Monetary policy and the three equation model Flashcards
what is the uk inflation target
2%
what is the central bank’s objectives
price stability, high employment, econ growth, stability in financial system, interest rate stability, foreign exchange stability
what are the three main central banks and which countries do they belong too
bank of england UK,
federal reserve system US,
european central bank Eurozone
why are central banks independent from governments
government motivated by votes
what does monetary policy refer too
actions the cb takes to manage the money supply and interest rates to pursue macroeconomic policy objectives
monetary policies are _____ side macroeconomic policies
demand
what are the two monetary policy tools
open market operations,
discount rates
how do omos work
cb purchases and sells securities (T-bills) in financial markets influencing the level of bank reserves and short term interest rates
what happens if the cb buys securities
adds cash to bank reserves, gives more money to lend so lower interest rates
what happens if the cb sells securities
puts on bank’s balance sheet so bank has less to lend, supply of money down, interest rate up reduces demand so inflation down
when the cb wants expansionary monetary policy does it buy or sell securities
buys
if the cb sells securities is this expansionary or contractionary monetary policy
contractionary
how does the discount rate work
cb provides reserves to banking system by making discount loans to banks
what is the discount rate
discount rate is the interest rate the cb charges banks for loans
what is a reserve requirement
cb mandates that banks hold a certain fraction of their checkable deposits as vault cash or deposits with the cb
what is inflation targeting
where the cb aims policy instruments directly at inflation
what does the is curve show
shows combinations of the interest rate and output at which aggregate spending in the economy is equal to output
what is the is curve
locus of points where the goods market is in equilibrium, any point on the line is equilibrium s=d
what does is stand for in the is curve
investment/saving
taylor rule d
estimate of the value of the real federal funds rate consistent with real GDP being equal to potential real GDP in the long run
what is meant by the term default risk premium
rate of company bond against riskless bond which is government bond (then give an example in the us it is t-bills)
who can also issue bonds
firms,
firm promises to pay
equation for default risk premium
rp = ibond - igovernmentbond, rp = interest rate of bond and interest rate of government bond
what does a large spread mean for the economy (difference between interest rate of government bonds and firm’s bonds)
bigger the spread is sign that economy not doing well because low confidence in investment
why is it expensive for firms to borrow money after financial crisis
banks lend at high interest rates because uncertainty, selling bonds public demands high interest rate because uncertainty
equation for real interest rate using federal funds rate and default risk premium
r = rff + rp
what else can cb do in deep recession
negative interest rates
how do negative interest rates work
cb has negative rate begging commercial banks to borrow, not negative interest rate to consumers, commercial banks don’t give negative rate to customers
how does quantitative easing work simplified
cb purchase government bonds from banks, firms, investment banks with electronically created money
marginal product of capital d *
the amount of additional output the firm can produce by investing in one more unit of capital
investment equation used in IS curve *
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)
what does aibar stand for in the is curve investment equation (a subscript i with a bar over the top)
fraction of potential output that goes to investment
what does a with a subscript and a bar stand for in the IS equations
the fraction of potential output that goes to a given parameter (acbar, agbar, aexbar, aimbar, aibar)
so from the is curve investment equation what does it say the amount of investment depends on
depends on the gap between the real interest rate Rt and the marginal product of capital rbar
what does it mean for investment if the marginal product of capital is low relative to the real interest rate
firms are better off saving their retained earnings in the financial market
what does it mean for investment if the marginal product of capital is high relative to the real interest rate
firms would find it profitable to borrow at the real interest rate and invest the proceeds in capital, leading to a rise in investment
in the long run what must equal what in the investment equation, It / Yt = aibar - bbar(Rt - rbar)
real interest rate must equal the marginal product of capital
equation for consumption IS curve
Ct = acbarYtbar, consumption = fraction of potential output on consumption x potential output
equation for government expenditure IS curve
Gt = agbarYtbar,
government expenditure = fraction of potential output on government spending x potential output
equation for exports IS curve
EXt = aexbarYtbar, exports = fraction of potential output on exports x potential output
equation for imports IS curve
IMt = aimbarYtbar, imports = fraction of potential output on imports x potential output
equation for IS curve
Yt~bar = abar - bbar(Rt - rbar)
what is abar equal to in the IS curve equation
abar = acbar +aibar + agbar + aexbar - aimbar -1
in the long run what is significant about abar in the IS curve equation (abar = acbar +aibar + agbar + aexbar - aimbar -1) *
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
what is significant about abar in the IS equation in the short run (abar = acbar +aibar + agbar + aexbar - aimbar -1)
abar will deviate from 0 in the short run because of shocks to the economy
what happens to the IS curve if there are improvements in technology that lead to an investment boom
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
what is the symbol for short-run output
Yt~bar
what does Yt~bar mean
symbol for short-run output
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)
reduction in aexbar which leads to a reduction in the abar term in the IS equation so the curve shifts in
what does MP stand for in MP curve
monetary policy curve
equation for the real interest rate
Rt = it - πt
what is a key assumption of the short-run model when we are looking at the MP equation
sticky inflation assumption,
this means that changes in monetary policy that alter the nominal interest rate lead to changes in the real interest rate
what shape of line is the MP curve on the IS curve diagram
x axis = output,
y axis = real interest rate
horizontal line because it specifies one interest rate
what happens when the central bank decides to raise their interest rate (to the MP-IS model) *
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
what is the classical dichotamy
says that in the long run, the real and nominal sides of the economy are completely separate
what are four reasons for the failure of the classical dichotamy in the short run
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)
what does Ms stand for
money supply
what does Md stand for
demand for currency
what does a higher interest rate do to Md
raises the opportunity cost of holding currency and reduces the demand for currency
why does increasing the money supply decrease the interest rate
interest rate is the cost of borrowing so if there is more money around then the price of borrowing will be reduced
what are federal funds in the US and what is the federal funds rate *
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
what is the discount rate *
interest rate charged by the federal reserve itself on loans that it makes to commercial banks and other financial institutions
do banks borrow at the discount rate or the federal funds rate *
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
monetary policy rule d
set of instructions that determines the stance of monetary policy for a given situation that might occur in the economy
what is the monetary policy MP equation *
Rt - rbar = mbar(πt - πbar),
real interest rate - cost of capital = how aggressively monetary policy responds to inflation (current inflation - inflation target)
what other diagram do you need to show when explaining the financial crisis using IS analysis
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
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
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
if the government wants to permanently reduce the level of inflation in terms of IS curve phillips curve analysis ***
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)
