EC108 Term 2 Flashcards
What causes business cycles?
Keynesian economics: the economy may reach short-run equilibria at levels below or above full employment
-demand side policy used to smooth fluctuations (stabilisation policy)
Mainstream economics: fluctuations have exogenous causes
-minimal govt regulation - focus on long-term growth
-real business cycle theory (RBC)
Alternatives: credit cycle e.g. Fisher debt deflation theory. Minsky’s Financial Instability Hypothesis
Aggregate demand is equal to…
Consumption + Investment + Government Spending + Net Exports
What is generally more stable, consumption or investment?
Consumption
Positive expectations of future demand cycle
Firms invest and hire
Higher spending by firms and workers
High demand for the firm’s products
High capacity and utilisation and high profits
Negative expectations of future demand
Low expectations of future demand
Low capacity utilisation and low profits
No incentive to invest or hire
Little spending by firms or workers
How do we find the output gap?
(Actual output - Potential output) / Potential ouptut
What is an output gap?
The gap between the economy’s current level of activity and the ‘potential’ level consistent with stable inflation in the long-term
What is a negative output gap associated with?
Lower rates of capital and labour utilisation - spare capacity in the economy
What is a positive output gap associated with?
Higher rates of resource utilisation, potential evidence of an economy ‘overheating’ with upward pressure on wage growth and inflation
3 main methods to estimate potential output
Statistical trend - output gap as the difference between actual output and the trend.
Estimate a production function - use it to generate estimates of potential output
Estimate output gap directly - current data from business surveys of capacity utilisation
3 negative effects during recessions
Unemployment (or fear of losing the job) as a major source of unhappiness and reduction of well-being
Social indicators (mental health, crimes, suicides, etc) worsen during recessions
Political pressure to mitigate recessions
Okun’s law
Higher output growth is clearly associated with a decrease in unemployment
Strong and stable relationship in major advanced economies since the WWII
Not one-to-one relationship due to:
-labour hoarding
-tighter regulations on hiring and firing
-longer traditions of lifetime employment
Involuntary unemployment
Unemployed people looking for work who would be prepared to take a job at the going wage but cannot get a job offer
Reservation wage
What an employee would get either in alternative employment, or from unemployment benefits (where available) were they not employed in the employee’s current job
Efficiency wage setting
Incentive for employers to pay more than the market-clearing wage in order to increase productivity (efficiency) and/or reduce costs associated with turnover
Wage setting-curve
Real wage necessary at each level of employment to provide workers with incentives to work well
Price-setting curve equation
W/P = (1/(1+μ))MPL
Labour supply
Number of hours people are willing and able to supply at a given wage rate
Real wage in terms of nominal wage
Nominal wage/Price level
What shifts the WS curve down?
Fall in the level of unemployment benefits
Fall in the disutility of effort (e.g. improving working conditions)
Fall in union mark-up, weaker unions
Price-setting curve
Real wage paid when firms choose their profit-maximising price
What is the equilibrium employment rate?
Wage setting = price setting curve
What happens to the price/wage setting curve when unemployment benefits increase?
The wage setting curve moves upwards/outwards
What happens to the price/wage setting curve when there is less competition?
Price setting curve shifts downwards
What are trade unions?
Organisations that represent the interests of a group of workers in negotiations with employers over issues such as pay, working conditions, working hours.
How do you measure output gaps on the wage/price setting diagram?
It’s the gap between the wage setting and price setting curve
What is the relationship between inflation and unemployment?
Inverse relationship
Do changes in aggregate demand affect the equilibrium level in the labour market?
No, only supply side changes will affect the equilibrium level
Tobin’s q theory of investment
Stock market value is forward looking and indicates how well the firm is able to implement the investment
Adaptive expectations characteristics
Backward-looking behaviour
Agents make systematic errors
Adaptive expectations does not allow agents to learn from their mistakes
What are systematic errors
Errors that are not determined by chance but are introduced by an innacuracy (involving either observation or measurement process) inherent to the system.
What are the characteristics of rational expectations
Forward-looking behaviour
Agents do not make systematic errors
Expectation formation behaviour is ‘model consistent’ (agents inside the model are assumed to “know the model” and on average take the model’s predictions as valid)
What will happen if the markup increases in the labour market
Price setting curve moves downwards, refer to the Price setting equation
Why is inflation bad?
Erodes savings
Discourages investment
Stimulates capital flight
Inhibits growth
Difficult to make economic plans
Provokes social and political unrest
Types of models used for monetary policy framework
Models are theoretically based and data driven (statistical and spreadsheet forecasts, structural, macroeconomic)
New Keynesian models - all actors are forward looking and use RE
DSGE models (Dynamic Stochastic General Equilibrium) - micro-foundations, include forward looking behaviour
How are the Central Bank’s preferences shown?
By a Loss function.
L = (yt - ye)^2 + β(pit - pi^T)^2
When the Phillips curve is on the CB preference curve, what is the most preferable outcome?
The intersection which is closest to the centre
Rational Expectations: implications
Economy is at equilibrium output, and inflation is at target (assuming no random shocks)
Dynamic behaviour of inflation disappears
Inflation not built into the system, so no costly disinflation
Simpler job for the CB
No policy lags in the AD
Also, no role for a stabilising CB to move the economy to equilibrium
The CB can influence expectations directly since wage and price setters are forward looking: under adaptive expectations, actual inflation has to fall before it affects pi^E
Expectations and the Lucas critique
Models that rely on relationships found in historical data are problematic. Relationships in historical data are conditional on past policy regimes, and will break down if the policy regime changes.
Economic agents change their behaviour in response to the new policy regime. Problematic if agents use rational expectations, but policy maker interprets data as though they are not REH agents.
Applications in the 3-equation model under REH: Govt spending effects & revoking CB independence.
Anchoring expectations
Central bank communication is used to keep inflation expectations anchored at the inflation target.
If the inflation target is perfectly credible and expectaed inflation is anchored, then an inflation shock will only last for one period.
There is costless disinflation (unemployment does not rise): The PC reverts back to the one indexed by the inflation target in the next period.
How to mitigate inflation bias
Commitment - optimal contracts between the CB and the govt
Delegation: independent central bank, central bank has different preferences from the govt, long-tenures of MPC members, central bankers are more inflation averse
Reputation building (game theory solution)
Negative correlation between central bank independence and average inflation
What does Tax (T) equal?
Taxation revenue - transfers
Permanent income hypothesis (Ricardian equivalence)
Forward looking agents will anticipate will have to pay higher taxes in the future and will not increase consumption
They will save, rather than spend the extra disposable income to pay for expected future tax increases that will be used to pay off the debt
Ricardian equivalence only works under these conditions
No credit-constrained households, able to borrow at preveailing interest rate (PIH)
Interest rates and time horizon faced by households and govt are equivalent
Households behave as if they are infinitely-lived (e.g. children’s utility incorporated in Consumption decisions)
Ricardian equivalence: implications for fiscal policy
Temporary tax cut → implies T ↑ later → T cut is saved C”↓”, AD unchanged!
Temporary rise in G, debt-financed → ye ↓ but cut in C spread across all periods → Fall in C
< Rise in G → AD ↑ in period 0, ceteris paribus.
Temporary rise in G, tax-financed (same as above by RE–PIH)
The assumptions that do not hold in Ricardian equivalence
Credit constraints - Consumption smoothing absent; Higher disposable income increases consumption
Govt has lower interest rate: households prefer debt-fi nancing (cheaper) over tax-fi nancing
Households do not always behave as if they are ∞-lived
e.g. No bequest to children
But financial market development found to strengthen Ricardian effects
Zw in the Wage-setting curve is a set of wage-push variables, what might they be?
Institutional, policy, structual and shock variables
What is the Gini Coefficient?
It measures how even how evenly distributed a variable is amongst the population, most frequently income.
Generally, why do advanced economies have a lower gini coefficient than emerging markets and developing economies?
Because taxes and transfers occur
What is a welfare state?
A set of govt policies designed to provide improvements in the welfare of citizens by assiting with income smoothing (for example, unemployment benefits and pensions)
Difference between progressive and regressive
Progressive: an expenditure or transfer that increases the incomes of poorer households by more than richer households, in percentage terms.
Regressive: an expenditure or transfer that increases the incomes of richer households by more than poorer households, in
percentage terms
Phillips Curve equation
πt = πt−1 + α(yt − ye)
What is stagflation?
Stagnation + inflation
What is stagnation?
Stagnation is a prolonged period of slow economic growth, usually accompanied by high unemployment.
Taylor rule equation
rt − rs = γ1(πt − πT) + γ2(yt − ye)
Monetary Rule equation
(yt - ye) = -αβ(πt - πT)
Value of β in the loss function with definitions
β = 1 - CB is equally concerned about inflation and output deviations from its targets
β > 1 - CB places less weight on deviations from employment (output) from its tagret than on deviations on inflation
β < 1 - CB places less weight on deviations from inflation from its tagret than on deviations on output
What does the Loss function truly mean?
The higher the value of the Loss function, the worse-off the CB is
Why is deflation bad?
It increases the real burden of debts (lenders benefit but they tend to have a greater propensity to save than borrowers)
If anticipated, consumers delay purchases:
-Effects on real interest rate
-Zero lower bound (nominal interest rate cannot be negative)
Deflation increases rigidity in the market
