Monetary Economics Flashcards
Functions of Money
- Storage of Value
- Unit of account
- Medium of exhange
Characteristics of “good” money
Authentificatin/uniform quality Diversibility durability ease of transportation/Exchange low cost of production steady supply
Nominal GDP meassurement
Expendiature Approach
Value added approach
income approach
Real GDP
Nominal GDP /1+ \inflation
Emperical Evidence about Money
Long-run: Money is neutral in the long run and has no effect on real variables
short run: Non-neutrality. Due to price regidities monetary policy can have real effects in the short run.
Money in Utility Model
holding money gives individuals utility in itself. This can be related to the lequidity theory.
money demand is decreasing in the nominal interest rate.
money demand is increasing in consumption
money demand is decreasing in the inverse lequidity preference
Euler Equation
marginal rate of intertemporal consumption = marginal rate of technical substitution
Euler Equation
marginal rate of intertemporal consumption = marginal rate of technical substitution
Fisher Equation
1+rt = 1+it /(1+pit+1)
The Classical Model
real variables only depend on real tings - money is neutral
prices are perfectly flexible
doubleing the money supply will just double the price level i.e. the wages and has no real demand effect
In conjunction with the Quantety theory of money we come to the conclusion, that a low level of inflation is the best solution, since high inflation imposes costs.
Neutrality of Money
Neutrality: The economy is independent of the initial level of money
Super Neutralitiy: The economy is independent of the growth rate of money.
Equation of Exchange
Mt vt = Pt yt
with the logs and then the difference we obtain the growth representation and the Quantety theory of money
Quantety theory of Money
increasing the money growth increases inflation 1 to 1
increasing the output growth increases inflation 1 to 1
increasing the growth of the velocity increases inflation 1 to 1.
Costs of inflation
higher inflation gives higher nominal interests thus a lower preference for holding money. But holding money gives utility. Thus holding less money decreases the utiity.
- maintain a low inflation.
Independence of a CB
Government only sets a target but leaves the methods to achieve it in the hands of the CB
Active Policy of a CB
CB reacts to changes in the Business Cycle
Passive CB
Does not react to the Business Cycle i.e. applies a fixed money growth policy.
Transmission mechansisms
Expectation channel Money and Credit cahnnel Assetprice channel Bank-rate channel Exchange rate channel
Instruments of a CB
policy rates
minimum reserves
open-market operations/transactions
QE
Inflation Target vs. Money Target
Since inflation transitions to demand thus to the real economy, a fixed inflation target for a given period with a continious adjustment of the money supply reduces volatility in the real economy.
Taylor Rule
i = alpha + alphapi(pit-pi) + alphay(yt-y)
Taylor Principle
CB should follow a agressive Taylor rule alphapi > 1 to have a uniquely defined inflation.
FED in the 1970 pre Volker and after
The estimation of the Taylor rule is not possible due to endogeneity
Cholesky Decomposition
pro:
simple implementation
easy to understand: ranking of exogeneity
checking for robustness by changing the ordering (should not be done!)
Contra:
- too many choices
- Timing causality becomes problematic in highly aggregated data. What holds on a day to day basis does not hold in Quarter by Quarter timing.
- Risk of picking a ordering that gives significant results (confirmation bias)
Romer and Romer (2004)
Used announcements of the FED to determine the intended interest rate - regressing all explanatory variables of macro model on the announced interest rate - the given residuals are the monetary shocks, the unanticipated monetary changes.
Using these generated shocks in the model should overcome the endogeneity and intercorrelation problem.
Narrative Approach (Romer and Romer)
pro:
- once the shocks are created it is easy to use
- more plausible than the Choleskey decomposition
Contra:
- More work to estimate
- Black box (“how are the shocks are estimated if not doin the estimation by yoursef”)
- Results are highly sensitve i.e. inclusion of Volcker period.
Reasons for price stickiness
Cotraction friction
Menu Costs
New Keynesian Model
Based on Calvo pricing we obtain price stickiness by introducing a market for intermediate goods where an continioum of firms are only allowed to adjust their prices with a certain probability at any given period.
This leads them to anitcipate the inflation and take that into account to build their current price. The less likely they are able to change the price the higher, if there is positive inflation
NKPC - Explain the parts of the equation.
pi = ß E pit+1 kappa xt + et
et is the cost-push shock
cost push shocks
price increase on foreign not locally substitutable goods. i.e. oil price shock, exchange rate shock caused by another country. Cost shocks in other raw materials that need to be imported.
IS Equation - What are the parts of the equation and why are they included?
x = Ex - sigma (i_t - E pit+1 - re)
alternative version with vt as the consumer sentiments
Money Demand
m = gamma y - gamma i + ut
Optimal monetary policy
Based around the loss function derived from the household utility gives the utility maximizing or to be precise the utility loss minimizing CB policy for a given shock.
Optimal monetary policy
Based around the loss function derived from the household utility gives the utility maximizing or to be precise the utility loss minimizing CB policy for a given shock.
Loss function
BAsed on the representive Households utility one can approximate a loss function, it is square in the deviation from the target inflation and the output gap.
Thus setting both deviations to zero would be optimal.
Divine Coincedince
In the absence of cost-push shocks the CB should follow with the nominal interest rate the natural interest rate. (wicksel rate)
Would still have recessions even if the output gap is zero. The natural level of output can decline.
Comittment
CB decides on a policy path and sticks/Commits to it. This commitment is assumed to be credible.
Discression
CB decides every period about their policy
Comittment vs. Discression
Pro Comittment:
- manages expectations (i.e. forward guidence)
- reduces uncertainty
- can constraint incompetent policy makers
Contra:
- time inconsistent
- world is too complex for a comitment “rule”
- reduces the flexibility in the reaction to a crisis “can all crisis be foreseen ?
Comittment vs. Discression
Pro Comittment:
- manages expectations (i.e. forward guidence)
- reduces uncertainty
- can constraint incompetent policy makers
Contra:
- time inconsistent
- world is too complex for a comitment “rule”
- reduces the flexibility in the reaction to a crisis “can all crisis be foreseen ?
Strict inflation targetting vs. Flexible targetting
keeping inflation down at all costs is not optimal, sometimes a focus on unemployment or economic growth might be reasonable.
As we saw the utility depends on the output gap and the inflation.
Zero Lower Bound
Liquidity trap. The nominal interest rate has reached the lowest possible level compared to the outside option of holding cash.
Saturated Money Demand.
Price Level targetting
Functions as a typ of short term comittment. CB has to initiate an above target inflation to get price level back on target. Like in the case with comittment.
Speed limit rule
changes in the nominal interest rate are limited. The problem is there are not only cost-push shocks in the world.
Quantitative Easing
Vanilla QE:
Does not work:
- exchanging bonds for money does not effect demand if they are just substitutes.
- Households are not made richer by Vanilla QE
- No inflation, since the velocity drops in the level the monetary base increases.
QE Alternatives
Operation Twist - lowering long run interests by exchanging short term bonds or money for long term ones.
Dircect purchase of privat assets
Helicopter money
Is not a monetary policy, since it can be used to pay off tax debts. Thus is equivalent to a tax cut, hence a form of fiscal policy.
