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Economic principles 2 > Monetary policy and the three equation model > Flashcards

Monetary policy and the three equation model Flashcards

1
Q

what is the uk inflation target

A

2%

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2
Q

what is the central bank’s objectives

A 
price stability,
high employment,
econ growth,
stability in financial system,
interest rate stability,
foreign exchange stability
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3
Q

what are the three main central banks and which countries do they belong too

A

bank of england UK,
federal reserve system US,
european central bank Eurozone

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4
Q

why are central banks independent from governments

A

government motivated by votes

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5
Q

what does monetary policy refer too

A

actions the cb takes to manage the money supply and interest rates to pursue macroeconomic policy objectives

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6
Q

monetary policies are _____ side macroeconomic policies

A

demand

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7
Q

what are the two monetary policy tools

A

open market operations,

discount rates

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8
Q

how do omos work

A

cb purchases and sells securities (T-bills) in financial markets influencing the level of bank reserves and short term interest rates

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9
Q

what happens if the cb buys securities

A

adds cash to bank reserves, gives more money to lend so lower interest rates

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10
Q

what happens if the cb sells securities

A

puts on bank’s balance sheet so bank has less to lend, supply of money down, interest rate up reduces demand so inflation down

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11
Q

when the cb wants expansionary monetary policy does it buy or sell securities

A

buys

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12
Q

if the cb sells securities is this expansionary or contractionary monetary policy

A

contractionary

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13
Q

how does the discount rate work

A

cb provides reserves to banking system by making discount loans to banks

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14
Q

what is the discount rate

A

discount rate is the interest rate the cb charges banks for loans

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15
Q

what is a reserve requirement

A

cb mandates that banks hold a certain fraction of their checkable deposits as vault cash or deposits with the cb

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16
Q

what is inflation targeting

A

where the cb aims policy instruments directly at inflation

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17
Q

what does the is curve show

A

shows combinations of the interest rate and output at which aggregate spending in the economy is equal to output

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18
Q

what is the is curve

A

locus of points where the goods market is in equilibrium, any point on the line is equilibrium s=d

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19
Q

what does is stand for in the is curve

A

investment/saving

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20
Q

taylor rule d

A

estimate of the value of the real federal funds rate consistent with real GDP being equal to potential real GDP in the long run

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21
Q

what is meant by the term default risk premium

A

rate of company bond against riskless bond which is government bond (then give an example in the us it is t-bills)

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22
Q

who can also issue bonds

A

firms,

firm promises to pay

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23
Q

equation for default risk premium

A 
rp = ibond - igovernmentbond,
rp = interest rate of bond and interest rate of government bond
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24
Q

what does a large spread mean for the economy (difference between interest rate of government bonds and firm’s bonds)

A

bigger the spread is sign that economy not doing well because low confidence in investment

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25
Q

why is it expensive for firms to borrow money after financial crisis

A

banks lend at high interest rates because uncertainty, selling bonds public demands high interest rate because uncertainty

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26
Q

equation for real interest rate using federal funds rate and default risk premium

A

r = rff + rp

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27
Q

what else can cb do in deep recession

A

negative interest rates

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28
Q

how do negative interest rates work

A

cb has negative rate begging commercial banks to borrow, not negative interest rate to consumers, commercial banks don’t give negative rate to customers

29
Q

how does quantitative easing work simplified

A

cb purchase government bonds from banks, firms, investment banks with electronically created money

30
Q

marginal product of capital d *

A

the amount of additional output the firm can produce by investing in one more unit of capital

31
Q

investment equation used in IS curve *

A

It / Yt = aibar - bbar(Rt - rbar),
investment / output = long run fraction of potential output that goes to investment - how sensitive investment is to change in interest rate (real interest rate - marginal product of capital)

32
Q

what does aibar stand for in the is curve investment equation (a subscript i with a bar over the top)

A

fraction of potential output that goes to investment

33
Q

what does a with a subscript and a bar stand for in the IS equations

A

the fraction of potential output that goes to a given parameter (acbar, agbar, aexbar, aimbar, aibar)

34
Q

so from the is curve investment equation what does it say the amount of investment depends on

A

depends on the gap between the real interest rate Rt and the marginal product of capital rbar

35
Q

what does it mean for investment if the marginal product of capital is low relative to the real interest rate

A

firms are better off saving their retained earnings in the financial market

36
Q

what does it mean for investment if the marginal product of capital is high relative to the real interest rate

A

firms would find it profitable to borrow at the real interest rate and invest the proceeds in capital, leading to a rise in investment

37
Q

in the long run what must equal what in the investment equation, It / Yt = aibar - bbar(Rt - rbar)

A

real interest rate must equal the marginal product of capital

38
Q

equation for consumption IS curve

A 
Ct = acbarYtbar,
consumption = fraction of potential output on consumption x potential output
39
Q

equation for government expenditure IS curve

A

Gt = agbarYtbar,

government expenditure = fraction of potential output on government spending x potential output

40
Q

equation for exports IS curve

A 
EXt = aexbarYtbar,
exports = fraction of potential output on exports x potential output
41
Q

equation for imports IS curve

A 
IMt = aimbarYtbar,
imports = fraction of potential output on imports x potential output
42
Q

equation for IS curve

A

Yt~bar = abar - bbar(Rt - rbar)

43
Q

what is abar equal to in the IS curve equation

A

abar = acbar +aibar + agbar + aexbar - aimbar -1

44
Q

in the long run what is significant about abar in the IS curve equation (abar = acbar +aibar + agbar + aexbar - aimbar -1) *

A

abar is equal to 0 because the acbar + aibar etc should add up to 1 because thats the fractions of output on the different things like consumption so added together they will be equal to 1

45
Q

what is significant about abar in the IS equation in the short run (abar = acbar +aibar + agbar + aexbar - aimbar -1)

A

abar will deviate from 0 in the short run because of shocks to the economy

46
Q

what happens to the IS curve if there are improvements in technology that lead to an investment boom

A

businesses become optimistic about the future and increase demand for machines and tools,
this leads to an increase in the aibar value: this parameter changes the amount of investment associated with any given level of the interest rate

47
Q

what is the symbol for short-run output

A

Yt~bar

48
Q

what does Yt~bar mean

A

symbol for short-run output

49
Q

what happens to the IS curve if there is a reduction in foreign demand for domestically produced goods (for example a large recession hits Europe or Japan and foreigners reduce demand for U.S. goods)

A

reduction in aexbar which leads to a reduction in the abar term in the IS equation so the curve shifts in

50
Q

what does MP stand for in MP curve

A

monetary policy curve

51
Q

equation for the real interest rate

A

Rt = it - πt

52
Q

what is a key assumption of the short-run model when we are looking at the MP equation

A

sticky inflation assumption,
this means that changes in monetary policy that alter the nominal interest rate lead to changes in the real interest rate

53
Q

what shape of line is the MP curve on the IS curve diagram

A

x axis = output,
y axis = real interest rate
horizontal line because it specifies one interest rate

54
Q

what happens when the central bank decides to raise their interest rate (to the MP-IS model) *

A

the MP curve shifts up as it is an increase in the interest rate and it is a movement along the IS curve,
this moves the economy into a negative output gap because the interest rate is now above the marginal product of capital so firms and households cut back their investment

55
Q

what is the classical dichotamy

A

says that in the long run, the real and nominal sides of the economy are completely separate

56
Q

what are four reasons for the failure of the classical dichotamy in the short run

A

many contracts set prices and wages in nominal rather than real terms,
costs associated with changing prices,
imperfect information,
bargaining costs (workers aren’t going to risk jobs asking for more money)

57
Q

what does Ms stand for

A

money supply

58
Q

what does Md stand for

A

demand for currency

59
Q

what does a higher interest rate do to Md

A

raises the opportunity cost of holding currency and reduces the demand for currency

60
Q

why does increasing the money supply decrease the interest rate

A

interest rate is the cost of borrowing so if there is more money around then the price of borrowing will be reduced

61
Q

what are federal funds in the US and what is the federal funds rate *

A

when a bank has reserves they are held in federal reserve banks so they are federal funds,
when a bank has excess reserves it can lend money to another bank at the federal funds rate

62
Q

what is the discount rate *

A

interest rate charged by the federal reserve itself on loans that it makes to commercial banks and other financial institutions

63
Q

do banks borrow at the discount rate or the federal funds rate *

A

banks will try and borrow from other banks at the federal funds rate but if they can’t borrow sufficient amounts in financial markets may borrow from the federal reserve at the discount rate

64
Q

monetary policy rule d

A

set of instructions that determines the stance of monetary policy for a given situation that might occur in the economy

65
Q

what is the monetary policy MP equation *

A

Rt - rbar = mbar(πt - πbar),
real interest rate - cost of capital = how aggressively monetary policy responds to inflation (current inflation - inflation target)

66
Q

what other diagram do you need to show when explaining the financial crisis using IS analysis

A

the decrease in output shown on the phillips curve as well as the decrease in output by a shifting to the left of the IS curve

67
Q

when you show the financial crisis on the phillips curve as a movement down the curve how do you show the situation being corrected by a fall in the interest rate

A

you draw it going back up the curve to the point that it was previously at,
so it goes from π1 to π2 and then from π2 back to π1 when the interest rate is decreased

68
Q

if the government wants to permanently reduce the level of inflation in terms of IS curve phillips curve analysis ***

A

raise interest rates on IS diagram by shifting the MP curve upwards, this causes a movement along phillips curve downwards, if inflation persists at lower level then households eventually lower expectation, this is shown by a shift downwards of the phillips curve and then the economy is at potential (see photo on phone of this)

Economic principles 2 (7 decks)

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