Macro Unit 5 Flashcards
What is fiscal, monetary policy and the government budget?
Fiscal policy: policies setting the levels of taxes, transfers and government spending, it may be used to stabilise the economy by changing AD
Monetary policy: central bank or government actions influencing economy activity by changing interest rates
The government’s budget:
(Spending on goods and services + gov fixed investment + transfers + interest payments) - taxation
If this equation is positive, the budget is in surplus, if it is negative the budget is in deficit.
What are the tools of fiscal and monetary policy?
We assume there are two policymakers; the gov control fiscal policy and central bank control monetary policy
The government’s budget uses changes in spending and government revenues (taxation) to affect AD in 3 ways:
- gov spending on goods and services (ie education), G
- gov investment (ie public infrastructure) is a component of aggregate investment, I
- taxes and transfer payments (benefits, pensions) affect AD indirectly by impacting household disposable income and hence aggregate consumption, C
The central bank change the policy interest rate to steer inflation towards the gov’s inflation target.
What is the difference between the nominal and real interest rate?
Nominal: interest rate that is not corrected for inflation. This includes the policy rate and market rates.
Real: interest rate corrected for expected inflation
Fisher equation: real interest rate = nominal interest rate - expected inflation rate (r = i - piE)
For a given nominal interest rate, higher expected inflation lowers the real interest rate
How do policymakers respond to a negative demand shock?
Assume that before the shock hits, the economy is in supply-side equilibrium, ie WS=PS, inflation is equal to the target rate of 2%
Suppose there is a negative shock to AD causing an initial fall in output and employment shifting AD down, inflation falls by 1% (=bargaining gap)
Central bank: inflation has fallen below target, it needs to relax monetary policy ie reduce interest rates to stimulate AD
Government: may wish to use fiscal policy to add to AD ie by increasing gov spending to replace the lower investment
The incentive is that if lower inflation persists, expected inflation also lowers and the Phillips curve shifts down, risking deflation
Whether one of the two policymakers act, or both, the effect is a n upward shift in AD
What is the dilemma faced by the central bank when faced with a negative supply shock?
- Economy starts in supply-side equilibrium. Suppose oil prices rise. The PS curve shifts down.
- If output remains at this level, there is a bargaining gap of 2%. The Phillips curve shifts upwards by 2%, so at this level of output, inflation is 4%.
- If the economy moves to the new supply side equilibrium, output decreases and the bargaining gap is eliminated.
- Unemployment rises enough to reduce the real wage on the WS curve to the lower real wage on the PS curve
- If the economy does not move directly to the new supply-side equilibrium, the initial rise in inflation becomes incorporated into inflation expectations.
- The Phillips curve will shift upwards again so that inflation at the original output level is 6%
- If the central bank now wants to raise the policy interest rate to restore the supply-side equilibrium, inflation will stabilise at a rate above the target
- Thus, the central bank faces a dilemma between controlling inflation or unemployment.
- to meet its objective of controlling inflation, it must eliminate the bargaining gap, but in doing so will increase unemployment by moving the economy to the new supply-side equilibrium
How does the central bank respond to a negative supply shock?
The central bank’s only tool is the nominal policy interest rate. It needs to raise this enough so that real interest rates rise. From the fisher equation this means that the policy rate needs to rise by more than expected inflation.
By raising interest rates by enough, output and employment decrease such that the supply-side equilibrium is restored at lower employment, eliminating the bargaining gap.
Should the central bank delay its response, the rise in inflation will become embedded in inflation expectations and so at the original level of employment this will shift the Philips curve upwards, increasing inflation further. If the central bank now raises interest rates, inflation will stabilise at a rate above target.
How can the government provide stabilisation during demand shocks?
Because G is a component of AD, government spending can have a stabilising impact compared to consumption and investment which are more volatile. Spending on health and education does not fluctuate with business confidence.
Automatic stabilisers are tax and transfer policies that have the effect of offsetting an expansion or contraction in the economy.
During a boom, household incomes and corporate profits rise. As incomes rise, tax receipts automatically rise. This dampens growth and acts as an automatic stabiliser. Proportional tax systems reduce the size of the multiplier, and higher incomes put people into higher tax brackets.
During a recession, we expect unemployment to rise. This likely causes an increase in the proportion of households eligible for unemployment benefits. So government spending on these income transfers increases automatically, and supports households to maintain a higher consumption level than otherwise
Discretionary fiscal policy is when the gov deliberately uses spending and taxation n to stabilise AD. A fiscal stimulus is when a gov cut taxes or increases spending during a recession. Fiscal contraction is when the gov raise taxes and cut spending during a boom
How is the size of the multiplier affected by fiscal policy?
Recall the credit-constrained households have an MPC close to 1 and households that are not will have an MPC close to 0.
The MPC of the economy will depend on the share of each group in the economy.
In a recession, after taking into account the affect of automatic stabilisers, we expect the share of credit-constrained households top rise, implying the average MPC will rise. A higher MPC increases the size of the multiplier and hence the effectiveness of discretionary fiscal stimulus in a recession.
What is crowding out?
The effect of an increase in government spending in reducing private spending.
Suppose an economy is at full capacity utilisation and there is low unemployment so there is no scope of output to rise.
A 1% increase in government spending on goods or services would displace or crowd out up to 1% of other spending in the economy, lowering the multiplier.
Another case if households think that higher gov spending will be followed by higher taxes. In this case, some households may put aside more of their income to pay the extra taxes in the future. They save more now to keep consumption smooth. This lowers the multiplier and reduces the effectiveness of the stimulus.
Crowding in occurs when households and firms anticipate that the gov will stabilise the economy following a negative shock, increasing confidence and crowding in private spending.
What is austerity and the paradox of thrift?
Policies by which a government tries to improve its budgetary position in a recession by increasing its saving and taxation, and cutting spending.
Paradox of thrift: if a single individual consumes less, their savings will increase. If everyone consumes less, the result may be lower rather than higher savings overall.
This happens if the increase in the saving rate is unmatched by an increase in investment or another source of AD. Then AD and income fall, so actual levels of saving do not increase.
What is true for one part of the economy is not true for the whole economy - fallacy of composition.
How can austerity measures potentially reinforce a recession?
The economy starts in a goods-market equilibrium where AD=Y.
A recession hits the economy after a fall in consumer confidence reduces autonomous consumption, shifting AD downward.
Suppose the government tries to improve its budgetary position by cutting spending. This reinforces the decline in AD, given that G is a component.
To avoid this, the gov should allow automatic stabilisers to operate and help absorb the shock. It can also provide a fiscal stimulus until business and consumer confidence return. The government’s budget deficit rises but this avoids a deep recession.
How do the government and central bank work together to control inflation?
The governments sets a target rate, usually 2-3% although this varies. The central bank use monetary policy to control inflation to this target rate.
The target inflation rate must not be too low or it risks deflation. If the interest rate were negative, pople would hold cash rather than save. This is the zero lower bound on the nominal interest rate. When an economy is in deep recession, a policy rate of zero may not be low enough to stimulate spending, and so it is possible negative interest rates will be needed to increase AD.
Eg if a real interest rate of -2% is required to increase AD, it will not be possible to achieve this using monetary policy unless expected inflation is above 2%. If expected inflation is negative, changing the policy rate cannot provide enough stimulus
Remember r = i - piE, so the XLB on the nominal interest rate means the lower bound on the real interest rate = -piE. If expected inflation is negative (deflation), the real interest rate is positive
Explain why brining down inflation is normally costly and how these costs can be avoided
A shock leads to a new supply-side equilibrium because the PS curve shifts down. At the original level of output and employment, inflation increased, thus the economy faces higher inflation and unemployment.
If expected inflation rises, the Phillips curve shifts up and tightening monetary policy to move the economy to the new SSE does not bring inflation back to target.
The central bank must raise interest rates to shift AD down to an employment level below the new SSE. Here, inflation is at the target 2% and the central bank can then relax its monetary policy to raise employment to the new SSE. This is a sustainable equilibrium but the adjustment of inflation expectations has made it more costly to get there.
If inflation expectations can be anchored to the inflation target rather than adjusting, the Phillips curve will not shift up even when inflation rises because wage and price setters expect the central bank to bring inflation back to target. Then, the central bank only needs to tighten monetary policy to set employment at the new SSE level, making disinflation less costly.
Explain the formula for present value and NPV
- suppose an investment project lasts a year and that the initial investment costs $I and there is no uncertainty
- assume the firm has sufficient funds to invest
- if it invests, the company will receive a return of $X in a year’s time
- the opportunity cost of this investment is the guaranteed real interest rate from investing in risk-free assets
- in both cases the firm would pay $I now and in a year’s time would receive $X from the project and $I(1+r ) from the risk-free assets
- the firm undertakes the project only if X>I(1+r)
- this compares the future return from the project (X) with it’s future costs (I(1+r)) which is the amount the firm would be giving up in a year’s time to obtain X
- the same criterion would apply if the firm had to borrow the initial cost I as it would have to pay back I(1+r) at the end of the year, so again should only invest if X>I(1+r)
- this can be written X/(1+r) - I > 0
- in the present its cost is $I but it’s benefit is smaller than X because it takes a year to arrive so the present value is X/(1+r), so net present value = X/1+r - I
- so the project should only be undertaken if NPV is +ve
Define present value and NPV
PV: the effective value today of a stream of income that will be received in the future. The present value is less than the future value when future income is discounted using an interest rate or the person’s own discount rate.
NPV: the present value of the income stream minus the present value of the associated costs
What is discount rate and risk premium?
Present values are used to make comparisons between benefits and costs received at different times. We calculate the present value of a future payment by discounting it.
In the example where the firm is only interested in maximising its profit and the project is risk free, the discount rate is r, the market interest rate on risk free assets.
Projects that are risky would have higher discount rates, d.
For a risky project with an expected return $X^E, the investment decision rule is invest only if NPV>0 where NPV = X^E/1+RP+r - I where RP+r = d
RP is the risk premium which is the difference between the return on a risky asset and the risk-free rate, this is strictly greater than 0.
RP’s magnitude depends on the degree and nature of uncertainty of the expected return on investment.
The size of the risk premium does not reflect individual preferences, but simply reflects the market price of risk.
For the firm, the discount rate, d, is exogenous since it is set by financial markets and the central bank.
Why does investment depend on the interest rate?
Recall that firms decide whether to invest based on the investment criterion: NPV>0 for the firm to invest
If expected future profits, X^E, increase for all potential investment projects that firms are considering, more of these projects will satisfy the investment criterion so aggregate investment will rise.
If expected profits remain constant but the market interest rate, r , rises, then the firms’ discount rates are higher, reducing the present value of expected profits and hence the net present value of all projects, fewer projects will satisfy the investments criterion so aggregate investment will fall.
What is the transmission of monetary policy decisions?
BoE sets the policy interest rate.
This impacts the market interest rates, asset pries, expectations/confidence and the exchange rate.
All of these impact domestic AD and net exports which therefore impact AD and domestic inflationary pressure.
The exchange rate also impacts import prices.
Domestic inflationary pressure and import prices together impact inflation.
What are market interest rates?
- when the central banks set the policy rate, it effectively controls the rate on all risk-free borrowing over relatively short periods
- commercial banks are essentially profit maximising firms. They respond to changes in the policy rate by adjusting the rates at which they lend to households which are typically above the policy interest rate
- the extent of competition among banks will affect the size of the markup or spread of the lending rate above the policy rate
How do changes in interest rates affect investment, asset prices, consumption and confidence?
-Investment: the present model suggests firms’ investment decisions depend on interest rates, but in practice, investment is not sensitive to the real interest rate because other factors do not remain constant. Ie during a recession, interest rates are lowered, but the risk premium may be increasing, offsetting the effect of the fall in the interest rate. In a recession, expected profit rate would also fall
- Asset prices: when market interest rates go down, the prices of financial and physical assets normally go up. Owners of assets feel wealthier, so autonomous C goes up
- Consumption: lower interest rates reduce the cost of borrowing which, together with wealth effects of higher asset prices, contribute to higher consumption
- confidence: lowering interest rates during recession for good reason can lead to higher expected demand, and thus higher business confidence, and higher job stability leading to higher household confidence
What is the indirect impact of interest rates on AD?
- nominal exchange rate, e, is the number of units of home currency that have to be exchanged for one unit of foreign currency
- relative price of foreign goods and services = nominal exchange rate x price of foreign goods/price of domestic goods ,, this is the real exchange rate, c
- when c increases, this is a real depreciation and the home economy becomes more competitive, increasing X-M
- suppose the home economy starts at target inflation but experiences a recession
- the recession reduces inflation, interest rates are cut to stabilise AD which brings inflation back up to target
- the lower policy rate reduces returns on home assets, making home assets less attractive to foreign investors
- home currency depreciates due to less demand
- assuming relative inflation rates remain constant, there is a real depreciation and so the real exchange rate increases
- home exports are more competitive, (X-M) increases, AD increases
How doe exchange rates affect inflation?
- A depreciation in the nominal exchange rate decreases import prices.
- Imports make a substantial share of the basket of goods in the cpi, so increased demand for imports increases CPI inflation
