Macro - Week 6

Question 1

what is the main determinant of long-run inflation?

Answer 1

money growth

Question 2

costs associated with inflation?

Answer 2

hard to measure

Question 3

what does the output-inflation tradeoff cause?

Answer 3

inflation bias; an independent central bank might solve the problem

Question 4

Money growth and inflation: the basics

Answer 4

• Inflation is an increase in the average price of goods and services in terms of money. Thus to understand inflation, we need to examine the market for money.
• Nominal money supply, M, is determined by the central bank.
• Real money demand is determined by the nominal interest rate (cost of holding money) and real income (transactions)
• L = L(i,Y); L_i<0; L_Y>0
• In equilibrium real money supply equals real money demand: M/P = L(i,Y) –> P = M/L(i; Y)
• Prices depend on M, but also on the determinants of money demand; here i and Y.

Question 5

how does money growth explain inflation?

Answer 5

• Real money demand, L(i; Y), does not change significantly (especially in the long run).
• Interest elasticity of money demand is around -0.2. Doubling prices requires lowering money demand by 50%, so interest rates must increase by a factor of 32 (unlikely).
• Income elasticity of money demand is around 1. Doubling prices requires income to fall in half (unlikely).
• Doubling the money supply is not uncommon.
• There is strong empirical evidence linking the inflation rate to money growth.

Question 6

how to reduce inflation without abrupt changes in prices?

Answer 6

Question 7

evidence on the effect of money supply

Answer 7

Question 8

why do we care about inflation?

Answer 8

• Increases opportunity cost of holding money and causes people to exert more effort to reduce their holdings:
  
  • No social benefit from these efforts.
  • Friedman rule: set nominal interest rates to zero. According to Friedman, opportunity cost of holding money faced by private agents should equal the social cost of creating additional money. It is assumed that the MC of creating additional money is zero. Therefore, nominal rates of interest should be zero. The result of this policy is that those who hold money don’t suffer any loss in the value of that money due to inflation.
• Sticky prices that lead to incorrect relative prices and menu costs: Policy recommendation: set inflation to zero.
• Taxes on nominal quantities, so distorts taxation.
• “Shoe leather” costs quantitatively small, other two could be solved by indexation.
• Okun (1975) and Carlton (1982) argue that inflation can significantly disrupt markets where buyers and sellers form long-term relationships: Makes it harder to set terms of long-term contracts.
• Inattention can lead to larger errors when planning for retirement or making decisions about long-term investments.
• Dislike of inflation in and of itself: Okun (1975): consider a policy of reducing the length of the mile by a fixed amount each year.
• High inflation is often also more variable, and, therefore uncertain.
• Symptom of a government that is functioning badly.

Question 9

benefits of output stabilization

Answer 9

• 0.06% is very small, so why do we care about stabilization so much? Maybe we are more risk averse, so is much higher.
• Stabilization also stabilizes hours worked.
• Uncertainty prevents investment and stabilization increases income in the long run (maybe even growth).
• If the poorest fraction of the population is hit particularly hard by a recession the above calculation underestimates the welfare gains.
• Suppose there is a short-run trade-off between output and unexpected inflation. Then, a central bank who can choose policy period-by-period would be tempted to increase inflation by surprise. If individuals and firms understand these incentives they will expect higher inflation to begin with. Given this higher expected inflation, the central banker must increase inflation so as not to decrease output. In equilibrium we get higher inflation and no effect on output.

Question 10

Rules vs. discretion: avioding the dynamic-inconsistency problem

Answer 10

Question 11

Fiscal policy punchlines

Answer 11

• The government must satisfy a present-value budget constraint.
• Badly run budgets can lead to explosive and unsustainable debt paths.
• Ricardian equivalence: the way governments finance their spending (tax or debt) does not matter.
• Violations of Ricardian equivalence.

Question 12

Government budget constraint

Answer 12

Question 13

Measurement issues

Answer 13

Question 14

Sustainability of fiscal policy

Answer 14

Question 15

Stable vs. unstable case

Answer 15

Question 16

Ricardian equivalence

Answer 16

• Ricardian equivalence is an economic theory that argues that attempts to stimulate an economy by increasing debt-financed government spending are doomed to failure because demand remains unchanged. The theory argues that consumers will save any money they receive in order to pay for the future tax increases they expect to be levied in order to pay off the debt.
• The Ricardian equivalence argues that an individual or family’s rate of consumption is determined by the lifetime present value of their after-tax income. The recipients of a government windfall perceive it as such. It’s a bonus, not a long-term increase in income. They will resist spending it because they know it’s unlikely to recur, and will even be clawed back in the form of higher taxes in the future.
• Only the present value of these government purchases, not the division of the financing of those purchases between taxes and debt, affects the economy.
• Violations:
  
  • Finitely lived agents that are not as altruistic towards their children as they are about their future selves. Ricardian equivalence assumes intergenerational altruism – Tax cuts for present generation may imply tax rises for future generations. Therefore, it is assumed that an altruistic parent would respond to current tax cuts by trying to give more wealth to their children so they can pay the future tax rises.
  • Borrowing constraints: Ricardian equivalence assumes perfect capital markets – households can borrow to finance consumer spending if needed
  • Distortive taxes.
  • Consumers are not rational: Many would not anticipate that tax cuts will lead to tax rises in the future. Many households do not project future budget deficits and predict future tax increases. If the economy is at Point A – a rise in government spending can lead to a fall in private sector spending. There is crowding out. But, if the economy is at point C (inefficiency) Then it is possible to increase government spending without a fall in private sector spending.

Question 17

whta are the determinants of money demand

Answer 17

i (cost of holding money) and Y (real income), so L = L(i,Y)

Question 18

what holds in EQ in the money market

Answer 18

• real money supply = real money demand, i.e. M/P = L(i,Y)this means that P = M/L(i,Y), so price is determined by the money supply and the determinants of money demand, i and Y

Question 19

what determines nominal money supply

Answer 19

central bank. Real money supply is M/P, so it also depends on prices

Question 20

how does money demand behave over time? what are the implications of this for inflation?

Answer 20

does not really change, particularly in the long run. Thus, movement in inflation mostly explained by changes in money supply

Question 21

Fischer’s identity

Answer 21

i = r + pi

Question 23

what is the liquidity effect?

Answer 23

• monetary expansion reduces nominal interest rates in the short run.
  
  • In the short run prices are “fixed” (M = PL(i;Y)): if M increases, L has to increase since P is fixed; that means taht Y goes up and r down along the IS curve.
  • In the long run prices are flexible, so this effect disappears.