Modern Macroeconomic Policy

Question 1

What is the sacrifice ratio?

Answer 1

How much output (and unemployment) must be forgone to reduce inflation by one percentage point.

Question 2

What is the quantity theory of money?

Answer 2

Py = MV
ΔP/P + ΔY/Y (=0 since output assumed in eq in the LR) = ΔM/M + ΔV/V (=0)

ΔP/P = π = ΔM/M

M (money supply) acts as a nominal anchor: growth of M fixes growth of prices

π - backward looking measurement

Question 3

The Fisher equation

Answer 3

EXPECTEDr(t) = i(t) - EXPECTEDπ(t+1)

where i is the policy rate

Question 4

What is the MR curve?

Answer 4

(yt-ye) = -αβ( π(t) - π TARGET)

Question 5

What is the MR influenced by?

Answer 5

alpha - the slope of the PC; the steeper the PC, the smaller the sacrifice rate
beta - CB’s preference over inflation and unemployment

Question 6

What is the sacrifice ratio?

Answer 6

• The % rise in the unemployment rate for a 1 percentage point fall in π
• The cost of disinflation

Question 7

What is Taylor’s Rule?

Answer 7

The rule which well described Fed’s interest rate behaviour.

rt - rs = 0.5 (pi(t) - pi TARGET) + 0.5 (yt - y TARGET)

Question 8

What is Taylor’s principle?

Answer 8

Δit = 1.5Δπ

Δrt = 0.5Δπ

Question 9

Determinants of size of policy response:

Answer 9

So:

↑β: High aversion → responds to shock with a larger rise in r.
↑α: steeper & flatter → smaller response to shock.
↑a: flatter (high r–sensitivity of AD) → smaller response needed.

Question 10

What is the yield curve?

Answer 10

The yield curve plots the yield on bonds of differing maturities against their maturity.
An upward sloping yield curve indicates that yields on bonds of longer maturity (e.g. 5 years) exceed yields on shorter-maturity bonds (e.g. 1 year).

Question 11

The transmission mechanism of the interest rate policy channel:

Answer 11

Depicts the channel from the official rate (policy interest rate) to the impact on inflation in the economy.

It includes: market rates, asset prices, expectations and exchange rate (which exclusively affects import prices).
From there: Domestic and net external demand
From there: total demand -> domestic inflationary pressures.
From domestic inflationary pressures & import prices to: INFLATION.

Question 12

What is the policy interest rate?

Answer 12

It is the rate set by the CB for short-term maturity bonds.

Question 13

What is the yield of a bond?

Answer 13

yield = coupon / price

Question 14

What is Quantitative Easing?

Answer 14

An unconventional monetary policy involving the outright purchase by the central bank of government bonds or other financial assets like corporate bonds.

Question 15

How is QE executed?

Answer 15

QE purchases are made by the Asset Purchase Facility, a vehicle set up by the BoE. The bank creates reserves ( a liability) to enable it to fund its loan to the APF. Then, the APF uses the loan to buy QE purchases, and pays back the loan to the BoE with interest. HM Treasury provides indemnity to the APF.

Question 16

What is QE purpose in terms of assets and money supply?

Answer 16

• higher asset prices, lower yield (lower interest rate)

- increase in money supply (because the CB uses reserves, not cash to purchase the assets)

Question 17

What is the relationship between bond price and yield?

Answer 17

The current yield of a bond is equal to: coupon/price. While the coupon is fixed, the price changes. If the price increases, current yield decreases.

Question 18

How does QE affect the yield curve?

Answer 18

QE pivots the Yield curve, reducing the iL of long maturity bonds.

Question 19

QE transmission:

Answer 19

• QE is intended to lower longer-term borrowing costs.
• the impact of QE is state-contingent
• the 3 main types of transmission channels are:
  
  1. signalling
  2. the portfolio balance channel (reduces interest rates on a spectrum of assests)
  3. market liquidity (reduces the liquidity premium, and the yield of the bond falls)

Question 20

What are the estimated impacts of QE?

Answer 20

a) on yields
- reduction of 10 year maturity yields of between 50 and 100 basis points
b) on macro variables
- limited evidence of the impact of QE on GDP & inflation
- positive impact on GDP and inflation

Question 21

QE and state contingency

Answer 21

• QE appears to be more state-contingent than interest rate policy
• the impact of QE might depend on degree of financial markets dysfunction
• the liquidity transmission channel is particularly important in times of market stress

Question 22

Criticism of QE:

Answer 22

1. Which channel does QE transmit through?
2. QE purchases do not comply with ESG principles
3. The Bank could be more transparent
4. CB independence & credibility might fall
5. Inflation expectations might rise (not nec. a bad thing)
6. Distributional impact: only some benefit
7. Unknowns about QE exist.

Question 23

What is the shadow interest rate?

Answer 23

• Measure the overall stance of monetary policy - combining both conventional and unconventional typess
• When the nominal interest rate hits the zero lower bound, it cannot be properly used in economic modeling. Thus, the ‘shadow policy rate’ acts as a substitute for the fed funds rate. The results of the shadow rate used instead of the interest rate around zero prove to be empirically more accurate.
• It is an interest rate proxy that combines the impact of unconventional measures with the actual policy rate.

Question 24

What is the Bank Rate?

Answer 24

The BoE bank rate is a nominal rate - the Bank’s policy rate.
The CB cannot directly influence the real interest rate.

Question 25

How are long-run real interest rates determined?

Why are interest rates so low?

Answer 25

By the balance between desired wealth (savings) and capital holdings (investments).
There has been a decrease in desired capital (investment) and an increase in desired wealth (savings). Why:
i) increase in ageing population: increase in desired wealth (savings)
ii) decrease in trend productivity growth: decrease in demand for capital (investment)

Question 26

Implications of low interest rates for monetary policy:

Answer 26

i) monetary policy during a recession:
- during recessions, CB cannot cut policy rates further to stimulate demand
- once the yield curve is flattened, there is not much monetary policy can do

ii) fiinancial stability:
- low yields imply high asset prices: scope to fall
- low yields prompt search for higher yields: high risk-taking
- the banking system become fragile: low rates bring fewer deposits

Question 27

Implications of low interest rates for fiscal policy:

Answer 27

i) if g>r (where r nominal interest rate) it means that debt as a proportion of GDP will fall over time
ii) argued that the current level and increases in debt are sustainable (because interest rates are very likely to remain low)

Question 28

Low interest rates:

Answer 28

• reflect long run structural trends in variables affecting savings and investment
• deem monetary policy powerless
• good for fiscal policy: give scope for gov to use fiscal policy

Question 29

Zero lower bound:

Answer 29

• when the interest rate is positive, cash is a strictly dominated asset
• cash and bonds face the same inflation risk
• cash would dominate if the return on bonds would be negative
• there is a zero lower bound on nominal interest rates
• once the effective lower bound is reached, there is a liquidity trap / deflation trap

Question 30

Minimum real interest rate:

Answer 30

min r = -π EXPECTED

• So, if inflation is negative, the real interest rate is positive and cannot be dropped any lower.
• Due to the ZLB, there is susceptibility to a deflation trap.
• If the desired interest rate is unattainable because it is lower than the minimum real interest rate (given by the ZLB) monetary policy is fairly powerless

Question 31

Negative nominal interest rates and policy:

Answer 31

• there is a lower bound on nominal interest rates, which is less than 0 (storage and similar costs of holding cash)
• the slightly negative lower bound is known as the EFFECTIVE LOWER BOUND (ELB)
• at the ELB, conventional monetary policy is ineffective

Question 32

How do negative interest rates work?

Answer 32

• used in Eurozone, Denmark, Switzerland, Sweden, Japan
• do not seem to adversely impact bank profits
• pass-through to households is limited;
• pass-through for corporate deposit rates, encouraging spending on the firm’s behalf (so as to reduce their cash deposits)
• current evidence suggests negative rates can provide significant stimulus