EC2B5 Flashcards
1
Q
IS-LM Model
A
IS: goods mkt equilibrium
- downward sloping
- AS = AD
- C + I + G (assumes closed economy)
LM: money mkt equilibrium
- money supply = money demand
- liquidity preference theory
- money supply is independent of the interest rate and is fixed by the CB, therefore vertical
useful for understanding the role of policy in stabilising economic fluctuations (fiscal and monetary policy)
2
Q
Liquidity Preference Theory (Keynes)
A
people hold money in order to undertake transactions (medium of exchange)
increase in GDP = increase in spending
3
Q
Crowding out
A
increase in income (AD) induces an excess demand for money, hence interest rate increases, but, this decreases investment spending which partially offsets the increase in AD.
4
Q
LRAS
A
In the long run, AS depends on the productive potential of the economy, labour supply, capital shock and productivity. This fixed level of output in the LR is known as the natural rate of output.
5
Q
Phillips Curve
A
Tradeoff between unemployment and inflation
- as inflation increases -> the cost of goods and services increases -> firms have more revenue -> firms employ more -> unemployment decreases
In the LR, unemployment is fixed at the natural rate of unemployment, so there is no such tradeoff. w
6
Q
Why does unemployment reach the NRU in the LR?
A
because the economy eventually adjusts to any changes in aggregate demand or inflation, leading to the labor market returning to equilibrium.
7
Q
Why does the SR Phillips curve shift up?
A
workers need to form an expectation of future inflation when negotiating wage increases. An increase in inflation expectations leads to higher inflation (wage spiral).
At the intersection of SPRC (diagonal downwards) and LRPC (vertical), inflation expectations = actual inflation.
8
Q
time inconsistency of monetary policy
A
governments understand that low inflation policy is in the LT interests of society, BUT they cannot stick to it due to their short term electoral incentives!
Before an election, may want to decrease employment so decrease i.r. to increase AD & inflation…
This meant that i.r. & inflation target couldn’t be controlled by the government any longer… CB independence (1997)!
9
Q
CB independence involves inflation target & penalty - advantages and disadvantages?
A
Advantages: reduces expectations
Disadvantages: with a supply shock, the CB faces a fundamental tradeoff between inflation and output stabilisation. A negative supply shock causes stagflation (inflation combined with recession).
A negative supply shock, which reduces the economy’s ability to produce goods and services, the CB can try to stabilize output, but this may lead to higher inflation, or they can focus on controlling inflation, which might worsen the recession.
10
Q
inflation nutter
A
exacerbates fluctuations in output and unemployment
11
Q
unemployment nutter
A
exacerbates fluctuations in inflation
12
Q
The FED’s dual mandate (Taylor Rule)
A
- achieve both price stability and maximum employment
- the TAYLOR RULE describes conduct of monetary policy
TAYLOR RULE
- interest rates should increase by 1/2%:
for each 1% increase in inflation above target
for each 1% increase in output above the natural rate
however, decreases transparency.
13
Q
speculative asset pricing bubble
A
a speculative asset pricing bubble occurs when:
- asset prices depart from their fundamental values
- as measured by the stream of FCF generated by the asset
excessive optimism -> speculative investment (information cascades) -> rising prices (+ stimulated by an increase in credit supply) -> excessive optimism
rising prices induce new investors to engage in the practice of leverage
- leverage is the use of borrowed funds for the purpose of investment in financial assets
- banks require they post collateral to ensure that borrowers repay their loans
14
Q
LTV ratios
A
LTV = maximum loan amount/collateral value
from 2002 to 2005, banks massively expanded mortgage credit to marginal households
- not based on improvements in income
- driven by a fall in bank funding costs
increased lending to borrowers with poor credit history and high LTV ratios
15
Q
what caused the US credit boom?
A
housing bubble was driven by speculative investors, hence, credit growth was an effect, not a cause, of the housing bubble
credit growth was demand-driven
expansion of credit availability by banks drove house price increases
banks lowered their lending standards
credit growth was supply driven (decrease in bank funding costs)
16
Q
did banks or speculators cause the US housing bubble? what is the consensus?
A
both played a significant part
- policymakers cannot do much to curb speculative investment
- but they can restrain bank credit expansion through macroprudential regulation
the expansion in credit supply and speculative investment fuelled house price inflation
17
Q
a role for monetary policy - LATW
A
increase interest rates higher than required to meet the inflation target during the boom phase
(-) the credit cycle is defined as expansion and contraction in the availability of credit over time.
the credit cycle has lower frequency (16-20 years) than the business cycle (5-8 years)
they are typically NOT synchronised
hence, LATW might require tightening monetary policy during a recession
18
Q
macroprudential policy
A
the application of financial regulation to product the real economy from swings and cycles in the financial system
its primary objective is to restrain credit growth during the boom phase.
two targets (inflation & credit growth) and one instrument (macroprudential tools - LTV ratios etc.)
19
Q
key macroprudential tooks
A
- counter cyclical capital requirements or reserve requirements
- caps on LTV
- caps on debt to income (DTI) ratio
- ceilings on credit growth
they all operate by forcing banks to restrict the supply of credit
20
Q
why is macroprudential policy better than monetary policy?
A
monetary policy is a blunt tool for dealing with a credit boom
- a few pp increase in interest rates will have little impact in curbing speculative investment
macroprudential tools are a more targeted weapon: it cuts off credit supply at the source
21
Q
PS FS model
A
illustrates the interactions between monetary policy and macroprudential policy
R: interest rates (x axis)
K: macroprudential tool (e.g. LTV ratio) - y axis
22
Q
PS curve
A
traces out all combinations of R&K for which the economy satisfies the inflation target
downward sloping because an increase in R means inflation falls below target, which requires an offsetting easing in K to return to the PS curve
WHATEVER HAPPENS ON THE AXIS DETERMINES WHAT HAPPENS TO THE CURVES!
23
Q
FS curve
A
traces out all combinations of R&K for which the economy satisfies the credit growth target
downward sloping because a decrease in R means credit growth increases above target, which requires an offsetting tightening in K to return to the FS curve
flatter than PS curve because a 1pp increase in K has a larger impact on credit growth than inflation, hence requiring a larger offsetting reduction in interest rates
at the intersection of the FS and PS curves, the economy is at both the inflation and credit targets, this is known as the macro financial equilibrium.
24
Q
Explain why the PS and FS curves are downward-sloping.
A
Price stability curve traces out all combinations of R & K for which the
economy satisfies the inflation target. If R rises,
AD decreases, hence inflation falls below target. To get back to
target, we require an offsetting decrease in K (i.e. easing in LTV ratio), which
increases the availability of credit to firms for investment, hence AD increases
and inflation rises back to target at point C.
Financial stability curve traces out all combinations of R & K for which the
economy satisfies the credit target. Start at point A. A decrease in
K increases the supply of credit, hence credit growth increases above target
To get back to target we need an increase in R, which increases the
cost of borrowing and decreases demand for credit, hence credit growth falls
back to target at point C.
25
subprime mortgages
involved lending to high risk borrowers with: poor creditworthiness, low income, high LTV ratios, "NINJA" (no income, no job, no assets) loans
globally low interest rates drove a search for yield, which made subprime mortgage lending an attractive prospect
26
mortgage securitisation "originate and distribute" model
1. originator banks made loans to subprime borrowers
2. they then securitised these loans, i.e. repackaged them into tradeable bonds known as mortgage backed securities (MBS)
3. they then sold them to other investors
4. the interest and principal payments from the borrowers' mortgages are used to pay interest on the investors' MBS bond
5. the default risk is mitigated through a process known as risk diversification, the MBS bonds are effectively made up of small bits of many different mortgages whose risks are uncorrelated.
27
tranching
- MBS bonds were sold at different varieties known as tranches, bearing different degrees of risk.
- investment grade bonds had the lowest risk: they were first in line to receive payments from the mortgage pool
- higher risk equity grade bonds were compensated with a higher interest rate
INVESTMENT GRADE AAA
MEZZANINE GRADE BBB
EQUITY GRADE Bb (highest risk and it)
28
collateralised debt obligations
mezzanine MBS were usually repackaged and sold as new securities; collateralized debt obligations (CDOs)
- essentially through a subsequent round of diversification and securitisation.
29
the subprime mortgage CRISIS
mortgage securitisation relied on the flawed assumption that individual mortgage risks were uncorrelated, I.e. not all borrowers would default simultaneously.
BUT SOMETIMES THEY DO!
in 2007, subprime borrowers started defaulting on their loans in significant numbers
US FED increased their interest rates by 4% (which led to a much greater increase in mortgage rates)
in August 2006, house prices had started falling on annual terms
30
insolvency
a bank is insolvent:
- if A
31
illiquidity
a bank is illiquid when
- it doesn't have the funds to meet its current debt payments
- i.e. its TEMPORARILY unable to pay its bills
- it should be bailed out (lender of last resort)
32
northern rock bank run
NR was a medium sized UK mortgage bank, with minimal exposure to subprime assets. It relied heavily on borrowing from other financial institutions rather than traditional retail deposits.
Hence, NR experienced a liquidity shortage, it was temporarily unable to roll over its debts but it was NOT insolvent. Hence, it was forced to seek liquidity support from the BofE.
this initiated rumours that NR was insolvent due to subprime losses -> herd behaviour -> deposits withdrawn -> bank run!
33
bank runs
banks only keep a small % of deposits as reserves. They lend the rest out to firms and households. This is known as fractional reserve banking.
They only need to hold a small % of reserves because normally only a small % of depositors will need to withdraw their cash at any given moment.
1. first reserves are depleted
2. then loans must be liquidated at "fire sale value" i.e. below their market value because the bank needs cash in a hurry
3. the bank cant meet all withdrawal demands because
reserves + fire sale value of loans < deposits
4. it runs out of money and is closed down
34
capital ratios
banks exposed to subprime losses were concerned about the erosion of their capital ratios
capital = A - L
capital ratio = A/L
banks hold capital to create a cushion against losses and thus reduce the risk of insolvency
a bank becomes insolvent when capital is depleted to zero
35
how can banks raise capital
by issuing shares on the stock exchange.
36
deleveraging
banks which had incurred subprime losses were anxious to rebuild their capital ratios. They replenished their capital ratios by the process of deleveraging.
- selling assets and repaying debts
- cutting lending
- which caused the credit crunch and global recession
37
reforms to financial regulation
there is a minimum amount of capital banks must hold as a % of total assets: set up by the Basel committee on banking supervision and adhered by banks across the world
until recently, they were determined by the Basel II accord, which imposed a minimum capital requirement of 2% i.e. shareholder equity/total assets > 2%
where total assets measures RISK WEIGHTED assets
- lower risk assets are down weighted
- e.g. govt bonds 0% weight, AAA corp bonds 20% weight
38
reforms to financial regulation - Basel II vs Basel III
Basel II also allowed banks to estimate their own risk exposure and self report their required regulatory capital: resulting in under capitalisation during the Boom phase of the credit cycle
In 2013, basel III was introduced to address these inefficiencies
- MCR was increased to 4.5%
- capital conservation buffer of 2.5% was also introduced (banks cannot pay dividends if they fall into this buffer zone)
39
reforms to financial regulation - counter cyclical capital buffer
requires banks to hold 2.5% of capital during boom phase to curb excessive credit growth and dampen the credit cycle
40
reforms to financial regulation - liquidity coverage ratio
requires a bank to hold sufficiently high quality liquid assets to cover its total net CF over 30 days
41
reforms to financial regulation - volker rule
bans commercial banks from proprietary trading, trump administration relaxed these rules
42
zero lower bound
as a result of the financial crisis and falling GDP, banks wanted to lower interest rates, but interest rates could fall no further, monetary policy had reached the zero lower bound.
- several countries had set negative i.r. on commercial bank reserves, but this is more difficult to retail customers due to the the alternative of holding CASH
- therefore, policy rates were stuck at 0
43
unconventional tools of monetary policy
1. QE
2. forward guidance
these were designed to decrease long term interest rates, i.e. flatten the yield curve
44
yields
return on bond based on its current price
45
bond yields
yield = coupon+principal / (price)
there exists a negative relationship between bond prices and yields
46
no arbitrage condition
short term interest rates are determined by the policy rate, investors can choose between buying a bond or depositing it in the bank. Hence, the yield on a LT government bond must equal an average of the policy rates over the life time of a bond.
- would be higher/lower depending on if markets expect the BofE to increase/decrease the interest rate in the coming years, markets "price in" this info.
- interest is higher on LT bonds than ST bonds because they incur a greater interest risk, (greater amount is known as liquidity/term premium)
47
QE steps
1. new electronic money is created by the central bank
2. this is used to buy assets e.g. bonds from financial institutions
3. bond price goes up
4. bond yields go down
5. financial institutions, after having sold bonds, now have more cash
6. in other words, there is more liquidity in the financial system
7. greater liquidity incentivises banks to lend more
8. also decreasing yields decreases interest rates
9. so there is more, cheaper credit so consumption and investment both increase
10. also, as bond/asset prices rise, this causes a positive wealth effect
11. therefore there is an increase in net exports due to decreasing interest rates
12. AD increases
48
the main channels through which QE operates
1. wealth effect: lower yields (ir) lead to higher share and bond prices
2. borrowing cost effect: QE lowers the IR on long term debts such as mortgages and govt bonds
3. lending effect: QE increases the liquidity of banks, increased lending from banks lifts incomes and spending in the economy
4. currency effect: lower interest rates has the side effect of causing the exchange rate to weaken (depr) which helps exports
49
portfolio rebalancing
how did falling government bond yields feed through to the real economy?
- through the portfolio rebalancing channel: change in the mix of assets held by the private sector
1. falling government bond yields spill over to other markets (e.g. corporate bonds) through the process of general equilibrium
2.banks use their excess reserves to buy private sector assets and increase lending to firms and households
50
government bond market
think of this as the supply and demand for funds
- demand for funds comes from the government seeking to finance its budget deficit
- supply of funds comes from investors seeking to buy bonds
- mkt yield of government bonds is determined at the equilibrium
- increased supply of funds means bond yields fall in order to restore market equilibrium
51
what happens to corporate bond yields wehn the BofE increases government bond purchases?
DEMAND IS VERTICAL
supply of government bonds increase which means that the yields of govt bonds decreases. so investors switch out of govt bonds and into higher yielding corporate bonds until their yields are equalised (S increases for corp bonds and so P decreases)
so: yields on government and corporate bonds have decreased due to banks holding excess reserves from QE operations. this induces banks to boost lemdog to firms instead, which earns a higher interest rate.
The supply of credit increases hence bank loan rates decrease so firms lend more!
BUT, although this can increase GDP, some commentators have argued that the additional money creation has been diverted into other asset creating bubbles (shares/bitcoin)
52
why is demand on the yield curve vertical
demand for funds comes from firms issuing bonds to finance investment spending.
A vertical demand curve means that the quantity of funds demanded doesn’t change much with interest rates — or, in some cases, not at all.
53
forward guidance
an implicit commitment by the CB to hold i.r. "lower for a longer period" (depress LT yields by depressing mkt expectations of the future interest rates)
this pledge suffers from the time inconsistency problem, as soon as economic recovery is underway, the BofE would be tempted to renege and raise rates to curb inflationary pressures.
markets anticipate this, hence the yield curve doesn't flatten as much as desired
abandoned in both the UK AND US!
54
nominal exchange rate
the rate at which a person can trade the currency of one country for the currency of another (the foreign price of domestic currency)
55
real exchange rate
the rate at which a person can trade the goods of one country for the goods of another (relative price)
56
floating exchange rate
- determined by market forces
- adjusts freely in response to changing market conditions
57
fixed exchange rate
- the central bank announces a target for the exchange rate and "defends" it by intervening in the forex market
- fixed against a foreign currency
58
the mundell fleming model
- extends IS-LM by incorporating trade in goods and services, capital flows, assuming a small open economy with perfect capital mobility
- domestic and foreign financial assets are considered PERFECT substitutes
- interest rates across all countries are the same, determined at the intersection of world supply and the demand for money (r*)
- domestic interest rate is fixed (at the world rate)
- capital flows are a key driver of exchange rate movements, driven by interest rate differentials. if IR increases, capital flows increase = appreciation
- IS is downward sloping (but investment is constant) and LM Is fixed and verticle because r doesn't vary and the exchange rate doesn't affect the money market
59
what is capital mobility
perfect capital mobility imples that the interest rate r in our domestic economy must equal the world i.r.
- if r>r*, capital inflows would decrease r to r* and vice versa.
60
fiscal policy under a floating exchange rate
an increase in government spending means an increase in AD which means an increase in IS so the exchange rate increases but NO effect on Y
in a small open economy, fiscal policy is completely ineffective
govt spending also increases the demand for money so r increases
this causes capital inflows so r falls back to r* but appreciation occurs
this makes domestic goods expensive relative to foreign goods, so NX fall, which offsets the expansion due to fiscal policy, i.e. crowding out!
(isn't the case in a closed economy because there are no NX)
61
monetary policy under a floating ER
increase in money supply by BoE increases LM so ER and Y increase.
increases supply of money causes excess supply of money, hence, the domestic IR starts to fall to restore the money mkt eqm.
as r
62
fiscal policy with fixed ER
increased GS, increased IS, increased i.r., r>r*, capital outflows, currency appreciation, BoE intervention, increased money supply due to BoE, creating money and buying foreign currency, Lm increases, er unchanged, Y stays high
WORKS
63
monetary policy with fixed ER
increase in LM, decreased er, r
64
self fulfilling prophecy
selling a borrowed asset when the price is high, and buying it back when the price subsequently falls
65
self fulfilling crisis
- if no one expects a devaluation, investors stay calm, no crisis
- if everyone expects a devaluation, everyone panics, currency devalues, CB uses foreign reserves to buy up its own currency, BUT this drains reserves fast!
- if reserves run out, currency can't be defended. it is forced to abandon the peg and it crashes.
66
country risk
- the risk of default on debt due to political instability/fiscal imbalance
- extra amount is known as country risk premium
- risk premium would be sufficiently high so that the expected (avg) return from investing in venezuelan bonds equals the return from investing in US bonds
67
currency risk
the risk of exchange rate fluctuations when investing in foreign assets
- extra amount is known as currency risk premium
- UIP condition:
rUK - rUS = % depr
68
risk premium
- in a small open economy, r=r*
r = r*+theta
where theta is the risk premium for both country and currency risk
for heavily indebted countries, r must be higher than r*, to prevent capital outflows
but, the increased r means that there is a decrease in investment spending, deceased money demand, and decreased AD (IS and LM decrease)
fall in investment means IS decreases so the demand for money decreases and r decreases and er decreases, bank intervenes by buying pesos and selling dollars, so LM* decreases, money supply contracts, e.r. reverts to its target level, no offset in terms of NX, so GDP remains low
69
what if banks just let their currency devalue?
- sell pesos and buy dollars -> increases LM -> decreases exchange rate -> net exports increase and GDP increases,
but this increases currency risk premium, as the UIP condition must always hold!!
hence, domestic interest rates increase further, deepening AD and the recession...
70
measures to increase gdp with fixed currency
1. dollarization
2. central bank autonomy
3. massive debt relief
4. fiscal policy
71
why should we fix over/undervalued currencies anyway?
+ reduces e.r. volatility
+ a surge in capital inflows can be destructive for exporters, a surge in capital outflows increases insolvency risks for firms holding foreign currency debt
- monetary independence
- vulnerability to speculative attacks
72
capital controls
restrictions on the free movement of capital across borders
- impedes the flow of capital to its most productive uses and harms economic growth
- misaligned e.r. along with capital controls can cause global economic imbalances.. political tensions!!
73
china's trade surplus
- from the late 1990s onwards, china has run persistently large trade surpluses with the US
-> trump has retaliated by engaging in a savage tarriff war with china!
74
is china a currency manipulator?
Y = C+I+G+NX
Y-C-I-G=NX
this shows that if a country produces more than it consumes/invests/spends, the extra output is exported -> trade surplus
add taxes
Y-T-C-I+(T-G) = NX
this separates private savings and government savings:
Y-T-C = private saving
T-G = govt saving
assuming the government has a balanced budget T=G then T-G=0
so the equation simplifies to S-I=NX
where S is savings and I is investment
so:
if savings > investment, then NX are positive -> trade surplus!
75
why is china's savings rate so high?
- one child policy
traditionally, children support parents in old age (transfer channel)
one child policy -> fewer children -> more financial saving instead
china's excessive savings -> US loanable funds -> the dollar appreciates -> US trade deficit
china's excessive savings -> US loanable funds -> the supply of US loanable funds increases -> the interest rate US decreases -> borrowing and spending increase -> US trade deficit
therefore, there are capital outflows from china, and the dollar appreciates against the remibi. so china isn't a manipulator! it's the result of high savings!
76
modiligani's life cycle hypothesis
in developed economies:
- middle aged save
- young/old borrow
in china:
- borrow is constrainted due to inefficient, state controlled banking
-> lend mostly to state owned enterprises, limited lending to the private sector
77
china's trade surplus: policy recommendations
- embrace financial liberalisation
1. remove capital controls
2. open markets to foreign banks
shift from:
investment/export led growth -> consumption led growth
78
a currency union
an agreement amongst members to share:
- a common currency
- a common i.r.
- a common exchange rate
79
the dollarzone
- created an economic superpower
- became the international reserve currency
- endured for over 200 years
80
the eurozone
- monetary policy controlled by the ECB
- prospered for over a decade
- european soverign debt crisis erupted...
81
european debt crisis
- banks' assets grew rapidly in the run up to the financial crisis
- credit growth fuelled and was in turn fuelled by massive housing booms
- european house price bubble also burst
- banks faced insolvency -> losses!
- government bailouts increased public debt
- EU economies required bailouts from the ECB - this was more severe in some countries
82
why join a currency union?
+ benefits > costs
+ economic integration (trade & labour)
+ fixed exchange rates vs sacrificing monetary policy (GGLL model)
+ trade integration, export out of recession
+ real wage depr
asymmetric shocks lead to falling labour demand, which increases unemployment and decreases real ways, this increases firm revenues due to lower labour costs which increases competitiveness!
- but most EU economies have inflexible labour markets, hence real wages don't fall in response to -ve demand shocks and unemployment stays high (tradeunions etc.)
- monetary independence - "one size fits all" asymmetric shocks
- contagion mechanisms
due to uncertainty in ireland following greece's crisis, the ECB massively repriced the risk of Irish govt bonds mkts because they believed ireland was about to default, so it did default! therefore, self fulfilling prophecy increases country risk premium which increases the i.r. ireland has to pay
- doom loop
83
the doom loop
1. bank insolvency risk increases
2. government bailout is required
3. country risk premia increases
4. government bond prices fall, interest rates increase
5. banks lose out! assets erode, capital ratio erodes, insolvency
6. banks insolvency risk increases
investors were concerned that govt borrowing difficulties would contrain bail out funds, deposit insurance committments, and therefore stopped investing in greek bonds. hence, the doom loop induced a "sudden stop" in capital flows, affected economies fell into DEEP recession (increasing ir, credit crunch...)
84
GGLL model
LL: show how the costs of economic integration vary depending on asymmetric shocks (the cost of giving up monetary policy)
GG: the benefits of joining depend on the level of economic integration (the benefits of a fixed exchange rate)
85
optimal currency area
a group of countries whos economies are sufficiently integrated by trade and labour mobility such that gains>losses from joining
86
conditions for OCA
1. trade integration
- EU states have less trade amongst each other
+ US states trade more
2. real wage flexibility
- EU real wages are inflexible due to strong trade union power and employment regulation
+ US labour mkts are much more flexible: language & culture
3. labour mobility
+ US higher: less generous welfare payments
- EU
4. fiscal federalism: fiscal transfers can be used to cushion against asymmetric shocks, tax revenues are redistributed from prospering -> depressed states
+ US uses federal income tax for this purpose (20% of GDP)
- EU federal budget is 1% of GDP
5. banking union: common arrangements across countries for: bank supervision, bank resolution, deposit insurance
+ EU
+ US
87
Brexit and the Euro
- mass migration from depressed european economies fuelled anti immigration settlement in the UK
- european leaders realised that monetary union cannot work without the institutional infrastructure that exists in the US, hence they have called for fiscal federalism and political union
- britain was alarmed at the prospect of being ruled from the distant, so it voted "no".
88
how can governments lead to default
govts which run persistent budget deficits risk public debt becoming unsustainable. at this point, they can no longer afford the i.r. payments on debt, leading to default
- tax revenues collapse
- unemployment benefits soar
- large scale bank bail outs are required
89
greece debt crisis
- greece enjoyed a substantial reduction in its risk premium when it joined the euro
- govt took advantage of cheaper borrowing costs and splurged
- 2010: GDP to debt ratio stood at 148%
- which was concealed through creative accounting and revealed only in 2010
- this prompted concerns about insolvency, which led to:
1. soaring borrowing costs
2. sudden stop in capital flows
90
the greek debt crisis
1. greece was on the brink of default
2. EU leaders decided greece must be recued
3. it recieved bailout loans of 110bn from the troika (ECB, IMF, european commission)
4. in 2017, greece defaulted on IMF loan repayments of 1.7bn
5. greece insisted on a 3rd bailout package, but the troika insisted on swinging austerity measures
6. greece gave in and took a third bail out package of 86bn
91
greece & troika's demands
GREECE
1. debt relief (30% writeoff on outstanding public debt)
2. postpone all debt repayments for 2 years
3. austerity measures were sapping AD from the economy, they should be postponed until economic recovery took place
TROIKA
1. immediate reduction in public debt
2. increased tax rate
3. wages and pensions vuts
4. sale of state assets
5. improve labour mkt competitiveness through supply side reforms
6. grexit...
92
what is a sustainable level of debt?
- where the government can meet its debt obligations WITHOUT incurring excessive costs/risking default (about 120% of GDP)
93
the disadvantages of excessively high debt
1. the crowding out effect
the govt borrows more -> increases demand for loanable funds -> increases interest rates -> makes borrowing more expensive for private investors -> private investment spending is reduced ("crowded out")
2. high debt levels raise fears that a currency may default on its obligations -> increases country's risk premium (investors demand higher returns for higher risks) -> can trigger a currency crisis!!
94
fiscal stimulus vs austerity
essentially a debate on the size of the fiscal multiplier. the fiscal multiplier tells us: given a $1 tax cut, how much does overall income increase?
1. keynesian view
2. expansionary austerity view (richardian equivalence)
95
fiscal stimulus - keynesian view
- households base their spending decisions on current income alone! (liquidity preference theory)
- taxes cut means household spend the extra income and the fiscal multiplier is LARGE
- therefore, tax increases can have damaging negative spillover effects on AD
- hence, keynesians OPPOSE austerity measures during a recession
a large fiscal multiplier means that austerity CUTS can actually EXACERBATE DEBT!
e.g.
D = 100bn
Y = 100bn
D/Y = 1
now suppose the govt cuts spending by 20bn and the multiplier is 2
D = 80bn
Y = 60bn
D/Y = 133% increased!!
96
fiscal stimulus - expansionary austerity view
- the fiscal multiplier is SMALL
hence, the adverse effects of austerity would be limited
this means that the costs of austerity > benefits of austerity (i.e. austerity is actually expansionary)
this is because of the RICHARDIAN EQUIVALENCE
households will save more to pay the higher bills they expect in the future because they know that the govt needs to balance its books over the LT. this is known as CONSUMPTION SMOOTHING (households choose to maintain a constant level of spending over time!)
this arsis due to diminishing marginal utility: deriving more utility from consuming one unit everyday than all the units during good times and none in bad times
97
richardian equivalence
under richardian equivalence, tax cuts have no impact on consumption and AD... because the decrease in public spending is offset by an increase in private saving
tax cuts -> tax decreases -> people pay less tax -> govt has less tax revenue -> individuals now know that tax cuts mean higher taxes in the future -> instead of spending their higher after tax income, they put it into SAVINGS , therefore no increase in spending!
thus, the proponents of austerity argue that immediate tax hikes wouldn't harm economic recovery, households would simply increase their borrowing in order to spread the cost of a higher tax bill over a no. of yrs
IF UNABLE TO BORROW -> cannot smooth consumption over time -> use tax cuts to boost current spending (cuts act like a loan from the govt) -> richardian equivalence doesn't hold
SO AUSTERITY MEASURES MEAN AD DOESNT INCREASE AND THE GOVT ACTUALLY HAS MORE RESERVES!!
98
why would fiscal stimulus have boosted spending in greece?
greece had suffered a severe financial crisis -> banks cut lending due to deleveraging (decreasing debt) and sudden stop of capital flows -> fiscal stimulus would have boosted spending, by giving cash to credit constrainted customers
fiscal multipliers tend to be large in the aftermath of the FC
99
greece labour mkt reforms - merkel
merkel argued that greece's economic stagflation was due to failure in AS, not AD
- greece has an overregulated economy
minimum wage was high, there was strong employment protection and union power which would have otherwise led to wage depr and increased competitiveness and this created an unfavourable business environment, lowering AS
a reduction in real wages would lower labour costs, firms would respond by boosting production and cutting prices, AD would increase, AS would increase, this would increase real money supply and LM would increase
BUT IN GREECE:
due to high indebtness, falling prices didn't stimulate economic recovery due to the concept of debt deflation!
greek households cut spending and paid down debt that had been accumulated
hence, the impact of fall in P on AD was significantly diminished
increase in I was offset by an decrease in C
so merkel was wrong, SSPs were necessary, but should have been combined with expansionary microeconomic policy!!
100
solow growth model - the basics
- used to understand long term economic growth
- explains how countries mainly grow through capital accumulation (i.e. investing in machinery etc.)
- according to the model:
1) poorer countries tend to grow faster than richer countries
2) over time, they catch up to the income levels of richer countries
3) this catching up process is called convergence
101
production function
- shows how inputs (labour and capital) are used to produce output (G/S)
Y = F(K,L)
where:
Y = output, K = capital, L = labour
- to simplify, we assume labour (L) is constant
y = f(k)
where:
y = Y/L = output per worker
k = K/L = capital per worker
102
marginal product of capital (MPK)
- the additional output produced by adding one more unit of capital per worker
- the slope of the production function
- each extra unit of capital adds less and less additional output: so gets flatter
103
investment function
- capital accumulation occurs through the process of investment: defined as the expenditure on plant and equipment
- investment is determined by the level of savings in the economy
1. households save a fixed fraction of their income, where s denotes the savings rate
2. savings are channelled for firms for investment through the market for loanable funds
inv = sy = sf(k)
- given than investment is a fixed fraction of output, it always lies below the production function and it has a similar profile
output - investment = consumption
104
depreciation
- capital stock is also offered by depreciation, the wearing out of old capital.
- a fixed proportion of capital stock depreciates every year, hence: depr = Bk
where B = depr rate
105
capital accumulation
the change in capital stock depends on two factors:
- if investment>depr -> capital increases
- if depr>investment -> capital decreases
so which effect dominates?
for poor countries (with a small k), investment>depr, therefore capital keeps growing over time.
but, at some point, when investment is exactly offset by depr, capital STOPS growing (k*)
this is called the steady state capital stock k*. where the economy reaches a LR equilibrium and economic growth grinds to a halt
106
convergence
- solow model: poor countries eventually catch up to the income levels of rich countries because capital is MORE productive when there isn't much of it around
- an extra unit of capital yields a large increase in output and therefore a larger increase in savings, thus, investment hugely outstrips depreciation, hence capital and therefore incomes grow faster
- an absolute convergence: poor countries grow faster than rich countries, not borne by real world evidence
- conditional convergence: poor countries don't grow faster than rich countries due to institutions (legal system, political stability, competitive mkts, etc.)
107
savings rate
- another possible explanation for observed disparities is the difference in savings rates
- what happens if the savings rate increases?
investment function shifts up, investment outstrips depreciation, capital stock grows to a higher k*
- therefore a higher savings rate trades off lower SR consumption with higher LR consumption, but an increase in the savings rate doesn't GENERATE LR growth. so how do advanced economies keep on growing? technological innovation!!
108
technological progress
- an extension of the solow model shows that LR growth arises from technological progress
- innovations will increase the productivity of labour and capital outputs
increases f(k) which increases k* which increases overall LR growth
BUT...
1. where does the technological progress come from?
2. why is it higher for some countries than others?
3. what is the role of policy?
the solow model CANNOT answer these questions, it assumes technological progress comes out of nowhere
109
endogenous growth theory
- address the shortcomings in the solow growth model
definition of capital stock is broadended to include knowledge; knowledge generates a positive production externality; explains the source of LR growth
e.g. scientist creates a new drug -> her underlying research becomes part of the capital stock -> other scientists can exploit this knowledge to create even better drugs -> more ideas for entreprenures to build upon and create even better expansions/innovations
- capital NO longer suffers from diminishing marginal productivity -> machines depreciate by knowledge never gets "used up"
- B(k) and s(fk) become straight lines (invesment is greater than depr therefore K and Y continue to grow in the LR) - difference between them is investment
this explains:
1. why some countries grow fast even when rich
2. why policy matters (investing in education,innovation,etc.)
3. why growth is self sustaining
110
intellectual property
- creates incentives to innovate
- gives a temporary monopoly to investors so they can recoup their investment costs
- without the IP protection, others could just copy the idea instantly - discouraging innovation!
BUT, to get a patent, inventors must publicly share how the invention works, this is good for society (spread of knowledge) but also risks such as IP theft or being copied illegally.
Trump accused china for IP theft which led to their trade way
111
how can the government prevent under investment in R&D activity?
tax breaks for firms engaging in R&D, government promotion of high tech industries
-
Key Links
-
Subjects
-
Company
-
Find Us
-
