Macroeconomics: Autumn Term Flashcards
Karl Popper quote on Scientific theories?
“The theories are passed on, not as
dogmas, but rather with the challenge to discuss them
and improve upon them”
When should a theory be considered scientific?
If and only if it is falsifiable (testable)
Definition of Economics?
The study of choices as they are affected
by incentives and resources.
Example of economic study and criminology by Becker (1992, Nobel Prize)?
Poverty is associated with greater criminal activity, Becker reasons, the poor have more to gain from crime than from doing a legal job. (Emphasis on rationality)
Why use mathematical models?
- Imposes consistency to theory
- Prevents contradictions
- Rely on models for predictions
- Allows for testing
Einstein quote on simplicity?
“Everything should be made as simple as possible,
but not simpler.”
What are business cycles?
Fluctuations of economic activity around a
long-term growth trend.
What are turning points in business cycles?
Peak: The last month before key indicators fall
Trough: The last
month before the indicators begin to rise.
What are persistent deviations from business cycle trends called?
Positive ones: Expansions (boom)
Negative ones:
Contractions (Recessions)
What is GDP?
Measure of national
income and input for a given country’s economy
What is the expenditure method for calculating GDP?
GDP is equal to the total expenditures for
all final goods and services produced within the country in a
stipulated period of time
Equation for GDP?
= C + I + G + (X- M)
consumption + gross investment + government spending +
(exports - imports),
Why is it gross investment when calculating GDP?
“Gross” means that depreciation of capital stock is
taken into consideration
What is the GDP implicit price deflator?
GDP in current prices (Nominal GDP) / GDP in base year prices (Real GDP)
Why do we use log transformations on time series data?
To handle exponential growth of a series and stabilize the variability
What type of variables should we consider taking logs of?
Variables expected to grow exponentially (like GDP, population, consumption)
Not variables expected to fluctuate around a fixed level around a fixed level
(inflation, interest rates, unemployment rates)
Why do business cycles occur?
Unexpected disturbances (Shocks in tech, oil, fiscal or monetary)
Why do Keynesian economists think cycles occur?
Due to nominal rigidities (wages, prices etc are not flexible in the short run)
What is the real business cycle theory?
Believe cycles are down to productivity shocks, modern markets are more flexible than Keynes thought
Keynes v Friedman on cycles?
Keynes: Gov should use policy to manage the economy which could moderate recessions
Friedman: Gov role in guiding economy should be restricted. (Monetarism- price level depends on money supply)
Why did Friedman think cycles was a misnomer?
-No regularity is amplitude, fluctuations or duration of the cycles.
What is regular in business cycles?
Comovements: macro variables move together in predictable ways
Comovement in an expansion?
Output rises, employment rises. Inflation may rise as well
Comovement in a recession?
Output of goods/services falls, employment falls
What is a procyclical variable?
The variable causes deviations from the trend that are positively correlated with the deviations from trend in
real GDP
What is a countercyclical variable?
The variable causes deviations from the trend that are NEGATIVELY correlated with the deviations from trend in
real GDP
What is an acyclical variable?
A variable uncorrelated with changes in GDP trends
Why is the growth rate of M2 important?
Positively correlated with growth rate of GDP. Money stock measures are available more quickly than GDP it is a good measure of the economy
What is the M2 variable?
M2 is a money supply measure which includes M1 (cash + cheques) as well as NEAR money ( savings, deposits, money market securities, mutual funds) which are assets than can quickly be converted to cash.
What is the IS relation?
Equilibrium in the goods market occurs when production (Y) = demand (Z)
Simple IS equation?
Y= C( Y-T) + I + G
What does investment depend on?
The level of sales (+)
The interest rate (-)
I= I( Y, i)
Why is demand an increasing function of output (for a given interest rate)?
- Increase in output, increases income, people have more to spend on goods
- Output increasing can increase investment
What effect does the interest rate have on equilibrium level of output?
Higher interest rate - lower demand for goods (at any output), decreasing level of equilibrium output
(IS curve shifts down)
Why is the IS curve downward sloping?
Increase in the interest rate leads to a decreasing output
What shifts the IS curve left?
Changes in factors that decrease the demand for goods (given the interest rate), e.g. taxes
What shifts the IS curve right?
Changes in factors that increase the demand for goods (given the interest rate)
What is the interest rate determined by?
The equality of the supply of and the demand for money
LM equation?
M/P = €YL(i)
Money stock= Demand for money (nominal income x nominal interest rate)
What makes up the demand for money?
Nominal income x nominal interest rate
What is the LM relation?
The real money supply with equal the real money demand (depends on income and interest rate) in equilibrium
What impact does an increase in income have on the interest rate (given money supply)?
An increase in income, increases demand for money. At a given money supply, this increases the equilibrium interest rate
Why is the LM curve upward sloping?
An increase in income, increases the interest rate
When does the LM curve shift?
When interests change but output doesn’t
What are open market operations?
The standard method Central Banks use to change the money stock
What is expansionary market operations?
When the Central bank buys bonds (increases the supply of money)
What is contractionary market operations?
When the Central bank sells bonds (decreases the supply of money)
What are assets for the Central Bank
Bonds
What are liabilities for the Central Bank?
Money (currency)
What is the price of a bond formula?
Price = (100)/(1 + i)
When does the LM curve shift down?
When the money supply increases
When does the LM curve shift up?
When the money supply decreases
How does a monetary expansion effect the LM curve?
Shifts it down- higher output, and lower interest rate
What is the liquidity trap?
At 0 interest rate (other than transaction money) people are indifferent to cash or bonds- demand for money becomes horizontal. Increases in the money supply have no effect on the interest rate (LM curve flat at low levels of output)
Liabilities for a bank?
Value of checkable deposits
Why do Banks hold reserves?
- Deal with flow of cash withdrawals
- Honour cheques
- Reserve ratio laws (10% US)
Assets of a bank?
Reserves
Loans
Bonds
Demand for currency equation?
C(Ud) = c(Md)
Demand for deposit equation?
(Dd) = (1-c)(Md)
Demand for reserves by banks equation?
(Rd)= (coefficient of reserve to deposit demand)(1-c)(Md)
The demand for central bank money is equal to?
The sum of demand for currency and demand for reserves
Demand for central bank money equation?
(Hd)= (c + 0(1-c)) €YL(i)
Equation for the money multiplier?
1/(c + 0(1-c))
Overall supply of money formula including the money multiplier?
Multiplier x Central bank money = Money supply
What does high-powered money mean?
Overall supply of money depends on the amount of central bank money (monetary base)
Origin of the 2007 financial crash?
Started in the subprime mortgage market
What is a solvency problem?
When the value of the assets decline under the level of liabilities (insolvency)
What is a liquidity problem?
Bank has a difficulty repaying investors
What is the leverage ratio?
Assets/ capital
Why is a high leverage ratio risky?
As if the price of assets falls the bank could become insolvent
What is the capital ratio?
Opposite of leverage
Capital/ assets
What is securitisation?
The creation of securities based on a bundle of assets, loans or mortages
What is MBS?
Mortgage based security: Returns from a
bundle of mortgages, with the number of underlying
mortgages often in the tens of thousands
What is CDO?
Collateralised debt obligations: Risky securities offering high returns.
What is SIV?
Borrows from investors, typically in the form
of short-term debt whilst holding various
forms of securities. Reliant on a bank as lender of last resort
What is CDS?
Credit default swap: Insurance against the default risk
Issues caused by securitisation?
The leverage of the financial system was much larger than had been predicted
US actions after the crisis?
-Cut interest rates.
- Increased Federal deposit insurance from $100,000
to $250,000
• Provided liquidity
• Troubled Asset Relief Program (TARP).
• The Fed is still the main buyer of the mortgage-backed
securities
Europe’s actions after the crisis?
(Slower to act than US/UK)
-Cut interest rates.
-Unlimited liquidity for European banks at a fixed interest
rate of maturities of up to an year.
-Increased types of assets ECB would exchange for cash
-Purchase of ‘covered bonds’ by the ECB.
Why the slow recovery on the aggregate supply side?
-Decreased level of natural output, cannot go back to pre-crisis level
Why the slow recovery on the aggregate demand side?
Limits to monetary/fiscal interventions. Liquidity trap, unconventional policies, pressure to reduce gov debt.
Effect of expansionary monetary and fiscal policies?
Monetary: Higher inflation
Fiscal: Increased gov debt
Do Banking Crises Affect Output in
the Medium Run?
- Typically decrease output even in medium run but there is variation across countries.
- Harder to Banks to get the money to the right borrowers
Reactions of top economists to the crisis?
Krugman: Old texts for inspiration
Lucas: Look forward, don’t go backwards
Buiter: Economy too complex to model
Thaler: Economics needs a revolution (behavioural economics)
Price of an asset equation (constant discount rate K)
Po = (E (D) + E(P)) / (1+K)
What is the efficient market
hypothesis?
The idea that a crisis is always unforeseen as prices are determined by new information (so cannot be predicted)
Evidence against market efficiency?
- Seasonality
- Small versus large stocks
- Value versus growth stocks
What can we do about the impact of crisis?
-Take prevention
measures to reduce frequency/impact
-Deal with pain when it does occur
Why do Diamond and Dybvig say the financial sector is prone to crisis?
Banks have short term liabilities but invest in long term assets- making them vulnerable to bank runs
Why do Allen and Gale say the financial sector is prone to crisis?
Interconnectedness of the system helps redistribute funds in normal times but leads to contagion when there is a liquidity shortage.
What is the Diamond and Dybvig model?
Showing the banks gamble with patient/impatient depositors- showing how bank runs can easily occur if people withdraw earlier than expected
How can bank runs be prevented?
- Government legislation on leverage and risk
- Pay early withdrawals less
- Suspend payments
- Lender of last resort
- Bailout
- Deposit insurance
What is a moral hazard?
When a person takes more risks because someone else bears the burden (insurance)
What is a complete market?
Each region is connected to all the other, impact of a crisis may be small/thin as each area liquidates a small amount of a long asset
What is an incomplete market- issues in a crisis?
Each region is connected only with a small number of regions. A crisis is felt strongly in neighbouring regions, this leads to large liquidations of long assets. Thus affecting other regions- leading to contagion
A solution to contagion in incomplete markets?
Breaking the financial system e.g. PRA in the UK has to ring fence retail arms from rest of banks operations
(Glass-steagall Act, 1932 did this in US, until it was repealed in 1999)
How can a central bank mitigate crisis in incomplete markets?
Can be the lender of last resort, and by intervening appropriately can prevent inefficient liquidation of assets.
Why do asset prices end up above the fundamental price?
When agents purchase assets with credit they have limited liability (can go bankrupt and not pay it back if it goes badly). Incentive to overbid. (Same with stocks)
Why do bubbles appear in riskier assets?
The riskier the asset the larger the bubble as there is more incentive for the agent to overbid.
Why can no bubble exists forever?
As the supply will adjust eventually
What impact does lower interest rates have on bubbles?
They increase the size of the bubble
What lowered interest rates in 00’s?
- Loose monetary policy in the US Fed’s response to the dotcom bubble
- Global savings glut (Excessive saving in China invested in the US)
- Financial innovation allowed banks to take more risks
Why does a fall in asset prices lead to recession?
- When asset prices go down, everyone can borrow less, lower output and further price falls in assets etc
- Known as the Financial Accelerator
Why was 2007/8 crisis worse than 2000 crisis?
- Residential investment in the US = 6% GDP
- Spending in IT sector in 2000 = 1.5% of GDP
- Less leverage in IT sector
- Larger IS shift left in 2007
How can a fall in asset prices affect a bank’s leverage?
The fall in asset prices, increase the leverage for a bank and increases the risk premium (ROE= ROA x A/E)
Factors other than asset prices which affect the risk premium?
Complexity: Securities poorly assessed. Toxic!
Liquidity: Banks reliant on term debt
Amplification: As the crisis got worse fire sales caused more problems
How do bank reserves change in a crisis?
They increase as banks start to hoard excess liquid reserves due to fears about lending
Why do Banks hoard liquidity in a crisis?
- More reserves = less exposure to losses
- Call in unused loan commitments
- Flight to quality
What does Keynesian theory suggest about the multiplier in a liquidity trap?
It is very large!
Large increase in output, without crowding out of private activity because of the low interest rate.
Why are temporary monetary
expansions not very effective in a
liquidity trap?
They only affect interest rate but not output
Why is a negative interest rate necessary to restore Y (output)?
To allow households/firms to repay large debts resulting from buying assets at inflated prices
Why hasn’t QE been enough?
- Coordination problems (Banks not lending to the same people)
- Expectation problems (Fear QE will be reversed, increasing risk premiums)
Examples of modern challenges to Keynes?
- Animal spirits (RBC models explain volatility with rationality)
- Keynes uses current income in his multiplier, Friedman favoured permanent income
Examples of modern challenges to Marx?
-Crisis do not seem punishment on inequality (Sweden crisis in 1990s)
Examples of modern challenges to Hayek (gov intervention to blame for crisis)?
-Sichel, post WW2 “expansions became longer… contractions became
shorter”
-Recessions less severe (12% fall in industrial production post 1913, 9% fall after WW2)
What is the aggregate supply equation?
P= (Pe) (1 + u) F(U, z)
Price = expected price level and the unemployment rate
Equation for the unemployment rate in terms of output?
u = 1 - (Y/ L)
Higher output leads to lower unemployment
What shifts the aggregate demand curve?
- Right when government spending increases
- Left when there is a decrease in nominal money
Why does an increase in the price level
lead to lower output?
Price rises, M/P falls, interest rate rises, demand falls, and output falls
