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Macroeconomics > SEM 2 - LEC 5 - MONETARY AND FISCAL POLICY > Flashcards

SEM 2 - LEC 5 - MONETARY AND FISCAL POLICY Flashcards

1
Q

What does the CB use monetary rules for

A
  • explicit inflation target as nominal anchor for inflation expectations
  • to keep economy close to target
  • interest rate as policy instrument (instability of velocity no longer an issue)
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2
Q

whats the quantity theory of money equation

A

p - price
y - output
m - money in circulation
v - velocity of money

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3
Q

what determines inflation

A

money supply growth.

money supply targeting can control inflation

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4
Q

what two conditions needed for Money supply targeting:

A

1) CB able to control monetary aggregate;

2) reliable relationship between inflation and money supply target

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5
Q

whats goodharts law

A

each observed regularity between monetary aggregate and in- flation disappears as soon as the CB tries to exploit it

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6
Q

why can cb not fully control monetary aggregates

A

• part of broad money created by private banks via the bank multiplier
-not under the CB control. CB alters the cost at which banks can borrow but cannot be sure a) this change will be passed onto customers, b) loans demand will react to lending rate changes
• instability of money velocity (e.g. effects of plastic money, changes in banking legislation, etc…)
• even under full control of money supply (fixed AD), supply shocks →inflation

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7
Q

how does the central bank keep inflation rate at target

A

cb adjust interest rates

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8
Q

what happens when beta is more then 1 in the MR equation

A

more inflation averse CB ⇒flatter MR sharper output reduction after an inflation shock

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9
Q

what happens when alpha which is the responsiveness of inflation to the output gap

A

α ↑: inflation more responsive to output gap ⇒ steeper PC

any cut in output has greater effect in reducing inflation (easier job for CB, flatter MR)

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10
Q

what happens if the pc is steeper

A
  • steeper PC makes job of CB easier

- more inflation averse (“hard nosed”) CB cuts AD more

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11
Q

what does the sacrifice ratio measure

A

% rise in unemployment for 1% reduction in inflation

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12
Q

what are more inflation averse cb’s like

A

→ sharper rise in unemployment, faster fall in inflation, but also more rapid return of unemployment to equilibrium

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13
Q

what are less inflation averse cb’s like

A

“gradualist” approach

→ smaller rise in unemployment, slower fall in inflation

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14
Q

whats the best response Taylor rule

A
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15
Q

what’s the Taylor principle

A

for the CB response to be stabilising, the nominal rate has to be raised enough to push real interest rate up

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16
Q

whats a zero lower bound

A
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17
Q

describe and graphically . whats entering a deflation trap at period 0 when the economy is hit by a permanent shock IS -> IS’

A
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18
Q

what does entering a deflation trap look like at period 1 : lower interest rate affects AD

A
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19
Q

whats entering a deflation trap look like at period 2 when the higher interest rate dampens AD

A
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20
Q

how to escape deflation trap• if IS shifted right, through point G, CB could achieve output y′1 with r0
• how can this happen?

A

• spontaneus recovery of autonomous
investment/consumption
• generate positive inflation expectations (higher future AD),
Minr ↓, PC↑ (difficult)
• unconventional monetary policies: quantitative easing (we
see this next)
• fiscal policy: MR becomes a more general policy rule (PR)

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21
Q

whats the yield curve

A
  • relationship between nominal interest rate of a bond and its time to maturity - since investors demand a premium to hold long-term bonds ⇒+ve slope
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22
Q

show graphically what happens following a -ve AD shock on yield curve ,

A

CB lowers short-term i (⇒YC → YC′). But if i already low and
shock very large, i → 0

shock very large, i → 0
- QE: CB buys bonds in secondary market to induce lower long rate⇒ YC′ ↷YC′′

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23
Q

what can QE have stimulus effects by

A

by liquidity transformation
- “stimulates aggregate demand if households have a higher propensity to consume out of deposits than out of other less liquid forms of wealth, such as mutual fund shares.”

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24
Q

what could go wrong with QE

A
  • CB credibility: potential political interference?
  • inflation expectations: potential future higher inflation?
  • financial cycle, new asset bubbles, e.g. housing prices? • excess reserves: inflationary risks?
  • exit from QE: inflation and macroeconomic stability?
25
Q

whats the problem with using staanderd inflation targeting

A

standard IT, given asymmetry of lower bound ⇒ on average, MP responds more strongly to positive than negative shocks
⇒shortfalls of inflation from targeted on average larger than overshoots
⇒average inflation will be below target
⇒inflation expectations anchored below target

26
Q

whats the difference between commitment and secretion

A
  • discretion: CB can re-adjust interest rates in each period
  • commitment: CB commits to adjustment path following a shock

• “stabilisation bias”: more costly adjustments under discretion due to time inconsistency
- harsh response of policymaker, unable to commit not to change policy once private sector sets prices

  • optimal policy under discretion: target inflation
  • optimal policy under commitment: target price level (difficult)
27
Q

consider temporary inflation shock and CB with πT = 0 ⇒ constant price level in equilibrium. what does this look like graphically in discretion and commitment

A
28
Q

commitment vs discretion. whats the difference in outcomes

A
29
Q

how do you get the Static Average Inflation Targeting (SAIT)

A

• “overshoot” long-run inflation target so that inflation rate close, or equal, to target on average
• higher expected inflation boosts inflation after negative shock and creates more room for policy to lower real interest rate below the neutral rate
- shortfalls in output gap and inflation are attenuated relative to standard inflation targeting.
- effectiveness of SAIT based on anchoring inflation expectations at target, achieved by delivering longer-term mean inflation equal to target

30
Q

what are the alternatives to SAIT

A
  • AIT with multiyear average of inflation target, price level target, add past constraints on setting of MP
  • different mechanims, but all deliver interest rates “lower for longer” following a negative shock
  • when lower bound more binding, expectations of easier monetary policy in future provide additional stimulus
  • Dynamic AIT (Reifschneider&Williams, RW): identical to IT, but makes up for past missed monetary stimulus owing to the lower bound constraint.
  • current setting of policy adjusted based on a term that keeps track of cumulative past effects of lower bound on setting of interest rates, net of past “make-up” adjustments to policy.
  • RWpolicyrulefollowingepisodesofpolicyconstrainedby lower bound is qualitatively similar to multi-period AIT and price-level targeting
31
Q

what does fiscal policy do

A
  • income redistribution (e.g., progressive taxation, social security)
  • resource allocation (subsidies/taxes for specific industries)
  • provision of public/quasi-public goods
32
Q

why is fiscal policy traditionally not considered a good stabilisation tool?

A

• presence of automatic stabilisers stabilisation, already in place:

  • recessions/booms⇒ tax revenues fall/increase, transfer payments rise/decrease
  • increase/decrease in borrowing, lower/higher taxation, greater/lower government spending stimulate the economy

• dicretionary policy is problematic
- shock identification: are fluctuations due to temporary AD shocks or permanent AS
changes?
- policy lags (information→ decision→ implementation)

• further problems:

  • changes in FP difficult and take time
  • short-run stabilisation may conflict with long-run targets
  • interactions with the private sector (crowding-out, Ricardian equivalence)

• resurrection of FP as a stabilisation tool when MP finds limits

33
Q

what does the fiscal stimulus look like after a large negative AD shock

A
34
Q

what are we talking about when we say discretionary fiscal policy

A

• we refer here to stabilisation-oriented fiscal policies
- spending changes that affect the demand side (not the
supply side)

• multipliers

  • short-run multiplier in the IS-relationship, under the “ceteris paribus” assumption
  • medium-run multiplier: how much output increases, once monetary policy response and crowding-out are considered
35
Q

whats the short-run multiplier of a fiscal stimulus

A
36
Q

what does fiscal policy look like in a deep recession under zlb

A
37
Q

what would the scenario of fiscal policy, with an over ambitious output target, yH>ye: A–>B

A
  • starting from A, government raises spending and IS(A,G1)
  • PR now goes through yH → PR′, and assume new πT′
  • PC shifts upwards and the government reverts stimulus to minimise loss function→ C
  • At C, inflationary expectations shift PC upwards
  • process continues until new medium run eq. in D (under REH, this is reached directly) ⇒medium run multiplier is zero and disinflation is needed to return to A
38
Q

how would you summarise fiscal policy multipliers

A

• for a given k (short run multiplier in the IS curve),
∆G → ∆Y depends on model, context and behaviour of CB
• if economy has spare capacity, the government can boost AD and welfare
• if economy is at equilibrium, and CB keeps the real interest rate unchanged, fiscal policy produces inflation bias and high government debt

39
Q

what can affect size of multiplier, slope and shifts of IS

A

tax and social security systems imply a “built-in” dampening mechanism

  • whenoutput↓/↑⇒thebudgetdeficit↑/↓
  • deficit is partly cyclical and partly “structural”
40
Q

how does automatic stabilisation work

A

after pic….

• government spending increases and stabilises the economy ⇒G(y) − T (y) > 0 ⇒deficit↑
- if G(y)−T(y) = a(ye −y) ⇒ Be = 0: only automatic stabilisers, no discretionary impulse, on AD (no IS shift) when economy returns to equilibrium, deficit disappears, no larger debt stock

• if G(y) − T (y) > a(ye − y) ⇒ Be > 0: discretionary impulse (IS shift)
when economy returns to equilibrium, deficit disappears, but larger debt stock
- Government could wait for y > ye, with budget surplus, to implement discretionary contractionary impulse

41
Q

whats the effectiveness of automatic stabilisers

A

• overall evidence: effects are modest
• but, countries with larger government sector
• experience larger effect of automatic stabilisers • undertake less discretionary fiscal policy
(less need for it)

42
Q

when is the fiscal stimulus more effective

A

• monetary policy supports fiscal policy, preventing interest
rate rise that would offset demand (e.g. ZLB and QE)
• temporary rise in G, even under balanced-budget spending
(see discussion on balanced budget multiplier)
• government borrows to finance G, households anticipate
future taxes and increase saving. This dampens the
stimulus, but does not eliminate the first round effects
• temporary tax cut, under credit constrained households,
leads to higher spending today

43
Q

whats austerity

A

a set of economic policies, usually consisting of tax increases, spending cuts, or a combination of the two, used by governments to reduce budget deficits.

44
Q

whats the government budget identity

A
45
Q

whats the determinants of debt to gap growth equation and whats the 4 key determinants

A
46
Q

what are the two fiscal rules (about debt to GDP growth)

A
47
Q

show graphically the government debt ratio. case 1 - the real interest rate exceeds the growth rate

A
48
Q

show graphically the government debt ratio. case 1 - the growth rate exceeds the real interest rate

A
49
Q

show graphically the switch from the case where the growth rate exceeds the final interest rate to the case where the growth rate is less than the real interest rate with tighter fp

A
50
Q

households should fully internalise over the lifetime the choices of government spending and financing. to know effects of deficit, need to look at implications for permanent income. explain

A
51
Q

explain the Ricardian equivalence when G is tax financed

A
52
Q

explain the Ricardian equivalence, G is borrowing financed

A
53
Q

what does the Ricardian equivalence and PIH depend on

A

• no credit constraints: households can borrow
• households and government face same interest rate and
time horizon
• households behave as if they lived forever (incorporate
utility of heirs in their consumption behaviour)

54
Q

explain a temporary fiscal boost, under Ricardian equivalence

A
55
Q

whats the optimal fiscal rule: ensures that debt/GDP does

not increase over time. and its implications

A
56
Q

explain deficit bias

A
57
Q

when do problems arise of cost of rising gov debt

A
58
Q

what happens if assume shock and r < γy, government needs to tighten fiscal policy to counteract effects on debt ratio and ρ ↑

A

Macroeconomics (14 decks)

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