Sem 2 Flashcards
What is real money demand a function of
real income and is inversely proportional to interest rates.
How does monetary policy affect the economy?
Lower interest rates make the price of corporate shares and bonds rise making households wealthier since future earnings are now discounted at a lower interest rate
Expansionary monetary policy makes more credit available to consumers and lowers the cost of credit
Why is there a relationship between short term interest rates and long term ones
Since companies can finance long-term investment with a succession of short-term loans over many time periods
How can Govts better influence long term investment
by affecting beliefs about future short term interest rates through forward guidance which is an indication of the future interest rates the central bank wants to achieve the success of which depends on the credibility of the central bank
What determines the strength of the transmission mechanism
If current interest rates have minimal effect on long-term interest rates then it is weak and is dependent on the prevalence of fixed rate mortgages
The transmission mechanism of monetary policy
Set interest and thus money demand then provide money supply for equilibrium
Long term interest rates should be an average of short term interest rates over the same period
By influencing the cost of borrowing AD is directly influenced
Why does rising government 10 year bond yields matter
Govt bond yields are a benchmark for a lot of other interest rates in the economy
Why have Government 10 year bond yields been rising
Yield on long term government debt is determined by investors expectations of short term interest rates plus compensation for risk (term premium)
This is rising due to expectations of high inflation which implies no cut in future
What does the Yield curve show and why is it significant
Shows the costs of borrowing for governments over time
Usually borrowing is more expensive over more time
An inverted yield curve signals recession due to high interest rates in short term and long term aggressive interest cuts reliable with the U.S.A
What does the IS-MP model show
simultaneous equilibrium between the goods and money market
Assumptions for the IS-MP model
Assumed price is fixed- which is reasonably realistic as the model is concerned with short term fluctuations.
IS schedule shows…
Equilibrium in the goods market
What causes shifts in the IS curve
Other influences on AD other than interest shifts the curve
Why is the IS curve negatively sloped
Negatively sloped since higher output requires higher AD and a lower interest rate for AD to rise
When is the goods market in equilibria
when AD=output
What does the MP schedule show…
equilibrium where the central bank is achieving it’s desired interest rate for every level of real income.
These levels of interest and income implies a level of money supply which is passively supplied by the central bank to reach equilibria.
What determines the slope of the MP schedule
how aggressively the central bank raises interest as income increases.
IS-MP normal equilibrium diagram
L4
Fiscal expansion in the IS-MP model chain of reasoning and diagram
Increase in G shifts IS curve outwards
New equilibria where new IS curve intersects MP curve
Central bank choses a higher interest rate
Higher interest rates discourage private investment reducing expansionary effects- crowding out effect
L4
Why did interest rates rise when G expands?
The govt could finance additional spending by issuing government debt which is bought by the central bank with newly created money
Therefore, expanding money supply creating a monetary expansion
If the Govt finances spending by borrowing from the private sector assuming the private sector and public are competing for the same pool of savings the govt may have to pay more to borrow
Whether public expenditure leads to crowding out or in is dependent on the current economic context.
Expansionary monetary policy on the IS-MP model
Looser monetary policy causes MP curve right/downwards which means a lower interest is chosen for any level of income
What happens with changes in money demand IS-MP model
The CB changes money supply to accommodate the changes in money demand
Interest rates don’t change because CB sets them according to output
What the fiscal multiplier depends on (responsiveness of expansionary fiscal policy on rises in GDP)
How much of the fiscal stimulus results in additional purchase of goods and services
Leakages arising from people spending money on imports
Whether they must raise interest rates or whether expansion raises govt debt questions
Ricardian equivalence
fiscal policy does not influence rational consumers since they know the government needs to pay back this money with interest and may raise future tax rates to pay this back. Therefore, a consumer may increase saving to afford this increased tax rates in the future.
However, in practise fiscal multipliers are usually positive and often higher in slowdown.
