital is installed and put to use
Explain the intuition behind the inverse relationship between the interest rate and the price of bonds
When the Fed decides to increase interest rates, it soaks up the money supply by selling bonds. Since the supply of bonds has increased and demand has stayed the same, price will decrease
