Macroeconomics: Spring Term Flashcards
What does the Phillips curve show?
A negative relationship between inflation and unemployment
low unemployment with a high inflation
What is the Phillips Curve equation?
π = (πe) + (µ + z) - αu
Walkthrough the elements of the Phillips curve…
Increase in inflation is caused by
- Increase in expected inflation
- Increase wage determination variables
- Fall in unemployment
What assumption does the original Phillips curve make?
That expected inflation is equal to 0
What is the wage-price spiral?
Low unemployment increases wages. Prices increase, workers ask for more wages, price increase… etc!
Why did the negative relation between unemployment and inflation vanish in the 1970s? (Phillips curve)
- Increase in oil prices
- Expectations for wages changed as inflation became consistently positive and persistent
When expectations of inflation (0=1), what does the unemployment rate impact?
The CHANGE in inflation rate
Equation for expectations-augmented Phillips curve?
(πt)-(πt-1) =(µ + z)-α(ut)
What is the natural rate of unemployment?
The unemployment rate when the actual inflation rate is equal to the expected inflation rate
What is the Phillips curve equation including the natural rate of unemployment?
πt - (πt-1)= -α(ut- un)
What is the non-accelerating inflation rate of unemployment?
Rate of unemployment required to keep the inflation rate constant
What happens to inflation when the unemployment rate exceeds the natural
rate of unemployment, t
It decreases
Do all countries have the same level of natural unemployment?
No, as the factors that affect it differ across countries
What explains the level of European unemployment?
Labour Market Rigidities
- A generous system of unemployment insurance
- A high degree of employment protection
- Minimum wages
- Bargaining rules
What is wage indexation?
A rule that increases wages in line with inflation
A higher proportion of wage contracts being indexed leads to what effect?
More indexed contracts, means the larger the effect of the unemployment rate on the change in inflation.
When λ is closer to 1, small changes in unemployment can lead
to very large changes in inflation
What happens to the Phillips Curve when inflation is close to 0?
The relation may disappear at these low levels (e.g. depression didn’t cause deflation)
What is Okun’s law?
Change in unemployment rate should be equal to the negative of the growth rate of output
What is the normal growth rate?
The level which keeps the unemployment rate constant (3%)
Why does output growth at 1% above normal only reduce unemployment by 0.4% in reality?
- Labour hoarding, firms would rather keep workers than sack them
- When employment increases not all new jobs are filled by the unemployed (0.6 : 0.4)
What does the coefficient in Okun’s law represent?
Gives the effect on the unemployment
rate of deviations of output growth from normal.
What effect does an increase in the real money stock have on output?
Decreases the interest rate, increases demand for goods and increases output
Difference between nominal and real interest rates?
Nominal: Expressed in the unit of national currency
Real: Expressed in terms of a basket of goods
The real interest rate is approx equal to…? (when the rates aren’t too large)
Nominal interest rate minus the expected rate of inflation
Which interest rate is affected by monetary policy?
Nominal rate
Which interest rate affects spending and output?
The real interest rate
What is adjusted nominal money growth?
Nominal money growth minus normal output growth which is equal to inflation
What is the Fisher effect?
The nominal interest rate increases 1:1 with inflation in the medium run
The central bank decides to decrease nominal money growth. What will happen in
the short run?
Leads to lower real nominal money growth and a decrease in output growth- if this is below normal it increases unemployment (Okun).
-Unemployment above natural level, decreases inflation (Phillips curve)
Lower money growth has what effect in the the medium run?
- Lowers nominal interest rate
- No effect on real interest rate
What is a point-year of excess unemployment?
Difference
between the actual and the natural unemployment rate
of one percentage point for one year
What is the sacrifice ratio?
The number of point-years of
excess unemployment needed to achieve a
decrease in inflation of 1%.
What does the Lucas critique state?
it is unrealistic to
assume that wage setters would not consider
changes in policy when forming their expectation
What did Sargent argue about disinflation?
It would only occur with small increases in unemployment. Essential that wage setters think the CB is committed to disinflation
Why did Fischer argue wages didn’t account for policy?
Many wages are set before policy changes- nominal rigidities. Even with credibility, too
rapid a decrease in nominal money growth would
lead to higher unemployment
Why did Taylor suggest disinflation should be phased in slowly?
To avoid an increase in unemployment, as wage contracts are staggered.
How is the real exchange rate calculated?
(Nominal exchange rate x price)/ Foreign price level
How can the real exchange rate adjust?
- Change in nominal exchange rate
- Change in domestic price level relative to foreign prices
How does the price affect output in an open economy with fixed exchange rates?
The price level affects output through its effect on the real exchange rate (higher prices, leads to appreciation and lower output)
How does the price affect output in a closed economy with fixed exchange rates?
The price level affects output through its effect on the real money stock, and in turn, its effect on the interest rate.
What happens when output is lower than the natural level?
Price level decreases, leading to steady real depreciation
In the medium run how does a fixed nominal exchange affect the real rate?
A fixed nominal rate is consistent with an adjustment of the real exchange rate through movements in the price level
How does a devaluation (decrease in nominal exchange rate) affect output?
The devaluation leads to a real depreciation (a decrease in the real exchange rate)
and, therefore, to an increase in output
Why is it too good to be true that a devaluation can return output to its natural level?
- Effects do not happen right away
- Direct effect of the devaluation on prices usually
What is the interest parity condition?
Under fixed exchange rates if markets think this will hold the domestic and `foreign interest rates will be equal
What can be done in an exchange rate crisis (fixed rates)?
- Try to convince there won’t be a devaluation
- Increase the interest rate
- Eventually CB must raise interest rates or devalue
Arguments against fixed exchange rates?
- Lose control of interest and exchange rate
- Expected devaluations push up interest rates
Arguments against flexible exchange rates?
Move a lot, and can be difficult to control through monetary policy
When are flexible exchange rates not preferable?
-If the CB is not trusted to follow responsible policy.
-If a group of countries are already tightly
integrated, a common currency may be the right solution
What is a hard peg?
The symbolic or technical mechanism by which a country plans to maintain exchange rate parity e.g. dollarisation
Problems with a currency board?
- Forced to resist demand for credit from gov and business
- Lack of an independent monetary policy.
- Strict fiscal policy rules to maintain the peg.
Conditions required for countries to classify as an optimal currency area?
- Similar shocks (therefore can use similar monetary policy)
- High factor mobility, adjust for shocks
What is growth?
Growth is the steady increase in aggregate
output over time
Why do we care about growth?
It is connected to the standard of living- we want to examine the growth rate per person
Problems with looking at GDP converted into dollars?
- Exchange rates vary
- Doesn’t account for lower prices of food and basic services in the country
What is GDP adjusted for purchasing power parity?
We calculate GDP using a common set of prices for all countries
What are international dollar prices?
The prices used to calculate Purchasing power parity
Trends in growth for rich countries since 1950?
-Large increase in output per person.
-Convergence of output per person
across countries
Is there a relationship between growth of output and output per person globally since 1960?
No clear relationship
What countries are the 4 tigers?
Convergence is apparent in Asia. (4% growth rates) Singapore,
Taiwan, Hong Kong and South Korea started catching up to the high
output of Japan
What are emerging economies?
Economies with high growth rates but low output per
person
Where is convergence not the rule?
Africa
Growth from end of Roman empire to 1500 approx was?
No growth of output per person in Europe
Growth rates from 1500-1700 and 1700 to 1820?
0.1% per year. It increased to 0.2% per year from 1700 to 1820.
What is a Malthusian trap?
A period where countries are unable to increase their output per person
What is the aggregate production function?
The output produced for given quantities of capital and labour
What is a state of technology?
A set of blueprints defining the range of products and the techniques available to produce them
What are decreasing returns to capital?
The property that increases in capital lead to smaller and smaller increases in output as the level of capital increases
What are decreasing returns to labour?
property that increases
in labour, given capital, lead to smaller and smaller increases in
output as the level of labour increases
What can cause increases in output per worker?
Increases in capital per worker OR
Improvement in the state of technology that shift the production function
What causes sustained growth?
Tech progress which shifts the production function up (capital accumulation cannot sustain growth)
Why has the income per capita in Europe decreased since the 1970s relative to the USA?
- Few people work;
- Those who work work few hours
- Those who work, when they do, produce little
Relationship between capital and output cycle?
Amount of capital determines the output/income which determines the saving/investment rate and in time the capital accumulation
Equation for output and capital per worker relation?
(Y/n) = F (K/N , 1)
1= Constant returns to scale
What are some assumptions used to simplify the capital output cycle?
-The size of the population, the participation rate
and the unemployment rate are all constant.
-There is no technological progress.
Higher capital per worker has what effect on the output?
Higher output per worker
Relationship between output and investment? How do we get this?
Closed economy
I = S + (T-G)
-public saving (T-G = 0)
-Assume private saving is proportional to income (S = sY)
Combine
(It) = sYt
Equation for evolution of capital stock?
Capital stock tomorrow = (1 - rate of depreciation) x Capital + Investment
Output to capital accumulation equation?
K = (1-d) K + sYt
all divided by N
What is the change in capital stock per worker equal to?
The saving per worker minus the depreciation
Change in capital
from year t to year t + 1 is equal to?
Investment in year T minus depreciation
If investment per worker is less than the depreciation then what affect occurs?
The change in capital per worker is negative
What is the steady state of the economy?
When the output and capital per worker are no longer changing (left side = 0)
What happens to investment and depreciation in the steady state?
-Investment per worker increases with capital per worker, but by
less as it increases
-Depreciation per worker increases in proportion to capital per worker.
What effect does the savings rate have on the LR growth rate and level of output?
- No effect on long run growth rate of output per worker (= 0)
- Saving rate determines the level of output per worker in the LR
The effects of an increase in the saving rate on output per worker?
An increase in the saving rate leads to a period of higher growth until output
reaches its new, higher steady-state level
(Sloped up with tech progress)
What does a saving rate of 0 or 1 imply to long run consumption?
O levels of consumption in both models!
What is the golden rule level of capital?
The level of capital associated with the value of the
saving rate that yields the highest level of
consumption in steady state
The effects of the saving rate on steady-state consumption per
worker?
An increase in the saving rate leads to an increase and then to a decrease in steady-state consumption per worker (curve!)
Difference between pay as you go and fully funded social security?
Fully funded systems workers save less but the system saves on their behalf (invests in financial assets), pay as you go its down to the individual
What is human capital?
Set of skills of the workers in the economy, as this increases so does output
How can human capital be used to increase output?
Increase savings (education and training) to increase the steady state which increases output
What is a model of endogenous growth?
Models that generate steady growth even without technological
progress.
Growth depends on variables such as the saving rate and the rate of spending on education.
WHat does spending on research and development depend on?
- Fertility of the process (number of new ideas)
- Appropriability of the research (extent firms benefit)
Difference between tech frontier and catch-up?
Frontier: Develop new ideas and products
Catch-up: Imitate tech, can explain convergence!
How do institutions affect growth?
They shape the organisation of the economy and influence investments (human and products) and organise production.
Key role in the laws which aid growth, market and property rights
How to calculate the expected present discounted value of 1 pound last year?
1 / 1 + it
What is 1 pound this year worth next year?
One pound this year is
worth 1+it pounds next
year.
What is the discount rate?
The 1 year nominal interest rate
What is the present value dependant on?
(+): actual payment, future payments
(-): Current and expected interest rates
Present value formula is?
1/(1+i) x (1/ 1 -(1/1+i) x £x
Simplified present value using real interest rates?
£Vt / Pt = Vt
How can inflation expectations be measured?
- From surveys of consumers and firms e.g Joint Harmonized EU Programme of Business and Consumer Surveys.
- Comparing the yields on nominal bonds with that on real government bonds of the same maturity
What is the yield to maturity?
The price and associated interest rate of different bonds
What is the term structure of interest rates?
Yield curve (relationship between maturity and yield)
What is arbitrage relations?
Relations that make expected returns on two assets equal
What is the price of a two year bond?
The present value of the payment in two years—discounted using current and next year’s expected one-year interest rates.
Close approximate equation for bond yields (2 years example)?
i2t = 0.5 (it + (ie)t+1))
Two-year interest rate is (approx) the average of the current one-year interest rate and next year’s expected one year interest rate
What does a downward sloping yield curve show?
Long-term
interest rates are lower than short-term interest rates.
Financial markets expect short-term rates to be lower in
the future
What happened to the IS-LM curve between 2007 and 2009?
Sharp reduction in spending (IS shifted left)
Monetary expansion (LM shifted down)
Decrease in the short-term interest rate.
What is the risk premium?
The difference between the interest
rate paid on a given bond and the interest rate paid on the bond with the highest rating
Examples of bond rating agencies?
Standard and Poor’s
Corporation and Moody’s Investors Service
Difference between a discount bond and coupon bond?
Discount: Single payment at maturity
Coupon: Multiple payments plus one at the end
What is the current yield on a bond?
The current yield is the ratio of the coupon payment to
the price of the bond
What are GILTS?
UK government issue bonds (usually 5,10, 30 years but also 50)
What are indexed bonds?
Promise payments adjusted for inflation rather than fixed nominal payments.
How do firms raise funds?
Debt finance: Bonds/loans
Equity finance: Stocks/shares (dividend payments)
Stock price relation implications?
-Higher expected future real dividends lead to a higher
real stock price.
-Higher current and expected future one-year real interest
rates lead to a lower real stock price.
Why can monetary expansion be good and bad for stocks?
It is all dependant on if the market expected it- decreases interest rates and increases output
Increase in consumer spending and its effect on the stock market?
If the LM curve is steep, the interest rate increases a lot, and output increases little.
Stock prices go down. If the LM curve is flat, the interest rate increases little and
output increases a lot. Stock prices go up.
Actions of the Central Bank after hearing of strong economic activity?
-Accommodate or increase the money supply in line
with money demand to avoid higher interest rates
-Keep the same monetary policy, leaving the LM curve unchanged
-Or the central bank may worry that an increase in output may lead to an increase in inflation.
What was Tulipmania?
It was a famous bubble: as the price was expected to rise for no rational reason it did!
In the seventeenth century, tulips became increasingly popular in
Western European gardens. A market developed in Holland for both
rare and common forms of tulip bulbs
What was the MMM pyramid?
In 1994 a Russian ‘financier’, Mavrody, created MMM and promised a 3000% return. The company had no assets or production- just worthless offices in Russia.
They used funds from
the sale of new shares to pay the promised returns on the old shares.
Who developed the theory of consumption in the 50s?
Friedman: permanent
income theory of consumption
Modigliani: Life cycle theory of consumption
What does total wealth comprise of?
Non human (financial and housing) and human wealth
Equation for consumption?
Ct = C (W(t),Y(lt) - T(t))
Equation for human wealth?
Y(lt) - T(t)
real labour income in year t - real taxes in year t
What is consumption an increasing function of?
Consumption increases with total wealth and after-tax labour income.
How do consumers react to a shock to the system e.g. tax cut?
No liquidity constraints: change inline with EPDV (Y-T)
Constraints mean consumption is only out of disposable income
How do expectations affect consumption?
-Directly: Human wealth (expectations of labour income, interest and taxes)
-Indirectly: Non-human wealth (stocks,
bonds and housing-financial markets)
How is consumption likely to respond to changes in income?
Consumption is likely to respond less than one-for-one to fluctuations in current income but may move even if income doesn’t change (consumer confidence)
What do investment decisions depend on?
Current sales, the
current real interest rate and on expectations of the
future.
Reasonable values for depreciation (loss of usefulness over a year)?
Machines: 4 - 15%
Buildings: 2 - 4%
What is the investment function?
I(t) = I (V (Pie et )
Depends positively on the expected present value of future
profits (per unit of capital).
Higher profits, higher PV, higher investment.
Higher interest rates, lower PV, lower investment
What are static expectations?
No change- e.g. future profits and interests rate remain at the same level as last year
Equation for rental cost of capital?
Real interest rate + depreciation rate
What is Tobin’s q?
denotes the variable corresponding to the value of a
unit of capital in place relative to its purchase price.
How are output and investment linked?
current output affects current profit, expected future output affects expected future profit and current and expected future profits affect investment
Why is investment movements larger than relative movements in consumption?
- Consumers at most increase consumption inline with income
- Firms may investment more than an increase in sales as the PV of expected profits increases
How do consumption and investment contribute to the GDP variation?
Level of investment is much smaller than consumption so changes in investment end up being of
the same overall magnitude as changes in consumption – contribution to GDP variation same
Equation for private spending?
(Beginning of IS curve)
𝐶 (𝑌 − 𝑇) + 𝐼 (𝑌, r)
How does including expectations change the IS curve?
Makes it steeply downward sloping- decrease in the real interest rate leads to a small increase
in output:
Including expectations what shifts the IS curve?
Right: Increase in gov spending or future output
Left: Higher tax, expected tax or expected interest rate
With the expectations IS curve why does a large decrease in current interest rate have a small impact on equilibrium income?
-A decrease in the current real interest rate has little effect if expected rates aren’t lower.
-The multiplier is likely to be small. If changes in income are not
expected to last, they will have a limited effect on consumption
and investment.
Why is the LM curve not modified by expectations?
The opportunity cost of holding money today depends on the nominal rate (not expected rate)
How does decreasing the current nominal interest rate effect current and expected real rates?
-If the increase in money supply causes changes to expectation nominal interest rate or current/future inflation rates then the change will be large (small if expectations unchanged)
With expectations included what does the IS-LM curves show?
Steep IS down, LM unchanged
-Change in current interest rate has small effect on output
Before rational expectations how were expectations viewed?
- Animal spirits (Keynesian, important but unexplained)
- Adaptive (backward looking)
Effect of deficit reduction in medium and long run?
Med: No effect on output. Lower interest rate. Higher investment
Long: Higher investment, higher capital stock, higher output
How can deficit reduction increase spending and output in the short run?
If people take into account the future benefits of the reduction
Current spending goes down (left shift), expected future output goes up (right shift), lower interest rate (shifts right)
Problems with backloading?
Credibility of the deficit reduction programme (cannot all be in the future)
Change in output from deficit reduction depends on?
The credibility, timing and composition of the programme as well as the state of government finances in the first place
What is the equation for deficit? (gov’s budget constraint)
deficit = rBt-1 + G - T
Real interest rate paid on gov bonds in circulation
Why can we say Bt - Bt-1 = deficit?
Assume that the only means of deficit financing is selling securities to private investors.
So if the government runs a deficit, government debt
increases. If the government has a surplus, debt
decreases
How is official deficit counted?
The sum of nominal interest (iB) + gov
spending - taxes net of
transfers. (A measure of the change in nominal debt)
Why is the official measure of deficit wrong?
If B is the debt and inflation is π, the official measure of the
deficit overstates the correct measure by an amount equal
to πB
Inflation adjusted deficit equation?
iB+G−T−πB = (i − π)B + G − T = rB + G−T
where r = i − π is the real interest rate.
What is the change in debt ratio equation?
𝐵𝑡 - 𝐵𝑡−1
𝑌𝑡 𝑌𝑡−1
= (𝑟 − 𝑔) 𝐵𝑡−1 +𝐺𝑡 − 𝑇𝑡
𝑌𝑡−1 𝑌t
What are the two terms in the debt ratio equation?
-Difference between the real interest rate
and the rate of growth of GDP, multiplied by the debt ratio at the end of the previous period.
-The second term is the ratio of the primary deficit to GDP
Evolution of the debt ratio in the UK?
60s: Strong growth meant average growth rate exceeded the real interest rate
70s: Lower growth, low interest rates
80s: Higher interest, lower growth. Large surpluses- increase in debt ratio
90s: Debt ratio feel due to surpluses generated
2000s: Debt ratio increased with the recession!
Why do we assume the gov runs primary deficits (surpluses) in relation to GDP thats constant over time?
For simplicity (namely that (Gt − Tt)/Yt is constant. We also assume that r and g are constant.
Two types of debt ratio lines?
Slope >1: Normal, when growth rate of GDP is smaller than the real interest rate
Slope< 1 Unusual, when GDP is larger. The equation is a straight line with
slope lower than one (1 + r − g < 1).
If a country has past debts and runs deficits what happens to the debt ratio?
It increases going further away from the equillibrium
Even if g < r, and if initial debt is positive, when does the debt ratio decrease?
If the government runs adequate primary surpluses
What happens to the debt ratio is g > r?
The debt ratio converges to the equillibrium
Whats the vicious circle of debt ratio?
Debt ratio above 100% so gov raises taxes to increase surplus, this is unpopular and leads to political uncertainty (increases risk premium and interest rates). Causes a deeper
recession and a higher r - g making it harder to stabilise the debt ratio.
Countries with high debt should reduce
it rapidly.
How can the debt ratio be reduced?
- Generate sufficient primary surpluses (cuts or higher taxes)
- Aim for fast growth (endogenous)
- Monetary financing by the central bank (inflation)
- Repudiate the debt, in whole or in part.
Why do policy makers wait rather than immediately introducing
adequate measures to adjust the budget?
-Govs often do not perceive the urgency
-To avoid losing political consensus, and thereby opening
social conflicts, governments tend to delay the fiscal
correction.
What is Ricardian Equivalence?
Once the government
budget constraint is taken into account, neither deficit
nor debt has an effect on economic activity (effect of lower taxes today is cancelled out by higher taxes tomorrow)
What is standardised employment deficit?
The deficit that exists when output is at the natural level of output
What is the rule of thumb on the link between output and deficit?
1% decrease in output leads automatically to an increase in the deficit of 0.5% of GDP.
What is the automatic stabiliser?
The deficits effect on economic activity
Two good reasons to run deficits in wars?
- Distributional: Pass the burden to those alive after the war
- Helps reduce tax distortions (tax smoothing)
Why are deficits persistent?
- Time inconsistency
- Common pool problem
- Information asymmetry
Examples of political rules used to reduce budget deficits?
- US attempted a constitutional amendment
- Rules to limit debt and mechanisms to reduce
What were the UK government’s key fiscal rules on judging policy?
- Golden rule: over the economic cycle, the Government will borrow only to invest and not to fund current spending.
- Sustainable investment rule, which requires it to keep debt at a “prudent level”.
What did Kopits and Symansky (1998) say good economic rules were?
Transparent • Flexible • Adequate (with respect to the specified goal) • Supported by efficient policy action • Simple • Internally consistent • Enforceable
Why are members of currency unions subject to constraints?
-Prevent them passing on the cost of fiscal
expansion.
-Prevent crisis spreading
=> Stability and Growth Pact, “Fiscal Compact” (TSCG)
Examples of EU rules on debt?
-excessive deficit (over 3% of GDP)
-excessive debt (over 60% of GDP)
- debt reduction rule – reduction of the excess over 60% of GDP
by one‐twentieth a year
-medium term, close to balance
-constraint on the real growth of adjusted expenditures
Examples of countries facing rules on fiscal spending?
UK: Budget Responsibility and National Audit Act in
2011
-Germany 2009: debt brake as a constitutional rule
What do fiscal councils do?
- Long-term sustainability analysis (pensions, health)
- Assess draft budgets
- Costings of policy
- Government forecasts
- Check the fiscal rules
What did the IMF say about the usefulness of fiscal councils in 2013?
“Econometric analysis suggests that certain characteristics of fiscal councils are associated with stronger fiscal performance, but that the mere existence of a council is not.“
What did Nerlich and Reuter say about the usefulness of fiscal rules in 2013?
“We find strong support that numerical fiscal
rules help to improve the primary balance, and that the budgetary impact can be further strengthened when supported by independent fiscal
councils and an effective medium-term budgeting framework.”
