week 11 macro
is 2% a good target?
Before the crisis most central banks aimed at π = 2%. Was that the right goal? Should banks have a target of π=0%? Or π=4% instead? Most economies don't think 0% is a good target. • The debate goes on but the answer depends on the costs and benefits of inflation... the answer for each country will depend on the conditions for each country but also the costs and benefits for each country.
conclusions on central banks
Conclusion- The way central banks work has changed slightly but the focus is the same: low and stable inflation Combined with through the interest rate rule some CB have the target to keep unemployment at the natural level- these reinforce each other. Modern times interest rate targeting and inflation targeting alone is not enough to prevent large asset bubbles from being created. Central banks are bringing new tools to the armoury. Can go to the bank of england website to understand more.
What are the effects of deficits on Output?
Fiscal policy has a big impact in the short run. What happens in the medium run. Ricardo barro proposition- proposed that once the government budget constraints taken into account. Deficits or debt will not have a long term effect on economic activity If people are rational and forward looking- reduction in taxes now higher taxes late, people are going to save that money so that the increase in public saving will be met with a 1 for 1 in private saving Ricardo assumes that people understand the basics of economics If this is true fiscal policy although it will have a short run impact will not have a long run effect on the economy.not a law just a theory. Important theory. If we look at the empirical evidence there is not much support for this statement- there isn't an inverse relationship between private and public saving. Consumers dont understand when taxes are going to increase in future instead of saving they are going to spend- more likely to happen if the government doesn't explain. If future generations have to pay then why not spend yourself? Massive pension problem in many countries- currently unsustablable because the populations are getting older. Parties cant agree dont have the courage so leave it for later governments. • If future tax increases are distant or unclear, consumers might ignore them so that Ricardian equivalence is likely to fail... • Conclusions: (i) Fiscal policy (larger deficits) are likely to lead to higher demand and higher output in the short run (but smaller than we assumed before because of the Ricardian equivalency) if there are some degree of the ricardian equivalency the impact in the short run is going to be small (ii) In the long run, higher government debt lowers capital accumulation (because of lowers savings) and hence lower output. Productivity goes down investment goes down.
philips curve in inflation targeting
From Money Targeting to Inflation Targeting Divine coincidence: Keeping inflation stable is a way of keeping output at potential (so even if policy makers do not care about inflation, it is a useful policy) coincidence that is helpful . UK central bank only has one target to keep inflation low and stable at 2%. The Fed also has that target but also has another goal to keep low inflation. If banks follow the rule it doesn't matter if you keep it low you keep unemployment low. These two targets are a consequence of each other t =* -(ut-un) But in reality.... Life is not that simple! Philips curve relationship not perfect. Its been changing over time. Instead of having strict rule of 2% most central banks now have a flexible inflation targeting. Have a range uk 0-2%. Central bank not obsessed with keeping inflation below 2%, allows inflation to go above whenever there a re good reasons. In the UK if it is above 2% for two quarters the governor of the CB has to write a letter to the queen to explain whats going on. • Flexible inflation targeting: Central banks adjust the interest rate to return to the target inflation rate over time, rather than right away Flexibility important when the economy is hit by a pandemic or shock. This is what most central banks now seem to be doing.
primary deficit or primary surplus
Government Debt • The term (Gt-Tt) is called the primary deficit and (Tt-Gt ) is called the primary surplus, so: Most developing countries tend to have a negative primary deficit. Tells us that the stock of debt in a sense debt is a stock variable and the primary deficit is a flow variable. Related but not the same thing. Interest payments on government bonds and bonds paid in interest rates. Already we can see that even if the primary deficit is 0 public debt will go up by the amount of the interest payments. Historical fact- past debt might be created by previous government. If they want to reduce the debt they will have to have a surplus in the primary deficit to compensate Change in the debt interest payments Primary deficit Bt- Bt-1 = rB t-1 + Gt- Tt moving Bt-1 to the right side of the equation we get the debt at the end of period t (Bt): Primary deficit: Bt= (1+r) Bt-1 + (Gt-Tt) Stock of debt is equal to hte primary deficit plus the debt accumulated plus the interest. This is the real equation to focus on. This can have some massive implications. Even if the government has no primary deficit the stock of public debt will go up significantly by interest payments. UK 2 trillion dollars- even at 1% the government will have to spend 20 million pounds every year. If inflation rates go up the debt is going to go up. Extra 80 billion.
inflation targeting (2 things)
Inflation targeting • For the two decades (a period known as the Great Moderation) before the 2007/8 crisis, most central banks had converged toward inflation targeting. Contributed to the global crisis because inflation was low which meant interest rates were really low- contributed to the housing bubble. Main reason for great moderation was central banks had converged towards inflation targeting and this had worked. Central banks gave credibility to each other. • The inflation targeting framework has two principles: • (1) Keep inflation stable and low; and • (2) follow, explicitly and implicitly, an interest rate rule. If you do one the other one is going to be achieved. Simple concept to understand. When a central bank says our target is an inflation of 2% everybody takes into account when the wage negotiations come. Interest rate rule is advantage of simple and achieving two goals. Allows to keep unemployment at the natural level.
loan to value ratio
Monetary Policy and Financial Stability Macroprudential tools aimed at borrowers: Main difference • Maximum loan-to-value ratio (LTV): A ceiling on the size of the loan borrowers can take relative to the value of the house they buy. In a lot of countries it was possible to borrow more than 100% of the value of the asset. House, car and holiday. Idea was the value of the house would go up and up . one way the banks intervened was to lower this LTV lowered quickly to 80% had to have 20% as a minimum government tried to help first time buyers to reduce 20% to 5%. • Reducing the maximum LTV is likely to decrease the demand for housing and thus slow down the housing price increase. Macroprudential tools aimed at lenders: Banks highly leveraged banks were forced to increase their capital ratios was 2-3% before th crisis went to 8-9% after much better shape • Basel II and Basel III agreements among countries imposed on their banks minimum capital ratios in order to limit bank leverage. • Imposing Capital controls on inflows (e.g. taxes). They found some commercial banks were bypassing the controls of the central bank instead of borrowing. Were going abroad and circumventing the rules of the CB. taxes introduced for other country borrowing. • Lowering taxes on foreign direct investment. Good investment. Seems to have worked quite well
deposit insurance, lender of last resort
Monetary Policy and Financial Stability: Avoiding Bank Runs Other things that came with the financial crisis. Debt to GDP ratio increased tremendously. Banks went under. • Deposit Insurance: gives investors confidence that they will not lose their funds if the bank becomes insolvent. Northern rock etc bank run. CBs increased their deposit insurance. Here in the UK who has a bank account is covered up to 85,000 pounds if the bank goes bankrupt. Brought investors confidence • Lender of last resort: A function of the central bank that provides a bank the liquidity it needs to pay the depositors without having to sell its assets. European central bank in 2012 2014 said they would lend as much money as italy spain portugal need to cover its debt. Brought confidence to the markets central banks became alot more proactive than they were before. • The crisis has forced central banks to consider whether they want to provide liquidity to institutions they do not regulate. More proactive
what two goals are there of monetary policy?
Monetary Policy: Goals • One can think of the goals of monetary policy as two-fold: § Maintain low and stable inflation; low not zero no economist recommends 0 because its zero- we get into a liquidity trap and deflation. Should be stable. Increasing can be attractive- boom. In the short run growth but in the medium run it has to be reversed. § Stabilize output around potential output and avoid/limit large recessions or booms. Try to keep output near the natural level. Avoid large swings in the business cycle. Can this be done?
Did this work?
Money Targeting did not work... M1: The measure of money stock equal to the sum of currency and checkable deposits. There is no tight relation between M1 growth and inflation, even in the medium run. Although there is a strong correlation between money growth and inflation it is far from perfect. There are lags. Lags are sometimes many years to go back to a cycle. Not responsive enough. M1 is a measure of money there is up to M4. most basic measure of money- currency + deposits in commercial banks. Central bankers realise that there are many other things other than money growth that explain inflation. Exchange rate movements effect inflation. Oil shocks or brexit will also affect the inflation rate.
why is a bit of debt not too bad?
More realistic scenario. Keep the level of debt unchanged- government has to collect a certain amount of tax to pay for the interest rate. The reduction in tax is a billion but only has to collect 100 million pounds of tax to keep public debt unchanged. If the debt is stabilised from year 2 on, then taxes must be permanently higher by r from year 2 on. Is public debt good or bad? Generally speaking there is very little advantage for a country to have 0 debt. A country who has 0 debt is a country who doesn't invest in education, science that increase the productivity of the country. As long as public spending falls on areas that are productive its not always a bad thing Borrowing money to buy a house is not necessarily bad. Different if the government spends money on vanity projects like a statue or mars- doesnt increase the productivity of the country. Too much debt is clearly bad
To Act or not to Act?
Should they act constantly or take a backseat • The financial crisis showed the very high costs of central banks (and other regulators) not act when a (housing) bubble emerges. Consensus to do as little as possible before financial crisis but became clear that this wasn't good enough - CB needs to intervene much earlier • The consensus seems to be: • It is risky to wait for a bubble to build up and burst. The bank should intervene before the bubble • To deal with bubbles or dangerous behaviour in the financial system, rather than the interest rate, the right instruments are macroprudential tools - rules that are aimed directly at any financial institutions involved.m acropreudential tools- most growth in tents if research in macroeconomic research. Rules created to regulate the behaviour of financial institutions and households. limit what people can do and institutions. Quantitative easing.
money targeting before the 1980s
Solution 1: Money targeting • Until the 1980s, the strategy was simple: • Choose a (low) target rate of money growth to keep inflation low and stable: If you wanted to keep inflation lowe and stable chose a target for money growth and kept it there § In recessions, the central bank would increase money growth- money in circulation (↓i+ ↑Y) and in booms it would decrease it (↑i + ↓Y). It would try to bring the economy back to the natural level. When you increase money growth interest rates go down output rates go up. Main strategy 1980s not used anymore
seignorage equation
The Dangers of High Debt The relation between seignorage, the rate of nominal money growth and real money balances (relative to GDP): Rate of nominal growth- relationship between real money and nominal money- done tworry too much about this equation. Growth of nominal money must be equal to 10% and that will be your income. Seignorage/ Y= ∆H/ H(H/P/ Y) • This implies that to finance a deficit of say 10% of GDP through seignorage, given a ratio of central bank money to GDP of 1, the growth rate of nominal money must be equal to 10%. • As money growth increases, inflation typically follows. Hyperinflation refers to very high inflation. Zimbabwe bank notes worth 100 trillion dollars- hyperinflation- issuing money to buy the debt the government issues.
why is high debt bad?
The Dangers of High Debt • We have seen that high debt requires high taxes in the future forever just to maintain the size of the debt. Higher debt the higher the taxes for the country will have to be forever. • High debt is also dangerous because it can lead to vicious cycles: when public debt get sto very high levels- GDP to debt ratio 200% 150%- repayments impossible it seems Investors worry about the government's ability to pay the debt ↓ As a result they demand higher interest rates . by demanding higher interest rates ↓ which makes it harder (and sometimes impossible) for governments to stabilize the debt. Push interest rates too high lead to the government to not be able to repay the debt. Manin danger of debt. Globalised world
what does the budget deficit equal?
The Government Budget Constraint: Deficits, Debt, Spending and Taxes • The budget deficit (inflation-adjusted deficit) equals Difference between public spending and taxes but with historical debt and the interest payments on debt that has been accumulated. Public debt is a loan that the government takes from consumers and companies. Government has to pay interest. The deficit is not only the difference between debt and taxes but interest rate of previous debt. Deficit t= rB t-1+ Gt- Tt where: Bt-1= government debt at the end of t-1 r = real interest rate rBt-1= real interest payments on the debt in year t Gt= government spending on goods and services in year t Tt= net taxes (taxes minus transfers) in year t The Government Budget Constraint: Deficits, Debt, Spending and Taxes Bt- bt-1 is the change in public debt which is equal to the deficit. If the government collects more debt than taxes then its going to go up but if there is more taxes then the change in government debt is going to be less. Interest rates on past debt enters this equation. The Government budget constraint: The change in government debt during year t (Bt-Bt-1) equals the deficit during year t: Bt- Bt-1 = rB t-1+ Gt- Tt
shoe leather costs, tax distortions, money illusion, inflation variability
The Optimal Inflation Rate Four main costs of inflation: If inflations get too high lots of inconveniences • Shoe-leather costs: Costs associated with more trips to the bank as people reduce their money balances. When inflation is high people dont want to hold any cash- so they can earn money. Not a major costs in most countries but with hyperinflation can be huge. Brazilian friend whenever they got paid in cahs everyone would run to the bank to avoid losing money or convert to a stronger currency- the value in their pocket would change from the morning to the afternoon • Tax distortions: High inflation leads to more higher capital gains taxes and higher income tax (bracket creep that pushes people into higher tax brackets). Rishi sunak said that brackets for income tax are not going to change for several years even though nominal income is up. Bracket to start paying 40% income rate is just over 50000 pounds but as nominal rates go up more people will be paying this • Money illusion: People appear to make systematic mistakes in assessing nominal versus real changes in incomes and interest rates. Should think in real but people look at nominal • Inflation variability: Higher inflation is typically associated with more variable inflation, which increases the risk of financial assets that promise fixed nominal payments in the future. Making investment decisions is much harder, limits investment. If inflation is stable easier to plan long term and make investment decisions
what are 3 benefits of inflation?
The Optimal Inflation Rate • Three benefits of inflation: This might affect he target the CB decides to adopt. Developed countries less importnat but delopign more important • Seignorage: Money creation - the ultimate source of inflation - is one way in which the government can finance its spending. The ability to create money which will create inflation is one way governments can finance its spending. Important source of income for buildings etc. Inflation target low will imply lower seigniorage income. This has to be a trade off • The use of the interaction between money illusion and inflation in facilitating real wage adjustments. Allows for real wage adjustment- by keeping nominal wages fixed inflation goes up drop of real wage. Aftermath of global financial crisis. Decrease in real wage allowed the labour market to make necessary adjustment to get out of the recession. Sometimes real wages have to drop. If inflation is not present its much more painful. • The option of negative real interest rates for macroeconomic policy: High inflation decreases the probability of hitting the zero lower bound. Inflation decrease the probability of deflation.
seignorage
The government can also finance itself by printing money. Need to pay the police and teachers so go to the central bank - print money and pay wages. • Money finance, debt monetisation, or fiscal dominance of monetary policy: The government issues bonds and then forces the central bank to buy its bonds in exchange for money. This creates a revenue for the government called • Seignorage: The revenue, in real terms, that the government generates with money creation (∆H). A percentage of money creation Delta h is the change in high powered money p is the price level. Source of revenue for the country. seignorage= ∆H/P
unconventional monetary policy:
Unconventional Monetary Policy Crisis central banks had no methods • One example of unconventional monetary policy is quantitative easing or credit easing: Central banks buy assets other than short term bonds, with the intention of decreasing the premium on those assets and thus decreasing the corresponding borrowing rates with the aim of stimulating economic activity. Liquidity trap meant they had to use QE allows central banks to buy other assets not just government bonds to stimulate economics activity through that • Central banks finance their purchases through money creation, leading to an increase in the money supply. No effect on the policy rate. Does stimulate the economy because there was more money around. Help with the housing market help with the stock market • Although the increase in the money supply has no effect on the policy rate, the purchase of other assets lead to lower borrowing rates.
Can reduce pain without debt- how?
napoleonic wars debt ratio 200% double what it is now- managed to get out of that with high growth. Possible to reduce public debt. Now interest rates are really low- public debt the government is paying 0.7% for a 10 year bond considering that inflation is higher than that there is a negative interest rate. If we get out of the pandemic soon with a period of high growth public debt can be reduced very rapidly.
why is a reduction in taxes not too positive?
• If G is unchanged, a reduction in T today must eventually be offset by an increase in T in the future (assuming full repayment). There is a trade off can have less taxes today but in the future will have to increase taxes higher than the initial decrease in taxes. • The longer the government waits to increase T or the higher r is, the higher the eventual increase in T must be. Nothing is certain but death and taxes- benjamin franklin. Intergenerational questions- sometimes the people who benefit from the reduction in taxes are not the same who will pay it back in the future. Raise intergenerational issues and also political issues. There is an incentive tp kick the can down the road because we can do really bad things now and someone else will clean the mess. Most governments tend to do when a bond comes to maturity- they have long maturity, they create a new bond to raise money to pay for the old bond. Dont raise taxes everytime a bond comes to maturity. Raise more. Can manage the stock of debt that a country has.
Taylor rule:
• In the 1990s, John Taylor suggested a rule of the policy rate it, now known as the Taylor rule: Central bankers know it by heart Based on philips curve- difference of inflation and inflation target and difference of unemployment and unemployment in the natural level Interest bank sets function of 3 components: Inflation and inflation target - (unemployment- natural rate of unemployment) it = i* + (t -*) -b( ut -un) i* interest rate rule, interest rate target is a component of two things Rn real rate of interest but also inflation target pi*. Interest rate rule tells bankers what to do. where i* = rn + π*, which is the neutral rate of interest plus the target inflation rate; and a and b are coefficients chosen by the central bank. The interest rate rule If πt = π*, the central bank should set it=i *. Inflation at target should set interest rates at interest rate rule If πt> π*, the central bank should increase it above i *. If ut> un, the central bank should decrease the nominal interest rate. If unemployment above natural level should decrease interest rate below target The coefficient b reflects how much the central bank cares about unemployment. How important is the inflation target and unemployment different? A and b will change for each central bank in UK b is 0 don't care about unemployment part. US central bank cares about both. Even without looking at b philips curve covers both. Simple rule. Guiding what central banks have been doing for decades.