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Macroeconomics 3 > Midsemester > Flashcards

Midsemester Flashcards

1
Q

What is the IS curve?

A

Way of summarising the way aggregate output in the economy is affected by changes in spending decisions of firms, households and the government, plots interest rates against output

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2
Q

How do expectations about the future affect the IS curve?

A

the investment plans of firms depend on their expectations of post-tax profits. Households prefer to smooth consumption so their current spending decisions are influenced by their expected lifetime income.

Increased uncertainty around the future can lead to precautionary savings

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3
Q

How can credit constraints affect the IS curve?

A

Credit constrains can mean that agents cannot take advantage of lower interest rates to increase investment / consumption

Changes in asset prices used for collateral can affect credit flows

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4
Q

How is the interest rate related to Demand

A

High interest rate is associated with lower output as spending on housing, consumer durables, machinery and equipment are lower

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5
Q

Where does the IS curve shift when expectations are more pessimistic

A

Shifts left - lower output for every interest rate

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6
Q

How does higher government spending affect the IS curve?

A

Shifts right

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7
Q

What does a higher multiplier mean for shifts and the steepness of the IS curve?

A

Shift is larger and the curve is flatter

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8
Q

What is the formula for consumption?

A

C = c0 + c1 (1 - t)y

= autonomous consumption + propensity to consume * disposable income

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9
Q

Formula for MPC

A

MPC = Change in consumption / change in disposable income

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10
Q

What is the intercept of the IS curve?

A

I + G + c0

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11
Q

What is the slope of the IS curve?

A

1 / 1 - c0 (1 - t)

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12
Q

If the G increases, how much does AD increase?

A

multiplier * change in G

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13
Q

What is the Fischer Equation?

A

r = i - pi

real rate = nominal interest rate - expected inflation

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14
Q

Is the IS curve rate real of nominal?

A

real as this is the true return on saving

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15
Q

What is the investment formula (IS)

A

I = a0 - a1 r

= future post-tax profits - interest rate sensitivity * rate

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16
Q

What is the long AD equation?

A

= 1 / 1 - c1 (1 - t) * (c0 + (a0 - a1r) + G)

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17
Q

What makes the IS curve flatter?

A

Higher K or a1
Any change in the size of the multiplier will change the slope of the IS curve. For
example, a rise in the marginal propensity to consume, c1, or a fall in the tax rate, t,
will increase the multiplier, making the IS flatter: it rotates counter clockwise from the
intercept on the vertical axis.

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18
Q

What shifts the IS curve

A

any change in autonomous consumption, autonomous investment
or government expenditure (co, a0, G) will cause the IS curve to shift by the change in
autonomous spending times the multiplier

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19
Q

What is an efficiency wage

A

Wages are set above the minimum that would be accepted so there is a threat of unemployment to induce effort

When unemployment is low, the cost of losing the current job is low so higher wages need to be offered

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20
Q

How do unemployment benefits affect the IS cure

A

Higher benefits shift the curve up as it lowers the relative cost of job loss

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21
Q

What does the WS-PS equilibrium represent?

A

At the equilibrium, the real wage is consistent with what is needed to secure sufficient labour (on the W5 curve) and for production to be profitable (on the PS curve).

22
Q

How does a higher markup affect the WS-PS curve

A

Higher markup means greater share of profit goes to firm, shift PS down

23
Q

What are nominal rigidities

A

Reflect the fact that nominal wages and prices do not immediately adjust to fluctuations in aggregate demand to keep the economy at equilibrium unemployment

24
Q

What are 5 factors that shift the WS curve down and reduce unemployment?

A

1) fall in unemployment benefits
2) fall in disutility of effort (improved work conditions)
3) Less legal protection for unions
4) Weaker unions
5) Unions exercise bargaining restraint

25
Q

How do higher taxes affect the PS curve

A

Higher taxes mean a higher tax wedge and push the PS curve down

26
Q

What shifts the PS curve up (better employment)?

A

1) Lower tax wedge
2) Lower markup (more competition)
3) higher productivity

27
Q

What are two cases when monetary poliyc can’t be relied upon for stabilisation

A

When there is a large enough shock that nominal rates are reduced to the zero lower bound or deflationary trap

When the economy has a fixed exchange rate

28
Q

If there is a positive real rate and 0 nominal, what is the rate of inflation

A

negative

29
Q

What die Milton Friedman claim was the optimal inflation rate

A

rate of deflation should equal the real rate of interest so nominal rates are 0

30
Q

What target a low but positive real interest rate?

A

Avoid dangers of deflation (which can emerge if weak aggregate demand leads to negative inflation)

Workers are resistant to nominal wage cuts and inflation can allow flexibility to reduce real or relative wages

31
Q

What happens in deflation

A

When aggregate demand is very weak, the central bank will want to reduce interest rates in order to stimulate interest-sensitive spending like investment.

This can push the nominal interest rate close to its lower bound of zero. But when a nominal interest rate close to zero is combined with falling prices (deflation), this implies a positive real interest rate which may be too high to stimulate private sector demand and get the economy back to equilibrium. This compounds

Real debt burdens rise

32
Q

What is the central bank’s loss function?

A

L = (yt - ye)^2 + b (inf - inf target)^2

33
Q

What does beta represent in the CB’s loss function

A

Shows how inflation averse they are (relative weight of inflation):
if 1, equally concerned about deviation from output and inflation

if > 1, inflation averse cares more about deviations from inflation target (stretched horizontally)

if < 1, unemployment averse (stretched to make tall)

34
Q

What is the formula for adaptive expectations?

A

infl = last infl + a (yt - ye)

35
Q

What does the Phillips Curve do?

A

PC is a constraint for the central bank as it shows all the output and inflation combinations from which the CB can choose for a given level of expected inflation

Have to be on the Phillips curve for that period

36
Q

What does the MR curve show?

A

MR Curve shows the CB’s preferred output-inflation combination for the Phillips curve it faces

Derived from finding points of tangencey

37
Q

What is the MR Curve Rule?

A

(yt - ye) = -ab(inf - inf target)

38
Q

What is the difference between MR and Taylor Rule

A

MR tells what output gap CB should choose when inflation is away from target

Taylor specifies interest rate the CB should choose to implement chosen output gap

39
Q

What is the Taylor Pricnicple

A

Relates to the fact that the CB uses the nominal interest rate to achieve a particular real interest rate on the IS curve

40
Q

What is the dynamic IS curve?

A

captures fact that aggregate demand responds to the real interest rate with a 1 period lag

= At - a*r t-1
Where A = k (c0 + a0 + G) and a = ka1

41
Q

How does the CB respond to a + inflation shocK

A

1) Shock shifts PC curve up
2) CB picks position on new PC that minimises loss (intersection with MR curve)
3) Since inflation is above target, CB will have to reduce output below ye to squeeze out inflation
4) CB uses IS curve to find real interest rate required to get back to MR, higher rate dampens output, so inflation starts to fall
5) Gradually normalises (reduces) rate until back at equilibriun

42
Q

How does the CB respond to a temporary + demand shock?

A

1) Rise in output builds a rise in inflation into system
2) Due to inflation inertia, only way to reduce inflation back to target is to reduce output to < ye
3) so CB raises interest rate to depress interest sensitive demand and reduce output
4) Gradually normalises

43
Q

How does the CB response differ between temporary and permanent shocks?

A

Permanent requires more aggressive response and leads to a higher stabilising rate of interest

44
Q

What would happen in the case of a + demand shock without lags?

A

Go directly from A to Z

As soon as shock realised, CB adjusts policy and immediately bring output to equilibrium. No chance for inflation to rise as AD shock is immediately and fully offset by changed interest rates

45
Q

What are the different long-term effects of demand v supply shocks?

A

1) supply shock changes equilibrium output

2) supply shifts MR schedule so it goes through points when inflation is at target and new ye

46
Q

What is risk?

A

Exists when we make decisions about the future based on known probabilities, allowing agents for form an expected outcome

47
Q

What is uncertainty?

A

impossible to assign probabilities to known outcome or where some outcomes are unknown

48
Q

What is the Rational Expectations Hypothesis?

A

Choice about modelling behaviour, if agents have rational expectations, they use all the information available to them and do not make systematic errors (model consistent expectations)

49
Q

What is the CB’s role under Rational Expectations?

A

Can directly influence public’s inflation expectations and do not incur the cost to output of reducing expectations No lag, economy jumps straight to new equilibrium

50
Q

What is the Lucas critique

A

Concerns the problems of basing policy decisions on forecasting models
that rely on relationships found in historical data.

If the relationships in the models are
conditional on the historical policy regime, then the models are rendered obsolete when policy regime chances. Risk that using these models will fail to produce the intended policy response due to the fact that economic agents change their behaviour when the new policy regime is introduced

51
Q

What happens when the monetary policy maker with an inflation target, targets output
above equilibrium

A

an inflation bias is built into the system; output is at equilibrium but inflation is persistently above target.

The economy ends up at equilibrium output because there is always pressure on inflation to rise when output is above
equilibrium.

52
Q

How can inflation bias be mitigated

A

need to prevent the targeting of above equilibrium output

  • delegation
  • reputation building

Macroeconomics 3 (4 decks)

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