Chapter 9 Flashcards
Causes of crisis
Assets become overvalued
Sudden triggers
Financial amnesia
Failure to maintain market discipline
Crisis contain at least one of the following characteristics
Incentive to take on too much risk
Lax regulatory environment
Herd like behaviour
Non financial exogenous shocks like covid
Examples of assets becoming overvalued
2000 crash when trailing P/E ratio is twice that of historical average
2008 crash house price to disposable income surpasses historical levels
Example of financial amnesia
People forget about the past and repeat errors after prolonged period
Assets become divorced from drivers of value
Incentives for weak governance
Incentive structure for senior management
Moral hazards - too big to fail
Bahviorual finance - herd behaviour and dismissal of inconvenient info, overconfidence
How to prevent financial amnesia
Education
Research into flags
Increase corp governance
Independent regulators
What started in 2022
QT
How much does USA contribute to GDP
26 percent
Largest developing countries
China and India
What is a sixty year cycle
Kondratiev wave
4 business cycle phases
Expansion
Euphoric
Recession
Recovery
Where does uk gnp fluctuate
2.5 percent
What is output gap
Loss of output from short term fluctuations relative to long term output
Reasons for output fluctuations
Tech shows
Cycle of net credit creation that lead to speculative bubbles
Measuring economic activity
Value of expenditure by firms
Value of output by firms
Value of purchases
GNP is equal to
GDP plus net income from abroad
Disposable income
Income after taxes and transfer payments
Output is equal to
Consumption plus investment
GDP is equal to
C + I + G
GDP in open economy
C + I + G + X - M
Private sector surplus
Saving - investment
Gov deficit
G + T - t - ty
Foreign sector surplus
Exports - imports
What is consumption driven by
Disposable income
What does increase taxes do to ad curve
Flatter AD curve so equilibrium output decreased
Schools of thought
Classical - prices and wages are fully flexible
Keynesian - prices and wages are slow at adjusting
Austrian / methodological - role of individuals or groups to understand economic phenomenon
Market prices reflect all information.
Problem of classical thought processing
Fall in wages doesn’t always mean increased labour as if demand decreases then labour will not increase
Monetarist view?
Inflation caused by money supply not AD
Problem with fiscal policy
Crowding out
Assumptions for monetarist
Individuals behave rationally and have all market info available
Markets competitive
Prices adjust to AD
Austrian economics thoughts
Prices that consumers are willing to pay for a good drive the value and labour used to produce it
What are the characteristics of a less productive economy and sophisticated economy
Increase immediate consumption - less productive economy
Increased differed economy = more sophisticated economy
What do Austrians see CB as
They see CB main cause of financial instability
What is budget surplus
Taxes - gov spending
What is balanced budget change
Increase in G is equalled by a increase in T
What are tax revenues in recession
Low as income is low
Types of fiscal policy
Discretionary- decided and implemented policy changes
Automatic stabilisation - no specific changes but processes kick in as economy ebbs and flows
What is fiscal drag
Phenomenon that occurs when tax brackets remain the same or don’t increase with inflation and rising incomes
Bank liabilities
Customer deposits, certificate of deposits and foreign currency deposits
Bank assets
Cash coins cash reserves deposits, loans bills
M0 is
Narrow money includes sterling, notes, coins outside of BofE plus banks operational deposits with BofE
What is M0 used for
Used in money multiplier calculations which is approx measure of banks balance sheet
M2
Notes coins and retail deposits held by non bank private sector
M3
Notes coins and all sight and time deposits held by non bank private sector
M4
Notes coins deposits CDs repos securities with securities less than 5 years maturity
What is money stock equal to
Money multiplier x monetary base
Money multiplier for m1 equal
Change in M1/ change in M0
What is MV equal to
Money x velocity = price x level of transactions
3 motives for holding money
Transaction motive
Precautionary motive
Portfolio / asset motive
What happens as interest increases with cash reserves
Cash balances fall as opp costs of holding money rises
What influences HH spending
Changes in loans
I rate
Credit availability
Wealth effect
When do firms hire workers
When MPL is greater than real wage
Natural level of employment
Proportion of labour force that is unemployed when labour market is in equilibrium
What happens when firms have no money illusion
Vertical supply curve
How does full employment output level increase
Supply side policies
Attitudes to work
Taxation
Innovation
Education rather then ad changes
Unemployment formula
Number of people available to work / total uk labour force
Uk unemployment definition
Those who are able and willing to work and actively searching
Eu unemployment definition
Aged 15 to 74 who are not working and have looked for work in last 4 weeks and ready to work in 2 weeks
Frictional unemployment
People between jobs and not easily employable bc of physical issues
3 categories of frictional unemployment
Those who have left their job
People returning to work force
New entrants to workforce
Structural unemployment
Changes in unemployment due changes in demand or production, arises from dislocation between skills of workforce and requirements for the job
What does structural unemployment demand of workers usually
To retain or relocate as there is disconnect between skills and qualifications required
Classical unemployment
Real wage too high
Keynesian unemployment
Demand deficiency bought about by lack of flexible prices and real wages required to restore classical full employment level
Natural rate of unemployment
Rate of unemployment in equilibrium of labour market - completely voluntary
What can increase natural unemployment level
Increased unemployment benefits and increased trade union power
What does tight labour market mean
Increased wages and increased prices
Velocity of circulation
Speed in which currency changes hands in given period
What is Phillips curve
Increases inflation means decreased unemployment
Menu costs
Chnage in prices in form of price lists
Shoe leather costs
Cost incurred when people try to minimise their cash holdings in times of inflation
What is Taylor’s rule
Stabilise economy and maintain growth long term
Taylor’s rule as inflation increases or decreases by 1 percent
Increase inflation by 1% means a greater then 1% increase in I rate
Decrease in inflation by 1% means a fall in I rate by less than 1%
What does BofE do
Banking and OMO
Liabilities of central Bank of England
Notes coins and deposits of comm banks
Repo rate
I rate charged to com banks for borrowing money
What banks are independent
BOJ, ECB, US FED
CB tools
QE
Forward guidance
Helicopter money
Bank regulations
How does CB transfer money to gov
Direct transfer
Buying gov debt that pays no interest or principle
Direct payment to population
Basel 1
Hold 8 % of risk adjusted value of assets
Basel 2
Increased r degree of risk differentiation
Basel 3
Increase ability to absorb shocks through improved regs, supervision and risk management
2 levels of bank improvement
Macro prudential - system wide regs to assess issues across banking sector
Micro pridential - improve individual bank resilience e
Basel 3 percentage
Max leverage ratio of 4.5% and min capital ratios
How can banks increase liquidity short term
Borrowing from CB
Liquidity coverage
Banks have adequate stock of high quality liquid assets that can be converted into cash easily and immediately
Net stable funding ratio
Banks maintain stable funding profile in relation to on and off balance sheet activities
What does fpc do
Increase stability and resilience and monitor systematic threat
How does credit affect economy
Increase credit means booms and expansions vice versa
Appreciation of sterling
Foreign value of sterling has increased
What makes a country less compteive in international markets
Inflation domestic greater than foreign inflation
Will need to use fiscal or monetary policy to get back in line, higher inflation means you can buy less with your money
Current account
Cross boarder flows of goods, services and other net income from abroad
Capital account
Involves flows of transactions in financial assets
Visible trade and invisible trade
Trade of goods
Trade of services
What does a surplus current account mean
Equal deficit of capital account
Real exchange rate equals
Price of uk goods/price of euro goods x euro/pound
Purchasing power parity
Nominal exchange rate moves to offset differential inflation rates between countries
If uk real ER increases what happens
Increase imports
Monetary policy and fiscal policy on fixed ER
Monetary policy is unefffevtive with fixed ER with perfect capital mobility
More potent in open economy
Fiscal policy is effective
Monetary and fiscal policy in floating ER
For floating, monetary policy useful short term but fiscal less effective
Countries with close economic ties may benefit from
One common currency
two reduce transaction costs
three enhanced scales production
What do successful currency unions need?
Fully mobile labour with minimum meaningful barriers
No capital movement restrictions
Similar business cycle so one bank rate is set
What is a premium in the forex market?
When the forward rate is higher than the spot rate
What is a discount in the forex market?
When the spot rate is greater than the forward rate
What does an increase inflation due to the exchange rate with purchasing power parity?
Increased inflation leads to a depreciation and exchange rate
Example, what does a decrease inflation mean for the USD against pound exchange rate?
The decreased inflation means the USd appreciates against the pound
What is covered interest parity?
Relationship between forward rates and interest differential known as cored interest parity
What is uncovered interest parity?
Relationship between expected change in spot exchange rate and interest differential
What does gdp at factor cost deduct and add
Deducts indirect taxes and adds back in subsidies
Explain GNP
GDP plus uk ownership of foreign based factors less foreign ownership of uk based factors
How is wages and prices affected for by chnage in nominal money supply in classical economics
And affect on output, employment and i rates
Equal percentage change in wages and prices
No chnage in output, employment of real i rates
What is characteristic of long term Phillips curve
Vertical at the natural rate of employment
How does BofE influence price and quantity of money
open market operations and discount rate
What is the us fed responsible and not responsible for
Responsible for setting interest rates
Not responsible for deposit protection insurnace or for managing government debt
What is balance of payments surplus
Exports more than it imports
What does interest parity do
Links forward rates and interest rates in two countries
What is an optimal currency region
Region that maximises economic efficiency by using a common currency
What is good for a single common interest rate
Similar business cycle location
What is the multiplier for a closed economy
1/(1-c)
Multiplier in a open economy
1 / (1-(c-e))
C is MPC and e is marginal propensity to import
What is the relationship of interest rate and exchange rate strength
Increased i rates in uk mean appreciation of the pound
What is the trade balance
Sum of visible and invisible trade
What are central banks repsosnible for
Monetary policy
Banknote printing g
Banking supervision
What is national income
GNP at factor costs less capital deprication
Explain what the multiplier is
Ratio of change in equilibrium output to AD changes
What is the international fisher effect
1+R£ 1+R$
———— = —————
1+E(Inf£) 1+E(Inf$)
What does $/£ mean
How many dollars you can buy with £1
Eg $1.62 = £1
If the forwards $/£ is higher than the spot $/£ then explain what is happening
Value of the pound is greater in the future therefore trading at a premium
What is interest rate parity formula
And give example formula
Forward rate/ spot rate = (1+Rx) / (1+Ry)
Forward $/£. 1+US i rate
——————. =. ———————
Spot $/£. 1+ UK i rate
Normal fisher effect equation
1+R = (1+r)(1+E(i))
R is nominal i rate
r is real i rate
E(i) is expected inflation
How do we get to international fisheries effect
If real rate of interest is same in each economy
