Expectations and monetary policy Flashcards
In general, when talking about the question of unemployment, decrease in the policy rate and long-term interest rate how do they operate?
do not operate in a vacuum
The Response of Output to a Monetary Expansion: Predictions from 10 Models
output will increase for some time in response to a monetary expansion
–> the size and the length of the output response is large
IMF, OECD: definition
The IMF (International Monetary Fund) and the OECD (Organisation for Economic Co-operation and Development) serve distinct roles but often work in tandem to promote economic stability and growth worldwide
models to predict the response of monetary expansion
3 are used by central banks
4 are international organizations (IFRM and OECD)
Should uncertainty about the effects of policy lead policymakers to do less?
yes, uncertainty should lead policymakers to exercise caution and potentially do less
Does the Fed know the exact value of the natural rate of unemployment ?
No, Fed does not know any of these things with certainty
What is the natural rate of unemployment?
The natural rate of unemployment is the level of unemployment that exists when the economy is at full capacity, not influenced by cyclical factors.
Why is it important for the Fed to consider the range of responses from different models when adjusting policy rates?
The range of responses indicates uncertainty about the effects of policy changes, which can significantly impact economic outcomes
What potential risks are associated with making aggressive policy rate changes based on uncertain outcomes?
Aggressive changes can lead to unintended consequences, such as excessive inflation or further economic instability, if the predicted effects do not materialize.
How does uncertainty in economic models affect the decision-making process of policymakers?
Uncertainty can lead policymakers to adopt more conservative approaches to avoid risks associated with unpredictable outcomes
What is a safer alternative for policymakers when faced with uncertainty about economic responses?
A safer alternative is to implement smaller, incremental changes to policy rates rather than large adjustments.
–> fine tuning
Multiplicative uncertainty: definition
type of uncertainty where the effects of certain variables or parameters can compound or multiply, leading to a broader range of possible outcomes
This uncertainty should lead policymakers to be what ?
- cautious
-to limit the use of policies
The higher unemployment or the higher inflation.. the more ?
the more active the policies should be
Fine-tuning
refers to the practice of making small adjustments to economic policy measures with the goal of achieving specific targets, such as constant levels of unemployment or stable output growth
Why are the effects of macroeconomic policy uncertain (another reason) ?
the interaction of policy and expectations
Methods of optimal control
to determine the best possible way to influence a dynamic system over time to achieve a desired outcome. It involves selecting a control policy or strategy that minimizes or maximizes a certain objective, often subject to constraints.
Why have economists moved away from the methods of optimal control in macroeconomic policy?
Economists have shifted their perspective, realizing that the economy is fundamentally different from a machine, as it involves strategic interactions among people and firms that respond to both current and expected future policies.
What are the new way of the thinking about macro policy ?
game theory
game theory : definition
a game between the policymakers and “the economy” more concretely, the people and firms in the economy
Game theory is not what ?
not a “entertainment”
–> It’s a strategic interaction between players
who are the player ?
- policymaker
- people
- firms
Why do governments refuse to negotiate with hostage takers?
To deter hostage taking by making it unattractive; negotiation would encourage future incidents.
What happens if a government negotiates after a hostage is taken?
It undermines their policy, leading hostage takers to expect negotiations and increase hostage situations.
What is the best policy regarding negotiations with hostage takers?
Governments should commit not to negotiate at all to prevent hostage taking
pi = pi e - alpha (u- un)
pi e = expected inflation
u = actual unemployement rate
un = natural unemployment rate
alpha : the coefficient of the effect of unemployment on inflation and expected inflation
What is the relationship between inflation and unemployment according to the derived equation?
Inflation depends on expected inflation and the difference between actual unemployment and the natural unemployment rate; higher unemployment leads to lower inflation, while lower unemployment leads to higher inflation
Achieving zero inflation and an unemployment rate equal to the natural rate, what does it show ?
not a bad outcome
–> would seem the Fed can do even better
What is time inconsistency in the context of the Fed’s policy?
Time inconsistency occurs when the Fed can improve outcomes by deviating from its announced zero-inflation policy, leading to higher expected inflation and ultimately higher actual inflation.
How can the Fed achieve better outcomes regarding inflation and unemployment?
The best policy is for the Fed to commit credibly not to lower unemployment below the natural rate, which helps maintain zero inflation and natural unemployment.
How can a central bank credibly commit to its announced policy?
- idenpendance of currently elected politcians
- give incentives to the central bankers to take the long view
- appoint a “conservative” central banker
What are some legal measures a central bank can adopt to prevent time inconsistency?
Legal measures include defining a simple monetary rule, such as maintaining a constant money growth rate, or implementing a hard peg to foreign interest rates.
independent central bank: definition
a central bank where interest rate and money supply decisions are made independent of the influence of currently elected politicians
What are the advantage when a central bank is independent ?
makes it easier for the central bank to resist political pressure to decrease unemployment below the natural rate of unemployment
If the bank focus on a long term view it what are the advantage ?
take into account the long run cost of higher inflation
–> long horizon : f ocus on achieving stable, sustainable economic outcomes rather than aiming for quick, short-term results
appoint a “conservative” central banker what does it mean ?
is someone who has a strong preference for keeping inflation low, even if that means sometimes accepting higher unemployment
Advantage of conservative central banker ?
When the economy is at the natural rate, such a central banker will be less tempted to embark on a monetary expansion. Thus, the problem of time inconsistency will be reduced.
What were more the trend for central bank the last two decades ?
Central banks have been given more independence from governments
Central bankers have been given long terms in office
Inflation and Central Bank Independence (Across OECD countries): impact
the higher the degree of central bank independence, the lower the rate of inflation.
What immediate effect do tax cuts have on the economy?
Tax cuts lead to lower taxes today, which increases demand and may boost output in the short term
What is the long-term consequence of tax cuts that are not offset by reduced government spending?
They result in larger budget deficits and the potential need for tax increases in the future
Why might politicians find tax cuts tempting if voters are shortsighted?
Politicians may cut taxes to gain immediate voter approval, knowing that shortsighted voters may not consider future consequences like increased debt.
How might shortsighted voter behavior influence election-related economic policies?
Politicians may increase aggregate demand before elections to lower unemployment and stimulate growth temporarily, aiming to win voter favor.
What is a “political business cycle”?
It is the pattern of economic fluctuations caused by politicians manipulating economic policy to stimulate growth before elections, often followed by a downturn after elections.
What tends to happen to output and unemployment in the medium run after a politically motivated economic expansion?
Output returns to its natural level, and unemployment returns to its natural rate
Does the evidence support the idea that short-sighted voters and cynical politicians are the only reasons for steady deficits?
No, the evidence shows other factors like wars, crises, and economic theories also significantly impact debt levels.
According to the “political business cycle” argument, what economic trend would we expect around election times?
We would expect faster growth before elections as policymakers might stimulate growth to gain voter support
a war of attrition
refers to a situation where opposing parties engage in a prolonged standoff, each hoping the other will concede first
In which context war of attrition happens ?
- fiscal policy, and deficit reduction
- episodes of hyperinflation
Hyperinflation: definition
an extreme form of inflation where the prices of goods and services rise uncontrollably at very high rate
How does a war of attrition affect fiscal policy?
It can delay deficit reduction as policymakers struggle to agree on how to reduce spending or increase taxes.
What typically causes hyperinflation?
use of money creation to finance large budget deficits
–> support for stabilization programs = elimate this deficit
Why are stabilization programs for hyperinflation delayed?
Support for these programs usually comes only after inflation severely impacts economic activity.
The alternation of parties in power: definition
the shift in control of government between political parties, typically with differing priorities for economic policy
What would be the impact of a constitutional amendment to balance the budget each year?
It would eliminate deficits but also remove fiscal policy as a macroeconomic tool, which is considered too high a price to pay
Why are deficit or debt ratio limits considered better than a balanced budget requirement?
They offer more flexibility, but may still lack adaptability to severe economic shocks
What problem exists with deficit or debt ratio limits in fiscal rules like the Stability and Growth Pact?
Such rules may lack flexibility for exceptional economic conditions and are difficult to design and enforce
How could automatic spending cuts help manage deficits?
They could trigger spending cuts without direct congressional action, making cuts easier to accept and reducing political blame
What was the Budget Enforcement Act, and when was it enacted?
Passed in 1990 and extended in 1993 and 1997, it introduced spending constraints and the PAYGO rule to reduce deficits in the U.S
How did the Budget Enforcement Act manage discretionary and mandatory spending?
Discretionary spending was capped, allowing gradual decreases over five years, while mandatory spending was governed by PAYGO rules.
What is the PAYGO rule?
It requires that any new transfer program does not increase future deficits, either by new revenue or spending cuts elsewhere
How did the Budget Enforcement Act respond to economic recessions?
By focusing on spending, it allowed deficits to increase in a recession without triggering spending cuts, supporting fiscal flexibility.
What lesson can be drawn from the Budget Enforcement Act and Stability and Growth Pact experiences?
Fiscal rules can assist in deficit reduction, but cannot replace the need for strong policymaker commitment
What is the consequences of high debt ?
High debt requires higher future taxes and can lead to vicious cycles that complicate fiscal policy
What happens when investors worry about a government’s ability to repay its debt?
Investors may demand a higher interest rate, increasing the government’s cost of servicing its debt
How does an increase in interest rates affect a government with high debt?
A higher interest rate makes it necessary for the government to run a larger primary surplus to stabilize the debt
What political consequences might arise from increasing the primary surplus to stabilize debt?
The necessary spending cuts or tax increases can be politically costly, leading to political uncertainty and potentially a higher risk of default
What is the potential outcome of a government losing control of its budget due to high interest payments?
It may lead to a debt level that the government cannot repay, validating initial investor fears
How do increases in debt ratios and interest rates feed into each other?
Higher debt ratios can lead to increased interest rates, which can further increase debt ratios, creating a vicious cycle.
How can initial fears about government debt repayment become self-fulfilling?
As investors demand higher interest rates, the government’s financial situation can deteriorate, leading to an inability to repay the debt
What are the two main outcomes when a government cannot stabilize its debt?
The government may either default on its debt or rely on money finance
What are the usual consequences of default?
It often involves creditors taking a haircut, where they receive only a portion of what they are owed, or it may involve restructuring or rescheduling debt
Why are governments generally reluctant to default on their debt?
Default can have severe economic consequences, such as bankrupting domestic banks, harming pension funds, and damaging international creditworthiness.
Default: definition
the failure of a borrower, typically a government or corporation, to meet its debt obligations
What is money finance or debt monetization?
It refers to the government financing itself by issuing bonds that the central bank buys, effectively increasing the money supply without directly printing money.
How is seignorage defined in the context of money finance?
real revenue of the government through money creation
seignorage: calculation
∆H/P = ∆H/H x H/P
What happens to inflation when a government relies heavily on money finance?
Increased money supply typically leads to higher inflation, which reduces the real demand for money and can create a vicious cycle requiring even more money creation
What can result from excessive money growth and inflation?
It can lead to hyperinflation
How do high inflation rates affect a government’s revenue needs?
Higher inflation diminishes the tax base, prompting the government to increase the rate of money growth to maintain revenue levels.
What are the four main costs of inflation identified by economists?
- Shoe-leather costs
- Tax distortions
- Money illusion
- Inflation variabilit
What are “shoe-leather costs”?
refer to the economic costs incurred by individuals and businesses due to the need to manage their money holdings in response to inflation
–> need more cash
How do shoe-leather costs change during periods of hyperinflation?
They become quite large, but their importance in moderate inflation is limited
How does inflation impact capital gains taxation?
Higher inflation rates lead to higher nominal capital gains taxes, even if real gains are zero
Bracket creep
refers to a situation in which taxpayers are pushed into higher income tax brackets due to inflation or nominal wage increases, even when their real income (adjusted for inflation) has not increased
How could the capital gains tax issue be resolved in relation to inflation?
By indexing the purchase price to the price level to adjust for inflation before calculating capital gains
What is “money illusion”?
The tendency for people to misjudge nominal versus real changes in incomes and interest rates due to inflation
How can inflation lead to incorrect economic decisions?
Inflation complicates simple comparisons and calculations regarding income and asset values, making decision-making more difficult
Why do some argue that inflation’s costs are partly due to a poorly designed tax system?
Because the interactions between taxation and inflation lead to distortions that could be mitigated by better tax indexing
What is inflation variability?
Inflation variability refers to the fluctuations in inflation rates over time, which can create uncertainty about future economic conditions
Why does inflation variability make financial assets riskier?
Financial assets like bonds, which promise fixed nominal payments, become riskier when inflation is variable because the real value of those payments can fluctuate unpredictably
How does constant inflation affect the valuation of a bond?
With constant inflation, both the nominal and real values of a bond’s future payments are known with certainty, making it easier to calculate their future worth
What happens to the real value of a bond with variable inflation?
The real value of a bond’s future payments becomes uncertain with variable inflation, making it harder to predict its future purchasing power
What are indexed bonds?
bonds that adjust their nominal payments based on inflation, protecting holders from the risks associated with inflation variability.
What solution can help mitigate the risks of inflation variability?
Issuing indexed bonds can help protect investors from the uncertainty of inflation, ensuring the real value of their returns remains stable
What are the three benefits of inflation?
1) Seignorage
2) Facilitating real wage adjustments through money illusion,
3) Allowing for negative real interest rates in macroeconomic policy.
Why Seignorage positif ?
Seignorage is positive for inflation because it enables governments to finance spending through money creation, reducing the need for taxes or borrowing and potentially stimulating economic activity by encouraging spending and lowering the real burden of debt.
What is the role of money illusion in inflation?
Money illusion can lead people to accept real wage cuts more readily when inflation is positive, facilitating necessary wage adjustments in the economy.
How does higher inflation impact the zero lower bound?
Higher inflation reduces the likelihood of hitting the zero lower bound, allowing central banks more flexibility to lower nominal interest rates during economic downturns
What is the impact of inflation on monetary policy during a recession?
In a high-inflation economy, central banks can lower nominal interest rates significantly to stimulate spending, whereas low-inflation economies have limited capacity to do so.
What is the current inflation target for most advanced economies?
The typical inflation target for central banks in advanced economies is around 2%
What are the arguments for and against a 0% inflation target?
dvocates of 0% inflation argue for price stability and simplicity in decision-making, while opponents believe it limits the central bank’s ability to respond to economic shocks.
What are the arguments for a higher inflation target, such as 4%?
A higher target can prevent falling into a liquidity trap and provide more room for monetary policy during economic downturns
What does the Lucas critique state about empirical associations between economic variables?
Empirical associations cannot be assumed to be constant over time; they depend on expectations and the behavior of decision-makers
Why is modeling economic decisions important in the context of the Lucas critique?
Modeling economic decisions is essential to capture how empirical relationships depend on expectations and the decisions of private households, firms, and central banks.
What application of the Lucas critique explains the disappearance of the Phillips curve trade-off?
The critique shows that the stable empirical relationship between inflation and unemployment can vanish when expectations change, necessitating consideration of these changes in expectations
What issue arises from the interaction of expectations with monetary policy according to the Lucas critique?
The critique highlights the inflation bias and time inconsistency problem in monetary policy, where policymakers may not adhere to their announced policies due to changing expectations.
How does the Lucas critique affect the understanding of monetary policy’s effectiveness?
It suggests that traditional models may mislead policymakers, as they fail to account for how expectations can alter the outcomes of monetary policy interventions.
