Policy In Action Flashcards
Design of MP
- Nominal money growth targeting
- Inflation targeting
- Interest rate rules (Taylor rule)
Deisgn of FP
- Intertemporal budget constraints
- Ricardian equivalence
- Rules and constraints
In SR, expansionary MP affects output….
….decrease in interest rate and a depreciation of currency, both lead to an increase in output
Under fixed exchange rates, MP is…
…lost. It’s simply used for accommodating FP
In MR, MP is…
…. Neutral. Changes in money have no effect on output or employment. Leads to a proportional increase in prices however
Problems with Nominal money growth
Design depends on a crucial relationship between money growth and inflation. In reality, it isn’t
Central banks primary goal for SR and MR
Inflation targeting, low stable inflation
SR MP is movements in the…
…. Nominal interest rate
Costs of Inflation
1) Shoe leather costs
2) Tax Distortions
3) Money Illusion
4) Inflation Variability
Benefits of Inflation
1) Seignorage
2) Option of Negative IR
3) Money Illusion revisited
Inflation Targeting
For the medium run. Provides greater clarity to consumers and firms about what the intentions for the central bank are in the MR. SR targeting is not sensible as may take focus away from output fluctuations
Philips Curve Relation
πt = πt-1 - a(Ut-Un)
Taylor Rule
it = i* + a(πt - π*) - b(ut - Un)
Interest rate directly affects spending.
In SR, expansionary FP leads to…
… higher output, increase in trade deficit. Effect on investment in ambiguous
In MR, expansionary FP leads to…
…. change in the composition of output, higher interest rates and lower investment
In LR, expansionary FP leads to….
… lower national savings, lower investment, lower capital accumulation and lowers levels of long-run output
In an open economy, FP is…
… more effective under a fixed exchange rate compared to a flexible one
Government debt during year t (Bt) is the sum of two variables
Past debt and current deficit
Bt = Bt-1 + Current Deficit
Budget deficit has two terms
Budget Deficit = rBt-1 + (Gt-Tt)
Primary deficit
Gt>Tt
Interest payments are measured as…
…real interest payments rather than as actual interest payments
Gov budget constraint equation
Bt - Bt-1 = rBt-1 + (Gt - Tt)
Debt-to-GDP ratio
helps us understand the size of the debt relative to being able to pay it back
The change in debt ratio over time is equal to two sums:
1) Difference between real interest rate and growth rate multiplied by the initial debt ratio
2) ratio of the primary deficit to GDP
Normal case of debt/GDP ratio
Growth rate is smaller than the real interest rate and thus (1 + r) - g > 1
Three ways to get out of a debt crisis
1) Generate sufficient primary surpluses
2) Resort to monetary financing by the central bank
3) Repudiate the debt, in whole or in part
Problems with increasing the primary surplus
Creates political uncertainty and increases the risk premium, therefore interest rates
Problems with monetising debt
Monetisation of debt will lead to inflation
Explanations as to why member countries are subject to constraints on FP
1) to correct the incentive to pass on the costs of fiscal expansion
2) To prevent financial crisis in one country spreading to all other members
Summary of RE
Households realise that higher debt today will have to be paid off tomorrow, which means taxes will increase in the future. Essentially lower taxes today means saving for higher taxes in the future
Policy response to the financial crisis
Gov used FP to make up private and public demand.
Also used MP to cut interest rates close to zero.
