Chapter 27 Flashcards
counter-cyclical policies
what are its two main categories?
attempt to reduce the intensity of economic fluctuations and smooth the growth rates of employment, GDP and prices. They shift the LD curve.
during recessions: to the right
during a runaway boom: to the left
1) countercyclical monetary policy: which is conducted by the central bank (in the US the FED), attempts to reduce economic fluctuations by manipulating bank reserves and interest rates.
2) countercyclical fiscal policy, which is passed by the legislative branch and signed into law by the executive branch, aims to reduce economic fluctuations by manipulating government expenditures and taxes.
why to slow down the economy at a runaway boom?
In some situations, effects on GDP and employment are a by-product of another policy goal. ex: when inflation is above the target level, Fed will raise interest rates to suppress borrowing, thereby slowing the growth of money supply and reducing the rate of inflation. Rise in are will shift LD to the left.
ex: too optimistic sentiments: unsustainable expansions may lead to severe downturns, because sentiments can implode suddenly and severely. = contracting the economy before it overheats
Countercyclical monetary policy: expansionary policy
-response to economic contraction
-increases the quantity of bank reserves and lowers interest rates
-Fed stimulates the economy by lowering short-term interest rates and expands access to credit (usually causes long-term interest rates to fall=long term average= ex: 3 years out of 10)
-this stimulates households to buy more durable goods
=> firms hire more workers to satisfy needs
-also firm invest more due to lower r => further workers are hired = LD rightward shift
increase/decrease in ff r
- increasing supply of bank reserves available to private banks = ff r decrease
- decreasing supply of bank reserves available to private banks = increases ff r
(exchanging electronically created bonds to reserves)
Tools of the fed to manipulate r and affect the demand of goods
1) changing the reserve requirement
2)changing the interest rate paid on reserves deposited at the Fed
-decrease in the interest rate shifts D for reserves to the left, decreasing ff r
3)lending from the discount window: source of reserves for private banks, especially during recession when other banks are afraid to lend
4)quantitative easing: long-term bonds instead of short-term bonds. This pushes up the price on long-term bonds and drives down-long term rates.
Quantitative easing occurs when the central bank creates a large quantity of bank reserves to buy long term bonds, simultaneously increasing the quantity of bank reserves and pushing down the r on long-term bonds.
Central banks occasionally invent even more ways of increasing the supply of credit during financial crises by creating specialised lending channels that increases lending in the credit market and thus indirectly stimulate the demand for goods services and labour.
Why does a higher bond price imply a lower r?
r = fixed coupon// price of the bond
Long-term expected real-interest rate
Long-term expected real-interest rate= long-term nominal interest rate -long-term expected inflation rate
How does the FED lower the long-term real r?
-lower long-term nominal r or raise long-term expectations of the inflation rate (or both). = forward guidance (page 709)
Inflation rate
- around 2%
- expansionary policy can put this inflation target at risk
- quantity theory of money: over the long-run the inflation rate will equal to the growth rate of M2 minus the growth rate of real GDP =excessively rapid growth of M2=risk of high levels of inflation
zero lower bound
- zero is a barrier (nominal interest rate can cross)
- lending money at a negative interest rate
- sometimes banks buy bonds with a slightly negative r= price of security
- if the inflation rates keeps falling (further below zero), the real interest rate will rise, shifting the LD curve.
- when the economy is in recession or growing only slowly, the central bank usually wants to lower the real interest rate to stimulate economic growth. = ffr can’t be lowered much further.
Federal funds rate
FFR= long-run federal funds rate target + 1.5 * (inflation rate- Inflation rate target) + 0.5 * (Output gap in percentage points)
Output gap
Output gap= (GDP-Trend GDP)/ trend GDP
two aspects of the taylor rule
1) when ffr increases , inflation rises. Every % point increase in the inflation rate will translate into 1.5 percentage point increases in the federal funds rate
2) when fed raises ffr as the output gap increases. A larger output gap, leads the Fed to raise ffr, thereby reducing the degree of stimulus. The formula indicates that every percentage point increase in the output gap will translate into half percentage point increase in the ffr.
Countercyclical fiscal policy
- uses lower government expenditure and and higher taxes to reduce the growth rate of real GDP. Shifts the LD curve to the left
1) expansionary fiscal policy uses lower government and lower taxes to increase the growth rate of real GDP
2 groups of fiscal policy
1) automatic countercyclical components: aspects that automatically partially offset economic fluctuations.
- automatic stabilisers: components of the gov budget that automatically adjust to smooth out economic fluctuations = such transfers help households cope with economic hardship and are widely believed to stimulate GDP (household spend more during recessions)
2) discretionary countercyclical components: aspects of the government’s fiscal policy that policymakers deliberately enact in response to economic fluctuations. (expenditure increases and temporary tax cuts)
