Inflation Flashcards
(23 cards)
DEF: Inflation
Change in the price level (change of overall prices) of a good or set of goods in the economy
- loss of real value of the unit of account
Two price indexes used in the UK
CPI + RPI (Retail Price Index includes mortages)
DEF: central bank
Owned by banks and government, serves as a clearing house of the banks (bank of the banks)
- has regulatory power over members
DEF: Clearing Houses
Bank of the Banks, every bank has a ‘spreadsheet’ to keep track of transactions between banks
- ‘cleared everyday’
Problems with Clearing Houses
i) When one bank’s gross debts are high (owing a ton of money to another bank to be cleared), it wants to default
ii) who controls the spreadsheet / the clearing house
Bank Failures + Panics
(ex. JP Morgan used to be a clearing house)
What are reserves?
Deposits at the central bank
What are (4) properties of reserves?
- Can only be held by banks recognized by the CB
- Can only be issues by central bank
- Short term (used to settle claims)
- Free of default (CB can always issue more)
how is the demand for reserves determined?
by assessing the opportunity cost of reserves (i-iv), demand for reserves falls with i-iv
Interbank Markets Assumption
Assume overnight, safe, nominal rates
why is interest rate on deposits always lower or equal to interbank rate?
Imperfect substitutes, lending in interbank market more risky, always better off at the bank of england if it pays you more
- no one would lend in interbank market if iv was always higher than i
Central Bank’s Power
By moving iv up, this will move the i up to match it, if interbank rate doesn’t move then no one will use interbank market (everyone will go through the central bank)
i=iv
This is how central bank controls interest rate it pays on ITS deposits and THEREFORE by the force of arbitrage, shifting the interbank market rate (ir)
Pre-2009 what was taught about CB to change interbank rate
old model (CORRIDOR) says banks increase supply of reserves to hit target given downward sloping demand
What is the purpose of a lending rate from CB in CORRIDOR SYSTEM
to put a ceiling on the market (same way deposit rate makes a floor)
Why did we change from corridor to floor system?
Financial crisis in 2008, banks afraid of lending to eachother, demand for deposits at CB shifts like crazy to the right
Corridor: huge shift in supply causes IR to plummet
NOW demand shifts not that big of an issue, we live in the horizontal bit of the floor system
DEF: nominal return
give x today, get y back next year
DEF: nominal net return
nom. net return on investment is same as promised rate today (sub in x=1, y=1+i)
i=y/x-1
Fisher Equation
Explains how three concepts (expected inflation, real IR, nom IR are linked)
Nominal rate = real rate + expected inflation
Long Run Definition
When all adjustments take place (ie. steady state)
- when you cannot fool people (expected is equal to the actual long run rate)
The rule CB use to choose SR interest rates will deviate from long run interest rate if
- Current inflation is not at long-run target (pi-pi bar is not zero)
- Discretionary policy shock (i hat is not zero)
IN SR how may expectations for inflation deviate from target
added term (pi ^as) to denote animal spirits
What does a higher real IR mean for consumption and investment
less consumption (more rewarding to save) and investment (more expensive to borrow to invest) today, therefore firms want to lower their prices and inflation will be lowered (negative relationship between interest rate and inflation)
HOW do central banks control inflation?
1) Using policy rule to set i = long run inflation plus r bar (long run real interest rate)
- need to know what r bar is, then we can announce inflation target and i will be consistent with that
2) How aggressively do we respond when inflation deviates from the target (second term in policy rule), knowing that we want to respond aggressively to control animal spirits
3) what shock do we introduce today given what our reading of the state of the economy is
Yield to Maturity (or interest rate)
constant annual rate that equals the return on the bond
(yield on 1 period bond, return on the bond)
(yield on 2 period bond, 1 period return, squared)
