Exam Flashcards
AT its core, what is the study of economic markets about? (4)
- allocation of scarce resources amongst competing ends
- improvements in allocation of resources raise productivity, income and living standards
- role of money & finance in broader economy and the ways finance can be allocated around the economy
- Key factors promoting efficient allocation of finance as well as main drivers that distort allocation of finance
Is conventional macroeconomics broken (consider booms, busts & overshoots (4)
- Booms & busts have always existed since commerce began
- recent bust: conventional economic thinking was too simplistic & over optimistic
- macro ec theory & models make too many simplifying assumptions (rational, perfect competition, institutional & political & legal system do matter for performance)
- 5 classes of animal spirits: confidence, fairness, corruption, money illusion, stories
- conventional macroec thinking places too little weight on the idea that the finance sector can be a source of instability / procyclicality
- Believing CBs can just keep CPI low and stable to stabilise the economy is incorrect. (asset bubbles exist despite low inflation)
Saltwater economist vs freshwater economist
Saltwater:
- Keynesian
- Yale. Seaside unis
- People & cos not rational, markets fail and need to be regulated, government needs to play a role in the economy. Paul Krugman
Freshwater
- Chicago
- Believe people are rational, market allocates resources efficiently, little role for government in the economy and the financial system.
- Robert Lucas
Inflation targeting (explain) - substantial rise in stock market and house prices
Substantial rise in stock market and house prices:
- rise in asset prices -> wealth effect -> increase C, increase agg D and inflation
- could be sign of forming asset bubble which can be destabilising for growth
Inflation targeting (explain) - acceleration in wages and fall in productivity growth
Acceleration in wages and fall in productivity growth
- rise in wages or fall in productivity growth both lead to increased unit labour costs, a primary driver of INFLATION
- Rise in unit labour costs is potentially a good indicator of inflation rises ahad
- V important
-
Inflation targeting (explain) - Improvement in current account deficit
Improvement in current account deficit
- CA is ambiguous for inflation
- could be: savings rising rel to investment, economy slowing, less inflationary pressures
- could also be rising exports (commodity boom) -> could be inflationary
-
Inflation targeting (explain) - accelerating increases in producer prices
Accelerating increases in producer prices
- early stage inflation - input costs are rising for businesses potentially adding pressure at later stages of production and output prices
Is stable consumer inflation a sufficient goal for a central bank to ensure economic and financial stability?
- Historically thinking amongst CBs was that stable inflation was sufficient
- Greenspan’s view: should not target asset prices, and that it was difficult to identify a bubble before it popped or to pop safely
- Current thinking HAS CHANGED: US housing prices burst in 2000’s, but inflation was stable
- Many CBs now favour targeting asset prices.
Assume a country has a large CURRENT ACCOUNT SURPLUS and less inflation than preferred. What would restore balance & why. (assume FP mainly affects real demand and MP mainly affects real exchange rate)
- Expand FP to boost real domestic demand (cut T, increase G. Targeted G is a more direct way of boosting domestic demand (IMF)))
- Expand FP may raise exchange rate, which assists importers in shifting production offshore (but reduces exports, reduces domestic demand)
- To counter - ease MP. This will lower exch rate and boost real domestic demand via I & C as well as exports
- More MP than FP. MP tends to have more direct effect on demand and ultimately inflation. Extent of FP depends on govts budget and debt position.
Is there a problem for MP if consumer prices are falling/deflating
Yes - for monetary control and large potential economic costs
- deflation -> postpone C & I as goods will be cheaper, cause deflationary spiral, negative for growth and unemployment (Japan)
- Lower bound to official cash rates, therefor UMP becomes necessary. Controlling inflation breakout is relatively easier
- This explains why many CBs have an upper and lower band to inflation targets
Balance of Payments and Exchange Rate
Q: Small open economy with floating exchange rate has large debt portfolio inflow into capital account of BoP.
1. How would such inflow occur?
2. Impact on yield of debt securities = ? exchange rate = ?
3. What would be impact on national (total) savings rate of the economy as a whole
Balance of Payments and Exchange Rate
1. How would such inflow occur?
- foreigner sells foreign currency & purchases local currency. Purchases bonds denominated in local currency eg $A, kangaroos, corporates etc
2. Impact on yield of debt securities = increase price of bond, lower yield. exchange rate = higher.
Bernanke: “savings glut”: large debt portfolio inflow impacts current account -> Asian countries have surpluses and excess reserves, savings put into bond markets of US and Australia
Balance of Payments and Exchange Rate
Q: Small open economy with floating exchange rate has large debt portfolio inflow into capital account of BoP.
What would be impact on national (total) savings rate of the economy as a whole
What would be impact on national (total) savings rate of the economy as a whole:
- current account balance must equal capital account balance
- credit in capital account must lead to an equal and offsetting debt in the current account
- current account balance is the difference between savings and investment. Therefore current account debit can be via increased investment or reduced savings
- typically, savings reduces
- transmission mechanism for reduced savings:
- higher exchange rate makes imported goods cheaper and exporting less competitive, so trade balance deteriorates
- lower interest rate discourages savings and encourages borrowing
Pros (4) and Cons (2) of currency union
Pros 1. reduce transaction costs 2. enhanced trade 3. remove nominal exchange rate risk within union 4. may lower interest rates if risk premium on joining countries is higher than the union. Cons 1. loss of independent monetary policy 2. loss of seigniorage income
Key requirements for currency union to be successful
- labour mobility across region (ability to travel - visa), lack of cultural barriers, institutional arrangements
- openness with capital mobility and price and wage flexibility across the region (optimal allocation of money and goods)
- fiscal integration to some degree (risk sharing system, automatic fiscal transfer to redistribute money)
- participant countries have similar business cycles. Otherwise common MP unlikely to be suitable
Main features & key lessons of the Asian Financial Crisis 1997
- large capital inflows into Asian tiger countries = current account deficits
- fixed or pegged exchange rates therefore money went to expansion in bank credit
- property boom ensued and large asset price gain
- heavy reliance of banking sector on short term financing
- Property bubble, hot money left
- interest rates raised to encourage money to stay & discourage overshooting
- higher interest rates exacerbated downturn
- CBs devalued exchange rate
- Devaluations exacerbated downturn and banking crisis as some companies borrowed unhedged USD
- lessons: too much reliance on short term capital flows, weakly regulated & operated banking sector, insufficient FX reserves to defend exch rates, underdeveloped bond & capital markets
Wealth effects, bubbles and central banks
1. Outline how the wealth effect from residential housing bust has influenced US economy since 2008 - trace major channels for transmission of this negative wealth effect on households, banks and securitisation markets and in turn macroeconomic/aggregate income/output
- lower household wealth, deleveraging, higher savings, less spending
- housing losses led to capital losses and procyclical behaviours including less credit availability and higher interest rates for borrowers and less investment
- dislocation / closure in securitisation markets also negatively impacts the availability of credit and interest rates
Outline how a CB might best gauge if there is a bubble in the housing market
- excessive credit
- excessive supply of underlying asset
- high prices relative to fundamentals / models
- irrational exuberance amongst market participants
How might a CB / financial system regulator attempt to avert a bubble in the housing market? What tools/instruments might the authorities use?
- jawbone
- increase policy rate
- raise reserve requirements
- withdraw excess liquidity
- adjust loan to valuation ratios
- increase capital requirements / buffers
Economics of Financial Regulation
Explain the rationale for regulation of securities markets, provide 3 reasons
- Increase information available to investors (asymmetric information)
- ensure the soundness of the financial system - avoid risk of system wide contagion
- improve control of monetary policy and ensure financial stability
What were some of the regulatory, banking & other weaknesses that contributed to the GFC
- in appropriate regulations - capital / liquidity
- regulatory gaps - shadow banking etc
- poor oversight by regulators, boards etc
- poor underwriting standards by banks
- poor risk management practices
- poor credit rating agencies
- poor incentive structures for bank management
- poor business models (originate to distribute)
Name 5 key principles underlying the new regulatory regime (Basle III)
- strengthen bank capital and liquidity standards
- improve OTC markets and infrastructures
- enhance incentive structures
- improve transparency & accountability
- reduce moral hazard imposed by G-SIFs (syst impt)
- Staying up with financial innovation / shadow banking
- global cooperation & coordination
Will there be another financial crisis involving deep loss of output, high joblessness & loss of wellbeing / why
Yes
- complex world
- financial innovation
- regulatory mistakes
- this time is different / myopia
Study of Economics & the Financial System
“the market is always right”
comment
- regulated, resilient financial systems are essential for macroeconomic and financial stability in a world of increased capital flows (information asymmetry, transaction costs, pool savings & risk)
- assumptions: perfect competition, perfect knowledge, rational behaviour
- booms & busts
- political system
- creation of money & credit by financial system can lead to imbalances and crisis
5 factors that determine the structure of the financial system of an economy - its mix of markets and financial institutions
fdg
How do you judge the effectiveness of a financial system
Sustainability and if trade ( current account) and capital flows ( capital account ) are maximizing economic growth and increasing net worth)
- Growth is sustainable, strong and stable – Output is maximized with min output gap. Low unemployment and inflation rate ( internal balance is maintained ). Balance of payment crisis ( external imbalance ) is avoided
- Scarce resources are efficiently allocated amongst competing ends
- Economic and financial aggregates – b/s , cash flow statements. Key ratios ( debt/asset, TOT..etc)
- National accounts – income, spending and production. ( GDP)
- Balance sheets : economy-wide assets, liabilities and net worth. Human capital is not included due to mobility and may not work.
- National wealth – compare with other countries. Saving and education. Money earned from resources invest in education ( human capital )
- Balance of payments : current account ( X/M) & capital account ( debt and equity in or out of the country )
How do you judge the structure of the financial system - its mix of markets and financial institutions
oioiu
Potential GDP is analysed with respect to (3)
- population
- labour force participation
- productivity
(4) politics / policy reforms
Balance of payments
- brings finance and economics together
- foreign investment and liberalisation of controls over capital flows have elevated the importance of the capital account
- Capital and current accounts must balance and the NOMINAL EXCHANGE RATE is integral
Govt has several policy instruments it can use to raise potential growth; list
- FP: level / change in taxes;
- MP: (level / change in interest rates as well as money supply & credit growth)
- exchange rate and exchange control
- , omestic competition policy
- international trade policy
Explain the economic circumstances that would result in the Fisher and Taylor Rules providing the same guidance in setting official interest rates
- FISHER If the rate of inflation is low, real interest rates will be approximately = nominal interest minus inflation. Or; nominal interest rates = approx real interest plus inflation
- TAYLOR: Taylor will also be approx same, ie nominal interest rate = actual inflation plus real interest rate (equilib). This ASSUMES: economy is growing at same pace as potential and inflation rate is at target
Fisher theorem & “neutral” interest rate
central bank interest rate (i) should be the same as actual rate of inflation (p) plus equilibrium rate of interest (r).
i = p+r
This is “neutral” because MP is neither restrictive nor stimulative
Taylor rule and the “neutral” interest rate
central bank interest rate (i) should be the same as actual rate of inflation (p) plus equilibrium rate of interest (r*).
THIS ASSUMES the economy is growing at the same rate as its potential and inflation rate is on target
IF NOT: CB interest rate can be raised or lowered by some multiple of the deviation of actual growth to potential growth, and any deviation of actual inflation and target inflation.
Fed should raise rates when inflation is above target or when GDP growth is too high and above potential
Consider the Trilemma Dilemma triangle
What are the problems that often confront countries that attempt to achieve all 3 objectives simultaneously
After Asian Crisis:
- Choice of exchange rate regime is fundamentally impt
- Choose either currency board with completely fixed nominal exchange rate (HK) or floating (Aus). Halfway is not durable (Thai)
- cannot have fixed exchange rate with monetary independence / autonomy if money flows freely in capital account
- currently in Asia - substantial foreign exchange reserves have built up
1. CBs seeking exch rate rigidity may have to distort MP which can generate procyclical MP when capital flows are procyclical
2. Systemic crisis if CBs clash with speculators and unhedged borrowers count on fixed exch rates
3. Most Asian economies have combo of some capital controls, exch rate inflexibility and MP also exercise various direct controls on banks
Asian currency union?
- within Asia, countries have relatively large regional differences and small trade and factor flows between Asian countries
- Externally, Asia is extensively integrated into rest of world. Most export markets are outside of Asia, and capital inflows come from outside of Asia
Why is a monetary / currency union without fiscal union likely to be sustainable
- ## MP is imported from group, may not be applicable for specific country (lack of flexibility)
PPP: Strong vs Semi Strong
Real exchange rate =
Strong PPP: exchange rate is the simple product of the price level in one currency in terms of the price level in another.
Semi strong: exchange rate move exactly offsets the change in relative price levels, leaving the real exchange rate unchanged
Real exchange rate = nominal rate adjusted for the relative change in price level in the two countries
Tobin’s Q - define, outline uses
q > 1 = ?
q < 1 = ?
- compares market values with replacement costs
- 2 related measures, q & q1
- q = (MV Eq + MV Debt) / Replacement Cost of Assets
- q1 = (MV Eq)/ Corporate net worth at Replacement Cost
Note: q > 1: market prices are overvalued
q < 1: market prices undervalued
Tobin’s Q: Advantages & Disadvantages
Advantages
- quick judgment of value
Disadvantages
- how to deal with intangibles (difficult to determine replacement costs)
- breakthroughs in productivity destroy value of existing stock
Shiller’s CAPE
- measure
- Shiller’s Cape & Tobin’s q
Shiller’s Cape: Real (ie infl adj) S&P Composite Stock Price Index divided by 10 year moving average of real S&P Composite earnings
- Shillers CAPE & Tobin’s q: both tell us nothing about timing of correction in an under or overvalued market. Both are mean reverting and move together
Asymmetric Information produces 2 problems:
- adverse selection (lenders cannot fully evaluate creditworthiness of each borrower. Charge average rates. MOre risky borrowers use services more. Inefficient
- moral hazard (one party to a transaction has incentive & ability to shift costs to another party
Tools to reduce asymmetric information (4)
- obtain more information
- impose controls on short term flows (circuit breakers, trading halts)
- government regulation
- Use financial intermediary - eg bank profits from information gathering by offering private loans
*** Govt Debt has risen considerably in recent years (US, Japan UK). List 5 factors contributing to a rise in Govt debt loads
- recessions have reduced govt tax take and also increased outlays (unempl benefits)
- costs assoc w/ supporting banks & cos during GFC
- discretionary actions to support economies in recession after GFC (large effect)
- previousloy higher debt load and servicing costs
- rising cost due to ageing population, increased social security, rising medical costs.
Other: Increased use of FP to stimulate growth during a downturn; 2. discretionary FP used as a major countercyclical tool to support agg demand; 3. Capital injections, government deposit and debt guarantees, bank rescue packages; 4. impact of automatic stabilisers (spending on unemployment benefits, tax revenues follow business cycle); 5. Note FP often more permanent - implying public debt creeps upwards. Also, easing bias (tend to cut taxes more in downturn than increase in upturn - not symmetrical)
Macroprudential policy - define
Examples
Macroprudential:
Aimed at strengthening the stability of the financial system as a whole. Concerned with the interconnectedness of financial institutions and markets, common exposures, procyclical behaviours that could lead to loss of potential economic growth and high unemployment.
Examples: control capital flow reversals, FX intervention, strengthen bank balance sheets, influence excessive credit growth.
BASEL III - capital adequacy and liquidity
Macroprudential - 2 approaches, variable & fuxed
Macroprudential, variable:
- countercyclical capital buffers, LTV ratios, forward looking provisioning, with flexible parameters
Macroprudential, fixed:
- gross leverage ratios, core funding ratios, that are NOT adjusted during the course of the cycle
Govt Debt: Maastricht Criteria = ?
Maastricht Criteria: Govt debt no more than 60% of GDP
Impact of discretionary fiscal stimulus
Little or no expansionary effect?
- crowded out by an appreciation of the exchange rate and associated deterioration in net exports (esp for countries with very high levels of govt debt) For low levels of debt (Aus), discretionary FP appear positive and sizeable
Fiscal consolidation - can it be expansionary
yes, for countries with doubts about solvency (and henced raised borrowing costs)
But usually it is contractionary. Contraction is smaller if there is flexible exchange rate and independent MP
Macroprudential examples
- Vary provisions for certain sectors where risks are building
- Dynamic provisions (build up buffers in good times in anticipation of bad)
- LTV
- Measures targeted at foreign currency lending
- Liquidity requirements
*** How does excessive Govt debt impact on income/output growth
- ## at extremes, excessive debt can trigger crisis (force default?)
*** Key policy options for countries with excessive debt
Options:
- policy austere, tighten fiscal belt, return to surplus, sell assets, pay down debt
- try and inflate debt away
- default and restructure debt
Bond yields and rising govt debt
- large and rising debt -> should pay higher interest costs
- however - Japan, US levels impacted by QE. Govt debt is just one factor. Others are economic growth rate, cash rate, who owns debt (foreigners or domestic)
Outline the arguments for and against a central bank targeting excessive asset prices
Note (glenn Stephens): it is not the asset, it is the debt behind it that is an issue - leverage and then collapse
- credit bubbles that burst threaten the stability of the financial system more directly than equity bubbles (debt held by banks are highly leveraged)
- Cost - could try to temper asset prices in something that is not a bubble at all
- cost - if using MP for asset bubble, costs may be higher elsewhere - eg increase unempl due to higher rates/slower economy
Emergence of asset bubbles can be due to:
- innovation that changes fundamental valuation in a meaningful but uncertain way (tech stocks, housing finance, structured finance - CDOs)
- surge in economic activity in that sector
- positive feedback mechanism
- Proportion of market believers increases (optimism)
- asset bubbles occur more easily when it is difficult to short the asset
Tools for CBs to deal with asset bubbles
When to use tools
- bully pulpit
- macroprudential tools (regulatory and advisory)
- monetary policy
When to use:
- assess likelihood of meaningful risk of asset price crash
- identify tools with reasonable chance of success
- confidence that costs of using tools are outweighed by the benefits
How to prevent too big to fail issue
- structural measures : size or activity restrictions
- Reduce the incentives to become too big
- enhance supervision
- enhance transparency and disclosure requirement
- increase bail-in powers. Reduce the cost of bailout if one is needed
- bank contribution to resolution funds
Exchange rate forecasting cannot be rational. Comment
- official cash rates are not adjusted in the near term unless there is a shock to growth / inflation
- other rates/market prices are affected by news & developments
What can financial regulators do to support innovative & efficient financial markets
- promote competition in the provision of trading services
- investors must feel safe (watch informational asymmetry
- separate operation activities of exchange from regulatory activities
- regulation is NOT about setting market prices
- also - Mishkin’s 3 reasons for govt regulation (increase information, ensure soundness of system, improve control of MP)
- ## consider costs of regulation - rules / laws may be overprescriptive
An efficient market is one where no one ever profits from having better information than the rest - true, false or uncertain / explain
(also cover 3 forms of efficiency, and 3 forms under EMH)
- markets setting asset prices at a distance from fundamental values will lead to a misallocation of resources and potentially systemic problems
- 3 forms of efficiency: operational (execute at min cost); informational efficiency (info avail is reflected in price0; and allocative efficiency (returns cannot be improved without increasing risk)
- 3 forms under EMH: weak (past history incorporated); semi strong (publicly avail incorporated); strong (all info, whether public or inside info)
How does excessive Govt Debt impact on income/growth
- higher debt -> borrower’s ability to repay becomes more sensitive to a drop in income.
- Debt in the range of 85%b of GDP becomes problematic
- When lending becomes curtailed, consumtion and investment drop off
- the higher the level of debt the higher the drop in aggregate activity
- disruptive financial cycles
Current Account Deficit
Can you tell if country is in CAS or CAD just from X > M
No.
Current Account
If S > I…
S> I = current account surplus.
eg China is saving more, these savings are being invested offshore
Net foreign investment is part of the capital account
Current account:
can we say definitively whether a budget deficit results in a CAD
No. Could be offset by household or business savings
Current account
If CAD, country X>M, therefore selling local currency to buy offshore, therefore currency will…
If CAD, country X>M, therefore selling local currency to buy offshore, therefore currency will depreciate, assuming floating rate exchange rate and cet par
Current account
Net worth
If there is a current account deficit, then the country is borrowing from the rest of the world and its net worth is falling (all else equal), unless the valuation of its assets are rising
