Macroeconomics First Term Flashcards
Who translated the IS-LM and AS-AD models from Keynes?
Higgs
What are the two issues of the IS-LM graph that need to be fixed?
An incommensurability issue as IS is in flow terms and LM is in stock terms
IS uses real interest rate whilst the LM depends on the nominal interest rate - Higgs uses a mix of both
Why are the IS and LM curves based off of different interest rates?
Investment is dependent on future interest rate (IS), whilst decisions to keep cash or put cash into bonds is based on current situation (LM)
What is the Fisher relationship?
1 + i = (1+i)/(1+πe) - multiply this by a planned investment to find returns
Leads to r = i - πe
πe previously seen as constant but in reality this is not the case
What does an upward LM curve mean in terms of money supply?
Money supply is exogenous (straight vertical line on i-L graph)
What is the real life case of the CB setting the money supply?
CB sets a certain interest rate and lets MS adjust - leads to horizontal flat LM, but this is not perfect either
Why does the CB keep the interest rate set?
Shocks in the money market (LM) from commercial banks are mitigated by keeping i the same - predominant thinking since the 1980s
How does the CB choose a certain interest rate?
An inflation target is set by banks and the interest rate is adjusted to reach this, following the Taylor Rule
How was the Taylor Rule found?
Taylor looked at past Fed action and approximated future actions related to interest rate - i is chosen relative t the natural or stabilising rate of i
What is the Taylor Rule equation?
(r-re) = 0.5(y-ye) + 0.5(π-πT) = (rt-rs)
re is the stabilising rate
y-ye is the output gap
πT is 2% for EU
How is r-re found?
Three equations - IS curve, AS and MR
What conditions are the IS held under?
Closed economy as well as flexible exchange rates
As Y = C + I + G, what is C?
C = Co + C1(1-t)y*
Co is based on consumer confidence and is positively correlated with i
C1 has a negative reaction to i as there will be less investment when i is low, so more consumption
What is y in the Minsky model?
y = A - ar where A is consumer confidence and is very volatile
How is y modelled graphically for Minsky?
yt = A - ar^s which is a vertical line on the i-Y graph - the IS is downward sloping and crosses the yt line at i*
What is the output gap in the Minsky model?
(Y-Ye) = -ar - r^s
What are the assumptions surrounding the labour market in this model?
Imperfect competition as it more realistic, with same upward and leftward results as last year
What does equilibrium in the money market cause?
Leads to equilibrium output and therefore equilibrium employment, including involuntary unemployment
What are the changes to the wage setting curve in the Minsky model?
Line No is added to the graph, a right-angle that is either side of the asymptotes of WS and to the left of LF, and represents the perfectly competitive labour supply
What does the WS curve show in the model regarding wages?
The higher the employment rate, the higher the wages as less choice for those that demand labour, from Marx. Distance between WS and perfectly competitive labour supply shows how wages are a function of the voluntary employment rate
How do unions revise wage demands?
W = P* x B(N, Zw), where B is a generic function, N is a positive factor and Zw are shift factors
What effects do shift factors have on wages?
Higher unemployment benefits will lead to higher No and WS so wages will be higher (insurance benefit schemes are similar)
Higher concentration of unions will lead to less intra-competition and the unions will be stronger, WS and No moves upwards (as will be the effect of any positive shift in Zw)
How is the WS curve drawn in the model?
WS is a straight line rather than a curve, linearized
What is the function for firm’s labour demands?
P x dQ/dL = W
The marginal cost of employing one more person
How does imperfect competition change firms price functions?
Choice over wages in occurred, affected by elasticity of demand (u)
W/P = (1/1+u)MPL, or P = (1+u)(W/MPL)
The more inelastic demand is, the more firms can exploit
What would the mark-up (u) be in perfect competition, and what is 1/1+u equal to?
1, and where u is small, 1-u
What three lines are on the W/P-N graph?
MPL or λ, as well as PS which is flatter, and (1-u)λ which is flat and is the model used for the actual PS line from now on (even though it should not be flat)
What does λ equate to?
Output per worker, affected by technology and law of diminishing returns
How is the W/P-N graph simplified to show wages and firm takings?
All lines are made flat, where wages are gap between x-axis and PS, whilst firm takings are gap between PS and λ
What is the effect on the labour market if there is an improvement in technology?
Both PS and λ move upwards, but as proportions between lines are the same, both get more in equal proportions
What is the effect on the labour market if there is a power shift to firms?
PS moves upwards whilst λ is constant, so that firms get more at the loss of workers - increased mark-up u taken by firms
What is shown when both WS and PS are put on the same graph?
WS upward sloping and straight, PS flat, with LF still in place, where the two lines cross there is equilibrium employment, distance between this and LF is equilibrium unemployment
What happens on the WS-PS graph when there are higher unemployment benefits (Zw increase)?
WS moves to the left due to the increase in unemployment, and there is a decreased power held by TU as a result
What is the effect of a higher mark-up on the WS-PS graph?
PS moves downwards due to higher unemployment rate, with lower wages and more value from product taken by firms
What is the effect of a technology improvement on the WS-PS graph?
PS moves upward as workers are getting more wealth in absolute terms, low unemployment rate to match
What is the equation for W/Pe?
W/Pe = B + a(y-ye) + ew
What is the equation for (W/Pe)equilibrium?
B + a(ye-ye) ew = B + ew
How is the change in expected real wage calculated?
(W/Pe)equilibrium - (W/Pe) to find change in We, comes to a(y-ye) in the end
How is the change in expected real wage linearized?
(dw/dt)/w - (dPe/dt)/pe
Nominal wage inflation - growth rate of expected price level, or simply expected price inflation
How is PS curve found when related to inflation?
Combine two equations
(dw/dt)/w = (dPe/dt)/Pe + a(y-ye)
This shows the conditions firms have to work around when setting prices, looking to the future
How do unions compensate a loss of purchasing power, given the PS?
Price inflation and a(y-ye), the output gap, must be taken into account
How do firms find the price inflation from u, W and λ?
P = (1+u)(W/λ)
logP = log(1+u) + logw - logλ
Time derivative then taken
(dP/dt)/P = (d(1+u)/dt)/(1+u) + (dW/dt)/w - (dλ/dt)/λ
Price inflation = change in market power of firms (0) + wage inflation + productivity changes (0)
How is price inflation found in relation to output gap?
(dP/dt)/P = (dW/dt)/W Leads to (dP/dt)/P = (dP/dt)/p |-1 + a(y-ye) from original PS curve equation when related to inflation
What is the second equation in the 3 Equations Model?
π = π-1 + a(y-ye), the Phillips Curve
Why is the Phillips Curve inertially augmented?
Past time period has an effect on prevailing situation
What does the IAPC show about the output gap?
Positive output gap leads to higher inflation
What is the impact on an increase in equilibrium output on the IAPC?
The line raises to represent workers loss of purchasing power and increased demands, pushing up inflation - this feedback of workers from the previous experience of having too low wages is the inertia effect
What is the effect of an investment boom on the IS and PS curves, with no CB oversight?
IS moves rightwards, with re still kept at as a stabilising rate. Higher y means higher wages and more employment so PS moves upwards to reflect this
What happens at the IAPC curves when there is this non-stabilised boom?
Price growth increases due to y increase - draw new ye line up to old IAPC, then across to old ye, where this crosses, draw a new higher IAPC with higher price inflation as a result, to represent workers demanding higher wages after inflation increases. When inflation increases again as a result of these TU adjustments, the same process will continue, with increasing y and π
What is the stabilising agent to avoid the boom issues?
CB and monetary policy - find how it reaches and targets a certain π value
What are the two loss functions of the CB?
(π-πtarget) and (y-ye) with aim to keep both at 0 and a symmetrical aptitude - equal dislike of deviation in either direction in either measure
Why is π not targeted at 0? Three reasons
Some measuring accuracy issues will lead to deflation in some cases, whilst some inflation will simply reflect improvements in goods - not a problem. Also, price differentials exist so that workers move from declining to thriving sectors - through not compensating for π may this occur, smoothing out transitions
What is the aim of the third equation in the 3 Equations Model?
Model CB action, moving from specific objectives to an objective function
What is the full function of the CB’s dislikes?
V = (y-ye)^2 + (πt-πT)^2
To be minimised
How is V shown graphically?
Bliss point in centre of many indifference circles - perfectly round when there is a symmetrical aptitude
Where V = (y-ye)^2 + B(πt-πT)^2, what effect does B have?
Where B is greater than 1, the CB is inflation averse and the circles are stretched horizontally, when less than 1 visa versa, unemployment averse
What is the MR curve in relation to the IAPC and V?
Among the family of indifference curves, the points of tangency with the IAPC lines up to create the MR, the monetary reaction function of the central banks to actions in the economy
How does unemployment rather than output change things?
IAPC becomes downward sloping and MR becomes upward sloping
How is the MR curve found mathematically?
πt = πt-1 + a(y-ye) is substituted into V. Then V is differentiated by dy (as this is within the time frame and remit of CB, unlike ye that only affects TUs). Then rearrange
What is the MR curve?
πt-πT = -1/ab(y-ye)
What does the MR curve show for the CB?
The best reaction they can make when faced by any given IAPC
What is the significance of B?
When over 1, more inflation averse, so flatter slope of MR line, a more aggressive policy set-up
What does MR replace?
LM, given that MS is not exogenous
What is the effect of a positive permanent demand shock on the 3 Equations Model on the IS and IAPC?
IS shifts rightwards, with the stabilising rate r crossing the new IS at a certain value of y - draw from this intersection down to the IAPC and then from there horizontally to the ye line and draw on a new IAPC line. Where this line crosses MR, the economy will settle, at a lower y than ye
What is the effect on inflation of this IS shift?
Decrease in inflation where output decreases, given πe = π + a(y-ye)
Why does the CB forecast a new IAPC?
So as to minimise change in π and y - find best prediction of these values and be able to be as close to bliss point as possible
What is the effect of forecasting a new IAPC?
r is changed to allow for y to move to keep V variables as unchanged as possible
What happens after the first movements in the IS?
Slowly y and π return to their equilibrium positions, whilst r remains higher than before, higher permanently stabilising interest rate
How does being inflation averse affect r?
Where there is a flatter MR due to being more inflation averse, there is a higher increase in r in the first instance followed by a quicker return to the bliss point (but more losses in jobs and output in first period - cold turkey), in comparison to the gradualist steeper MR approach - averse to losing jobs and output
What is the effect of a negative permanent demand shock?
IS moves downwards and so does r after going through the motions
Why is the MR equation good?
Accurate idea of policy since 1990s and describes accurate situation of choosing i to reach a target y, causing impact on π (good temporal chain)
What are the 3 Equations?
1) y = A - ar
2) πt = πt-1 + a(y-ye)
3) (πt-πT) = -1/aB(y-ye)
What is the impact of a temporary negative shock?
IS shifts leftwards and then immediately backwards. There is a drop in y and π as a result. The CB creates a new IAPC line, and the intersection with MR is traced upwards to the original IS, not the short-term one, as the CB knows that the shock is temporary - smaller change in r. After first move, same slow return to original position at original r level
What are the cases of a positive permanent supply shock?
1990s internet boom, where productivity of labour (lamda) increased whilst u remained the same. Same outcome as a decrease in unemployment benefits
What is the effect of a positive permanent supply shock?
3rd graph of labour is required, as PS moves upwards leading to higher wages and employment rate. New ye is created to the right of the new one. The same IS curve holds throughout. Same πe is desired, but with new ye, a new MR curve is drawn, with y and π slowly moving to the new equilibrium
What happens in the short term in a positive permanent supply shock?
AIPC is drawn through new ye and πt, where it intercepts old ye then the economy is there, there is a time lag before the economy can produce at full capacity - constrained change
What changes are required to the 3 Equations Model for it to work with the Taylor Rule?
Not too much, but not just directional but also temporal sequence needs to be factored in
What is the double lag structure?
For changes of r to impact y it takes on lag and for changes in y to impact π then there must be another lag (6-12 months)
How is the IS changed to reach temporal correctness?
(y1-yt) = -a(r0-rs)
r takes time to impact y
How is the IAPC changed to reach temporal correctness?
π1 = π0 + a(y0-ye)
y takes time to impact on π
How is the Taylor Rule changed to reach temporal correctness?
V = (y1-ye)^2 + B(π2-πT)^2
How do you apply the temporal correctness of the Taylor Rule to the MR?
Move IAPC forward by one time period to create π2 = π1 + a(y1-ye), which can then be plugged in to the V equation. Then derive this by y1 and rearrange to give
(π2-πT) = -1/ab(y1-ye)
How can the Taylor Rule be found where all variables are at time period 0?
Take a new form of IAPC
π2 = π0 + a(y0-ye) + a(y1-ye)
Then plug this into the previously found MR in which the time periods are all different. Rearrange to have all variables at time period 0 on one side. On the other side, sub the IS curve in for the variables (y1-ye)
What does the Taylor Rule look like with all variables at 0?
a(1/aB+a)(r0-rs) = (a(y0-ye)+(π0-πT))
What does the Taylor Rule show?
The inflation gap, output gap and interest rate gap, as well as how π changes based on y and r
How is the Taylor Rule changed to show that it fully works with the 3 Equations Model?
a = B = 1
Why is a = B = 1 taken?
Shows that there is a symmetrical dislike of unemployment and inflation (B=1) so 1/2 and 1/2 can be used in front of the output and inflation gap - this has been found to be true empirically. However there is no foundation for a=1, only that it helps reach this situation
Why is the 1/2 and 1/2 situation not always correct?
Taylor found this by looking at the Fed, however the ECB is more inflation averse so the numbers may be different. Also this is only for the Great Moderation pre-2008 case
What are the three problems with the Taylor Rule?
πe = πt-1 so forward looking expectations are required yet may not be possible to be found
CB cannot always reach its preferred r value
(y-ye) so why is more output not desired?
In what conditions can the CB not reach its preferred interest rate?
r = i-πe
Negative interest rates do exist such as in Sweden, where people pay to keep liquidity. However if the i value goes any lower than just negative, then it will only ever have a very small impact. Beyond this, the lending rate can never be negative for the CB. Therefore when very low interest rates are required, they cannot be met
How can a large drop in consumer confidence cause the CB to be unable to react?
IS shifts leftwards in a major way, creating an IAPC and ye crossing that is deflationary. This leads to a very negative r being required which is not possible, so an r value near 0 is taken. As r = i-π0, then a negative π value requires a higher r rate due to the double negative. However this higher r rate only causes more deflation due to the downward sloping IS and upward sloping IAPC, so a downward deflationary spiral is reached that monetary policy cannot fix
What is required to stop a deflationary spiral?
Governmental fiscal policy
What are the issues of the deflationary spiral?
It is caused by a backwards looking IAPC reflecting on past π values, and is only made for Great Moderation, not a constant downward movement
How has πe been found, in order to get πt?
Firstly EAPC or expectations augmented Phillips Curve that uses both risk and uncertainty so that all values are possible. Then the 1961 Rational Expectations Approach using only risk was taken
How does Rational Expectations work?
A full information set of subjective forecasts based on previous outcomes. In the case of individuals finding πe, they will be using subjective forecasting, and whilst some will find the wrong outcome the subjective values will all converge to one objective probability on a bell-shaped curve
Why will errors not affect the outcome of Rational Expectations?
They will cancel each other out on either side of the objective probability
What is the full information set like?
Has all past data available in a probability distribution, where there are no systematic errors, on subjective one off ones
How is πT found under rational expectations?
πT = πe + a(y-ye) + Eo where the first two parts are the deterministic component and Eo is the stochastic component or forecasting error
What is the deterministic component?
The best attempt at what actually drives an equation and is correct when there is no subjective forecasting error
How are the findings of Rational Expectation used in finding the variables in the Taylor Rule?
Take a weighted average of previous findings where weight is based on expected probability, so that the knowledge of the past is projected on to the future with a number of previous values
Is it plausible to rule out uncertainty?
Yes
How is πe for time period t modelled?
πt^e = E (πt | Omega(t-1)) where omega is the full information set so a probability can be attributed to each value of π
Why do average errors come to 0?
We are not fools and learn from last time, we do not let systematic errors come in
What are the characteristics of Eo?
Unbiased so E(Eo) = 0, symmetrical so there is an equal chance of shocks into the negative and positive, and errors will all average to 0 on a bell-shaped curve. Homeostaticity also applies, as does no correlation in errors across days
How do you interact with others within the 3 Equations Model?
Act as if everyone uses it, as it is the best so by a Darwinian process it should be used by all. As a result, endogenous expectation from within the model are used
How do TUs find πe for wage bargaining (new IAPC)?
They use the 3 Equations Model due to a similar Darwinian process, and take an IAPC with Rational Expectation so πt = πt^e + a(yt-ye) + Eo
How do TUs use the MR and IAPC to find πe?
TU does not know where on the IAPC that the MR will cross, so a rational expectation of the crossing is taken with a full information set
How is the MR used to find πe in terms of finding what the CB will do?
yt-ye = -aB(πt-πT) is original MR
yt-ye is plugged into IAPC with RE to give
πt = πt^e - a^2B(πt-πT) + Et
What is the result of taking the weighted average of the MR-IAPC crossing under RE?
πt^e = πt^e - a^2B(πt^e - πT) + 0
When rearranged leads to
0 = a^2B(πt^e - πT)
Only true when πe = πT
In the case of fully credible and publicised disinflation shift, what is the effect?
πT
What happens simply when the disinflation is not fully publicised?
There are multiple PCs before the lower position is reached, leading to short-term drop in output
Who is the person who proposed the idea that disinflation will have no effect on output?
Sargent Wallace, from 1976
How is Sargent Wallace undermined?
1980s and Thatcher being unable to control high inflation, as claims to decrease inflation are not fully credible - under RE, if they were, it would be easy to control inflation
Who by, and how is the inflation setting idea changed in order to overcome the issues faced by Sargent Wallace?
Barro Gordon 1983, where the policy maker (PM) be it the CB or not, faces a loss function
V = (π - π)^2 + (y - ky) where both * factors are ideal values rather than targets or equilibriums
What is the aimed for output by government?
Higher output and lower unemployment to help matters before an election
What is the SRAS, or Lucas surprise supply function equation? (Upward sloping line on inflation-output graph)
y = y* + θ(π-πe)
Shows that inflation decided output not visa versa as previously thought, as part of RE revolution
In the Barro Gordon model, why would y* not equal y and be at the LRAS?
Firms do not know if prices are changing simply due to inflation or because demand has increased, so when inflation increases they may accidentally supply more when this is not required. When inflation is more volatile, more incorrect judgements are made, as shown in the equation
Why is the LRAS straight and vertical?
In the long run π - π* = 0
What would happen if firms believed the government claim to be wanting to reach π* in terms of firms’ actions?
They would set contracts and financial arrangements around it, setting them on one particular SRAS in their future-facing arrangements
What would the government do if firms believed their claims?
Staying at the LRAS would not be the closest position to the bliss point of y* given that a certain SRAS was taken, so inflation is raised in order to reach this more productive position, giving those investing in bonds on that SRAS a worse set of returns
How do firms avoid the government changing the π after making a claim to lower it?
In RE, firms know that they can be played, so where the indifference curves around the bliss point cross the LRAS, this will be taken as the π value, so the government is not incentivised to ever deviate
What is RF?
The reaction function to firms and households once they set a certain SRAS (based on the crossings of indifference curves) - where the RF crosses the LRAS, that is the π used
What is the inflation bias?
The difference between the π level where RF and LRAS crosses, and π* - upwards of government targets
How is the RF found?
Plug LUCAS into y section of the Barro Gordon V equation. Then carry out dV/dπ and then rearrange to find π
What is the RF?
π = (π* + θ^2πe + θ(k-1)y - θE) / (1 + θ^2)
What does the RF show?
The actual inflation rate that the PM will go for when the PM puts forward a certain expected inflation rate
What is the outcome of taking the RE of RF?
πe = π* + θ(k-1)y which shows the rational expectation of firms and households, where the PM puts forward π* and the firms and households sign contracts at πe as a result of this
How is the actual π value found?
Plug previous πe equation into the large π equation which leads to π = π* + θ(k-1)y - (θ/1-θ^2)(E) where the end of the equation represents the shock between expected inflation rate (as modelled above) and the actual inflation rate
What is the time inconsistent and time consistent equilibria?
π* is time inconsistent, whilst time consistent will be the RF and LRAS crossing
What was the problem of the 1980s?
Inflation was too high and there was no trust in PM to actually lower this - all better at lower π but it was never to be reached without trust, two Nash Equilibria
Why could firms and households not trust the government for just one time period to create a relationship of trust?
Because the game was not one-off but finite, so when the government was ending (General Election) it would be incentivised to increase π to increase y - backwards induction leads to a rational outcome of no trust
How can the government overcome the finite game of no trust in reaching πe?
Create an independent CB that decides π and does not face reelection and has a term of office not related to an election cycle (7-8 years)
What would happen if a country unilaterally made it’s bank independent?
The banks did not have a good track record (high and volatile π which causes many surprises) so there would be no effect as there would be no trust in the idea that the CB could control π
How do independent central banks gain reputation?
They borrow reputation from countries with independent CBs that have historically low π rates (Switzerland and Germany) - this is done by fixing your exchange rate with such a country
How did the ERM work?
1972-1992: everyone fixes their exchange rates to the Bundesbank’s mark, and given that this exchange rate is viewable by all, a public commitment to a low π can be made
How does fixed exchange rates play into the impossible trinity?
You cannot have effective monetary policy and flexible exchange rates as people would just exchange their money should an inflation change occur
Why are exchange rates good at keeping inflation stable across countries?
Exchange rates can be verified and witnessed every minute so any changes in r (or what r should rationally be) can be percieved
How is the exchange rate kept equal?
When the +/-2.5% margin of error is approached, CB makes a large intervention to change the inflation rate over time
What must not occur for the ERM to work in terms of currencies?
Devaluation of exchange rate will slow the process of moving the inflation rate down, as Italy was incentivised to do, reaching the cheating high output equilibrium
Who wrote about the ERM?
Giavazzi and Pagano (1988)
Which other financial body follows the ERM?
The IMF does so in stabilisation programme, pegging the exchange rate to the dollar
How can the ERM be set most strongly?
By having all currencies the same, as then no devaluations will occur, so there will be no interest rate differential and there is no possibility for cheating - locking in disinflatory gains
What is the background to the New Zealand case?
High inflation rate, no close neighbours with good inflation history, economy based around natural resources
How do New Zealand overcome the inflation issues?
Use of the principal agent relationship, where the Governor of the Federal Reserve controls inflation and has a contract which means they will be punished if they do not reach a low rate
Why does the Governor plan work in terms of being trustworthy?
There is a symmetry of information between government and private sector, and the commitments are publicly enforceable where discrepancies either side of the target inflation rate are punished
Why does the Governor have no interest in reaching a short-term bliss point?
Make the Governor work under a model of k=1 so there is no incentive to increase output above the LRAS
What are the punishments that could be given to the Governor?
Dismissal, reduction in salary, or public shaming through committee hearings in which the reasons for not reaching the target inflation rate must be explained
How is the 3 Equations Model finished by the Governor model?
Explains why y = y bar as part of the V loss function, this leads to fixed exchange rates for all
What is the extreme version of the Governor model?
Currency Board, where the legislature sets that 80%-90% of the money supply must be directly convertible to another currency (dollar/euro)
Where is the Currency Board used and why?
Estonia and Argentina, best in small countries with small monetary base, means parity of exchange rates fixed in law
Why do devaluations not occur in the Currency Board system?
If a devaluation would ever occur, it would have to be passed in law, by which point investors would have time to move bonds - never any surprises
How is the inflation rate actually found in real life?
HICP is used, but debate over if asset prices such as houses and shares should be part of the inflation rate in particular before 2008
Why should assets be part of inflation?
Overvalued assets in the DotCom bubble and before 2008 can be avoided as the bubbles will be pricked, leading to stabilisation
Why is the perfect inflation rate hard to keep at within the asset market?
A low r means that there are many safe assets, greater incentive to look for something more exciting than government bonds which may increase the interest rate
Why are commercial banks and assets not viewed in the 3 Equations Model and why should they be?
They are not seen as agents to be modelled by the CB, yet CB does not directly set r, as rL of commercial banks is the rate that firms and households use - the difference between this and ro needs to be examined to explain full power of CB
When does the commercial banking sector not need to be modelled?
When the sector is running smoothly
What are the four axis on the commercial banking sector graph?
Interest rate (CB or commercial lending), loans (flow of loans rather than stock), deposits and reserves (liquidity, monetary base injected into economy by CB through open market operations)
What is the relationship between loans and deposits?
Often 1:1 so straight diagonal line
What is the relationship between deposits and reserves?
Both firms and banks need a set ratio of fixed deposits and liquid reserves to keep stable - straight line but closer to deposits than reserves as more deposits can be taken than reserves
What do commercial banks do if they need liquidity?
They go to the CB
What happens when there is an investment boom?
Demand for loans increases, moves to right (just like IS)
How are loans given out by the commercial banks?
A mark-up from ro to rL, but in monopolistic competition with other banks - there is a perfectly elastic supply of loans Ls, they set an rL (price-maker) and let firms come to them (quantity-taker)
How does rL interact with the rest of the economy?
rL is the interest rate that is used to find output based on the IS curve
How do loans impact on the private sector?
When loans are taken out, there is a corresponding deposit in the private sector from where funds are withdrawn to pay for the loan (illiquid asset for firms)
How does the bank-firm-household flow work?
Banks lend to firms, firms and households trade in goods and labour, and households pay into banks with their reserves - keeps flow carrying on
Why may loans not end up as deposits?
Loans may end up as cash or foreign deposits - does not break monetary circuit as loans are not part of it, given that loans will always be payed back through deposits in the end - reason for 1:1 ratio
How are loans usually paid, including temporal sequence?
The exchanging of deposits rather than cash, where loans are made first followed by deposits put it - this is unlike first year, given there is no a temporal mismatch between assets and liabilities
How do loans (assets) and liabilities differ in the time taken to get ahold of them?
Requesting assets takes time, whilst liabilities (liquid reserves, deposits) can be pulled up at any point
What are the rules on liquid reserves?
Often required that 5% of all deposits be held in liquid reserves that can be taken out at a whim if required - not all reserves are given out therefore
How is liquidity found by commercial banks?
Some is given out by the CB, the rest is found through the overnight inter-bank lending market (LIBOR) but no new liquidity is there, just exchanges
What may the net position of LIBOR be?
Increased demand or increased supply of liquidity
What is the equilibrium interest rate of LIBOR when all liquidity is balanced?
ro, which can be effected by the CB
What do commercial banks demand more of when there is an increase in demand for loans?
More deposits and more liquidity - this is fixed by the CB lending at ro (the discount rate)
What will the CB decide to do when more liquidity is requested by commercial banks?
Monetary policy will meet and raise ro leading to an equal rise in rL and Ls, depressing the demand for loans and moving the IS backwards and Ld backwards
When the economy is working well, why will the CB have power over commercial banks?
Any increase in ro will have the same effect on rL so sector can be ignored, only when there are differences in the rises or decreases are there issues
What happens to commercial bank thinking, relating to loans, when interest rates are low?
Loans are low risk, so the risk of them not being collected is lower and they are handed out to people with no income, no job and no assets - in any case, the risk of repayment can be sent elsewhere once the loan is made
How does the housing market allow banks to be open with loans?
There is an overheating of the market with prices always expected to go up - therefore, repossessed houses be worth more than the interest from the loans made for them, so loans carry no risk
What happens when banks realise that these loans may not be repaid?
No one knows who will repay the loans so there is no trust between banks on lending risk, so the LIBOR fails
When LIBOR fails, what happens to the loan supply?
There is a rationing of credit so the supply line of loans Ls becomes vertical - perfectly inelastic
Which bank had large issues with the failure of LIBOR and why?
Northern Rock as it relied heavily on LIBOR for liquidity
How do commercial banks act if they cannot find liquidity at LIBOR?
They ask the CB, leading to the deposits-reserves line to angle around towards the reserves axis, given that consumers are now panicking and taking out all their deposits
What happens to investments in a banking crash?
Panic and loss of confidence as no ability for investment opportunities - no loans so no investment, IS shifts backwards - big issue
What is the real world implication of this crude model of a collapse in confidence in the banking sector?
An output gap is created by the banking sector, with real world implications
What does the CB do to help the loans issue in a financial crisis?
Lowers ro to induce investment, but this does not pass on to commercial banks due to the fact they still need liquidity - CB’s move only increases inflation rate
