Conventional and unconventional Monetary Policy Flashcards
When is a policy is said to be time-inconsistent (2)
-The policymaker gains at the current time when the future policy action
is announced and believed by people
- But policymaker does not gain by implementing the policy when the time comes to do so in the future, even if nothing fundamental has changed
What is a time-consistent policy
A time-consistent policy is one where there is no incentive ex post
to follow a different policy from the one announced earlier
Why are some policies time inconsistent?
- Since expectations matter, the policymaker can achieve more at the current time if announcements of future policies are believed
- But that benefit lies in the past when the time comes to implement the announcement, so policymaker now sees a different policy as optimal
what does it mean when MPN > MRSl,c
If the MPN is greater than the MRS_l, C, it means the worker could produce more by working an additional unit but chooses not to. This indicates an inefficient allocation of labor.
what is inflation bias
In simple terms, the upward shift of the Phillips curve makes it much harder for the central bank to boost real GDP without also generating substantially higher inflation. This inflation bias arises because the public anticipates the central bank’s attempts to push output above the natural level, leading to rising inflation expectations that undermine real economic gains.
What is the duration risk
Uncertainty about changes in future interest rates/yields 𝑖
′(duration risk)
What will happen to the budget constraint with a higher risk premium
Steeper
What will happen to the budget constraint with a lower risk premium
Flatter
What is the portfolio balance effect
- When the central bank purchases risky assets like long-term bonds from the market, it reduces the overall supply of those risky assets available to private investors.
- To pay for these purchases, the central bank provides reserves (risk-free assets) to the sellers.
- So the relative supply of risky assets falls, while the supply of risk-free reserves increases.
- This represents a movement along the demand curve for private investors - they now face a lower supply of risky assets relative to risk-free assets.
- With lower relative supply, the prices of the remaining risky assets are bid up higher by investors.
- Higher risky asset prices translate to lower risk premiums or expected returns on those assets over the risk-free rate.
- These declining risk premiums reduce the overall long-term borrowing costs in the economy.
- This is known as the “portfolio balance effect” of quantitative easing (QE).
Why does the money curve slope down
Money demand curve slopes down due to diminishing marginal benefit of real balances
Factors that shift up the money curve (2)
It shifts up if money itself pays interest
It shifts up with higher real GDP increasing transaction needs
What happens to money demand with higher interest rates
The interest rate (i) represents the opportunity cost of holding money instead of bonds
Higher i means higher cost of holding money
So higher i leads to lower demand for real balances M/P
what is the best amount of money to hold
The best amount of money to have is when the extra benefit you get from having more money equals the cost of not earning interest on it (b×M/P)=(i−im) MP=MC
Link of short-term interest rate and long-term
If investors only care about expected returns and are risk-neutral, then in equilibrium, all bonds must offer the same expected return. This means that long-term interest rates must be related to expected future short-term interest rates. This relationship between short-term and long-term rates is the basis of the expectations theory of the term structure of interest rates. If investors expect short-term interest rates to rise in the future, they’ll demand higher yields for longer-term bonds to compensate for the risk of locking in their money at lower rates. This pushes long-term bond yields higher relative to short-term yields.
expectations theory of interest rates
Expectations theory of long-term interest rates
- Let’s think about investors that are risk neutral - only care about returns, don’t worry about risk
- Choose the bond with the highest expected return
- All bonds end up with expected returns as what would happen with the low return
- However, in equilibrium, all bonds issued must be held by someone.
- Therefore, bond prices (or equivalently, bond yields) must adjust so that all bonds have the same expected return.
- This implies a connection between short-term and long-term interest rates, known as the “expectations theory of interest rates.”
In simple terms, if investors only care about expected returns and are risk neutral, then in equilibrium, all bonds must offer the same expected return. This means that long-term interest rates must be related to expected future short-term interest rates. This relationship between short-term and long-term rates is the basis of the expectations theory of the term structure of interest rates.