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EC 502 Macro > Term Two > Flashcards

Term Two Flashcards

1
Q

What three factors contribute to the Solow Growth Model?

A

Technical Progress (A)

Capital Accumulation (K)

Population Growth (L)

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2
Q

Define Y/L

Y/K

K/L

A 
Y/L = Output per capita
Y/K = Output capital ratio.
K/L = Capital per capita
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3
Q

What are Kaldor’s Stylized facts on Growth?

A

1) K/L and Y/L ratios grow through time.
- Capital Intensity grows through time.

2) The K/Y ratio is steady.
- K and Y grow at a similar rate in the long run.

3) Hourly Wages keep on increasing.
- Y/L increases, productivity increases, meaning wages increase.

4) Profit rates are steady.
- Y/K is constant, output per K is constant (returns to K are constant).

5) The share of L and K in total income remain constant.
- Not matter the level of profit or wages, the shares remain the same (in terms of proportion).

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4
Q

Explain the role of savings in the Solow growth model.

A

All savings are channeled to investment.

Investment leads to more output.

Higher output will result in more saving and further investment. This is how long-run growth occurs.

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5
Q

What are the two assumptions about the Solow growth Prod Func?

A

1) There are diminishing marginal product of K and L

2) There are constant returns to scale.
- If you increase K and L by the same amount, Y will increase by the same amount.

this second assumption allows us to write the production function in intensive form.

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6
Q

What do the lower case letters in the intensive form signify?

A

They signify a ‘per capita’ value.

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7
Q

What does the intensive form production function diagram look like.

A

The normal production function, just with per capita y and k values on y and x axis respectively.

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8
Q

What is the relationship between Investment, Saving and the Solow growth production function?

A

S=sY where s is the savings rate

I=S therefore I=sY

I/L = sY/L

Y/L =y=f(k)

f(k)s = I/L

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9
Q

What does it mean if K depreciates?

A

Depreciation is where capital loses value through use or just time.

Depreciation is the reduction in the stock of capital.

Sigma denotes this.

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10
Q

What is the fundamental Solow Growth Equation

A

Change in k =sf(k) -(sigma + A + n)k

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11
Q

What is the steady state?

A

It is a point where there is no capital accumulation or reduction.

sf(k)=sigmak.

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12
Q

Draw the steady state in a diagram.

A

Lecture wk 13

Slide 27.

The production function is the highest curve. Then lower with similar gradient is the savings function.

Below that is the depreciate (capital Widening line)

Steady state capital is where saving function crosses the depreciation line. Kbar.

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13
Q

What is the rate of growth for K and y in the steady state?

A

It is zero.

If s increases the equilibrium k and y values (k,y) will increase. However growth will only actually occur in the transition towards the steady state.

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14
Q

What affect do policies aimed at s have?

A

They will cause a chnage in the Level of per capita income, but not the rate of growth. (In the steady state)

Policies do NOT affect the long run growth beyond the transition period.

slide 33 lecture 13 has a diagram to explain this effect.

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15
Q

What is the rate of growth in y in the steady state?

A

The rate of growth of y in the steady state is the rate of population growth, n+a possibly or a

that is the change in Y over Y.

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16
Q

What will happen if there is an increase in technical progress, population growth or depreciation rate?

A

The capital widening line will rotate outwards.

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17
Q

What does Y=F(K,AL) mean

A

It is labour augmenting technical progress.

AL is now effective labour.

It is labour being measured in efficiency units.

Growth of AL= n+a

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18
Q

What is the steady state growth of Y and K?

What is the growth of Y/L and K/L?

What is the growth rate of y and k = K/AL.

A

n+a

a

0

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19
Q

Give two ways which will cause a countries’ income to grow through time.

A

Accumulating K in the transition towards the steady state.

Technical Progress (or pop growth??) During the steady state.

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20
Q

What factors cause one country to be richer than another?

A
  • Savings rate
  • Technological Progress
  • population growth.

The further an economy is from the steady state, the faster it will grow.

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21
Q

What is Absolute Convergence?

A

It is where two countries who have the same s, sigma, n and production function, giving the same y and k.

The Poorer country will grow faster than the richer one and will catch up in the transition toward the steady state.

They grow through capital accumulation and there is diminishing returns to capital. The further you are from the steady state, the higher your return.

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22
Q

What are the axis and curves for the Convergence diagrams?

What is different for conditional convergence?

A

y axis= sf(k)/k

x axis = k

Straight horizontal line; sigma+ n + a

Downward sloping curve; sf(k)/K

For conditional, you draw two steady states and show how the one further from its own SS grows the fastest, regardless of whether it is poorer or richer to begin with.

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23
Q

What is the growth accounting equation?

A

dA/A = dY/Y -Sl(dL/L) - (1-Sl)(dK/K)

where Sl is the share of labour so the other is share of capital.

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24
Q

What is the Solow Residual?

A

It is the growth in output which cannot be explained by factor accumulation.

It is effectively Total Factor Productivity (TFP).

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25
Q

What is the difference between endogenous growth theory and solow growth theory?

A

In Endogenous, the growth does not converge to steady state.

There is constant MPK.

Increases in S or A will have a permanent effect on growth.

Returns to K have to be exactly 1. If they are > 1, explosive.

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26
Q

Why does Human capital not have diminishing returns?

A

It is because the Private Returns are diminishing.

However their is a positive externality to the rest of society.

So overall there are constant returns to scale.

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27
Q

What is the growth formula including Human Capital?

A

Y=AK^aL^bH^d

a+b+d=1

A=H^1-d then

Y=K^aL^bH

d= Private gain from H

1-d The external gain from H.

1-d is what the government should fund

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28
Q

What do the first branch of NGT models suggest about LR growth?

A

Externalitites from HK and infrastructure will lead to growth in the long-run.

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29
Q

What do the second branch of NGT models suggest about LR growth?

A

Knowledge can be used endlessly and has constant returns as a result of this fact.

property rights will incentivise knowledge discovery, but will then make the knowledge excludable.

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30
Q

How is Knowledge accumulated?

A

It is accumulated through;

Doing things and learning from them.

R&D; Research will create new knowledge.

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31
Q

What is intertemporal trade?

What is the price of intertemporal trade

A

Borrowing and Lending

The price is the real interest rate r. `

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32
Q

What are the assumptions of intertemporal trade?

A
  • There are perfect financial markets to trade within. (They provide the link between the present and the future).
  • Only two periods; present and future.
  • Future variables are only expected, based on;
  • Rational expectations (on average correct)
  • Rules out systematic errors.

(A systematic error is an error with a non-zero mean. So when you average out your results, it still has an effect on the data).

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33
Q

What determines the price of;

  • Tomorrows consumption today.
  • Todays consumption tomorrow.
A

1/(1+r)

(1+r)

Where real interest rate is the opportunity cost of borrowing today or consuming today.

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34
Q

how can you tell if someone is a borrower or a lender?

A

Y1-C1>0 Saver/Lender

Y1-C1

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35
Q

What causes a shift in the IBC?

A

A change in either Y1 or Y2 will cause it to shift.

Either one will result in a parallel shift either inwards or outwards.

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36
Q

How do firms increase their future income?

A

They invest in K (capital) which is non-consumable.

They can borrow at rate (r) to invest with or they can use their retained profit from previous periods to invest with.

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37
Q

What is the net present value of investment for a firm. When is it profitable for a firm to invest.

A

V=F(K)/(1+r) - K

It is profitable to invest up to where V=0.

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38
Q

How to find max profit from investment?

A

Draw a diagram.

Cost of borrowing: (1+r)K

Gain of borrowing: Y=F(K)

Where the two intersect is the profit max.

Profit is given by the points where the prod func is above the cost of borrowing line.

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39
Q

What happens if all of someones income saved is then invested?

A

Y1-C1 = I1 = K2

Where K2 is the capital available in period 2.

That means the income in period 2 is;

Y2 + F(K2)

Because it is what the capital produces to give income, as it cannot be directly consumed.

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40
Q

What is the consolidated private sector budget constraint?

A

C1+C2/(1+r) = Y1 +Y2/(1+r) +F(K2)/(1+r) -I1

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41
Q

What effect will investment have on someone’s wealth?

A

It will cause their wealth to increase, thus their IBC will shift outwards.

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42
Q

What can government debt be split into?

A
  • Primary deficit G1-T1

- interest on debt from past rg.

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43
Q

What is the expression which explains government debt?

A

T2-G2=(1+rg)(G1-T1) + D1 +rgD1

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44
Q

What is the IBC for Government?

A

D1+G1+G2/(1+rg) = T1+T2/(1+rg)

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45
Q

When government debt = 0 what is the nation’s IBC?

A

C1+C2/(1+r) = (Y1-T1) + (Y2-T2)/(1+r)

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46
Q

If the government interest rate rg is equal to the nation’s interest rate r, what is the nation’s IBC?

What is said about this?

A

C1+C2/(1+r)=(Y1-G1) + (Y2-G2)/1+r

It is ricardian equivalence.

It means the private sector internalizes the public sector.

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47
Q

What effect does ricardian equivalence have on consumers?

A

COnsumers know that if the government cuts taxes, government expects consumption to rise.

However, because of ricardian equivalence agents know that governments will have to increase taxes again in the future. They will save their extra income in order to prepare for this to happen.

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48
Q

What is the current account of a nation?

A

It is the Primary current account + Interest payments on Net foreign assets

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49
Q

What happens if rg =r and there is a tax change?

A

You use the equation with G spending.

Ricardian equivalence suggests that tax is embodied in the equation, therefore no change.

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50
Q

Why may Ricardian Equivalence fail?

A
  • Different interest rates.
  • Not all citizens will be alive in the same period (mortal)
  • Not all citizens have the same taxation profiles.
  • Credit constraining providing borrowing restrictions.
  • Distortionary taxes. The tax will change incentives which will affect consumption choices.
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51
Q

Is consumption more or less volatile than its counterparts? Explain why?

A

It is less volatile than Output and significantly less volatile than investment.

This is because consumers take part in consumption smoothing to aid this.

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52
Q

Why does keynesian consumption theory fail?

A

C0+C1Y = C

where c1 is MPC

and c1+c0/Y is APC.

This implies that the volatility of consumption is equal to the volatility of output which we know not to be true.

var(co+c1Y) = Var c1^2Var(y)

Which is not true.

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53
Q

What is the optimal amount of consumption from the micro founded theory of consumption?

A

That MRIS=(1+r)

It is where the consumer’s budget constraint and indifference curves are at a tangent to each other.

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54
Q

What is MRIS

A

Where MRIS is the marginal rate of intertempotal consumption.

The rate at which you give up one unit of consumption tomorrow in return for consumption today.

MRIS is the slope of the indifference curve.

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55
Q

What is the slope of a consumer’s budget constraint?

A

-(1+r)

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56
Q

What would cause a change in income and what effect would it have on the economy.

A

Temporary change; A good year of profits for a firm.

Permanent Change; A technical discovery.

Both of these cases will cause the curve to shift to the right, however;

Temporary will lead to a smaller shift than permanent.

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57
Q

What effect will Y1 increase have?

What effect will Y2 increase have?

Explain?

A

Y1 increase will cause increase in consumption of both periods, because of consumption smoothing.

Y2 increase will cause consumption in both periods to increase also. This is because people are able to borrow against their future expected incomes.

because of perfect financial markets.

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58
Q

What is the permanent income hypothesis?

A

It is that Consumption depends soley upon the permanent income of an individual and that temporary changes will only affect the average propensity to consume.

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59
Q

What effect will an increase in r have on the IBC

A

It will cause it to rotate around the endowment point on the diagram.

60
Q

Break down the sub and income effect on a net saver from an r increase.

A

Sub: C1 down and C2 up

income : C1 up and C2 up

there for C2 up and C1 not sure

61
Q

Break down the sub and income effect on a net borrower from an r increase.

A

Sub; C1 down and C2 up

Income C1 down and c2 down

Total;

C1 down, not sure on C2

62
Q

What does the life-cycle hypothesis say about consumption and saving?

A

It says that saving doesnt depend on age, but saving does.

63
Q

Define permanent income.

A

It is the average of income over your lifetime. So to change it, the income increase must be constant and not up then down.

64
Q

What effect will a binding borrowing constraint have?

A

It will cause a kink in the IBC.

It will also cause consumption to be more volatile than output - something which is not true with consumption smoothing.

65
Q

What is gross investment?

A

It is Net investment + depreciation of capital.

Kt+1 - Kt + sigmaKt = Gross Investment

66
Q

What is the profit max optimal capital point?

A

MPK = Marginal Cost of Capital.

MPK = (sigma +r)

(1+r) is the rental price of the capital.

sigma is the rate of depreciation of capital.

(sigma + r) is known as the user cost of capital.

67
Q

Draw a diagram to show the optimal capital stock level for a firm.

A

lecture 17, slide 10

Top diagram is production function and line slope (1+r) 
Output (y) 
K stock (x)

bottom diagram is MPK and Kstock (x)

You have a (1+r) line and a downward sloping MPK curve.

K* is where the two intersect.

IT IS WHERE R CURVE IS TANGENT TO THE Y CURVE.

68
Q

What do K* and Investment depend upon?

A
  • Expected future profiability
  • Interest rated
  • depreciation

Increase in technical progress will improve the profitability of the capital.

69
Q

Draw a diagram to show the effect of an increase in technology.

A

See the production curve shift outwards.

MPK shifts out, meaning there is a higher level of optimal capital stock.

70
Q

What must you do if you take a variable out a variance function.

A

You must square the variable.

71
Q

Explain the accelerator principle.

A

K/Y ratio is given by value v.

K*=VY

Where Y is the expected GDP output level in the next period.

If this level increases from Y1 to Y2, then capital increases from K1 to K1.

Investment = K2 - K1.

which is = v(y2-y1)

Which is V times the change in Y.

Volatility Explanation;
Var (it) = V^2 Var(change in Y)

V^2 because you took it out of the variance function.

If v = 3 then variance of I is 9 times more than that of Y.

72
Q

What is the formula for Tobin’s Q?

A

Tobin’s Q = (Market Value of firm) / Replacement cost.

Q>1 investment > 0

As its market value is higher than the price to purchase.

Q

73
Q

What is a share?

A

It is a claim on the value of the firm, this claim can be traded at market values on the stock market.

74
Q

What are replcement costs and the firm’s value?

A

Firm’s Value; The present value of expected future profits of the firm.

Replacement costs; are how much it would cost to buy the entire capital stock of the firm.

75
Q

What are the axis for the Tobin’s Q diagram, explain what it looks like.

A

x axis = Tobins q,

y axis = investment level.

at 0 is the tobin’s q line.

Upward sloping diagonal line which intersects where tobin’s q =1 and investment = 0.

76
Q

Linking Tobin’s Q and Neo-Classical theories together, explain the effect of;

  • r increase
  • Technological improvement.
A
  • r increase will provide a higher bond return, so more people will buy them instead of stocks.

Stock values will fall and so will tobin’s q, therefore less investment

  • Technological Improvement;

this will increase the profitability of firms, therefore the stock value will increase and there will be more investment.

77
Q

What are IAC’s

A

IAC’s are investment adjustment costs. What they mean is that;

The higher the investment, the higher the adjustment cost it will take.

1 + half circle and line = MPK /1+r
is optimal level of investment.

As the investment level decreases, half circle and line will fall with each investment until the optimal investment K* is reached.

78
Q

Give three reasons why investment is a very volatile component of AD.

A
  • Constraints on the level of borrowing in the market.
  • The volatility of the stock market is very high.
  • Var I = v^2(var Y) (proof is in your notes somewhere).
79
Q

If Tobin’s Q>1, should you take over a firm?

A

No, because it will be cheaper to build the firm yourself, i.e; all of the capital etc than pay the market value for it.

80
Q

What is a business cycle?

A

It is where there is fluctuations around a certain trend level of output.

81
Q

What are the stylized facts around budget contraints/

A

1) Recurring but irregular. Around every 5-8 years (lasting)
2) The fluctuations around a trend are relatively small.
3) Expansionary BC last longer than contractionary BC.
4) Private spending = Pro-Cyclical

Public Spending = Acyclical

5)

Leading Y;

inventories, stock prices, money balances, capacity

Lagging Y;

Unemployment, Inflation

Coincident;

Interest and investment

6) Investment is more volatile and consumption is less volatile than output.

Imports and exports are volatile.

CA balance very volatile.

82
Q

What are Burns Mitchel diagrams?

A

They normalise all BC peaks to 1 and look at the average effect 10 years before and after.

83
Q

What factors lead to a business cycle.

A

Many random shocks (impulses) form are changed by the propagation mechanism into stochastic cycles.

Stochastic Cycle = Impulses + propagation

Combination of shocks are known as impulses which are random.

84
Q

What is the propagation mechanism for the Keynesian business cycle theory?

A

It is that prices are sticky.

Essentially prices and inflation do not adjust quickly, which means cycles are caused because the economy deviates away from equilibrium employment.

Non-neutrality of money in the short-run time frame.

85
Q

What is the propagation mechanism for the RBC theory?

A

Response of the capital stock

Response of the labour supply

86
Q

Show the RBC effect of a productivity increase on L and K in the short run, show L as inelastic and elastic.

A

Lecture wk 18, slide 36-37

87
Q

Describe the propagation mechanism res ponce of k stock in RBC theory.

A

If there is a Y increase, people will not consume it all due to consumption smoothing.

This means saving increases, this saving causes investment, which will increase capital amounts.

Higher K means Y increases again

therefore propagation.

88
Q

Describe the propagation mechanism in response to an increase in L supply in RBC theory.

A

There is a positive productivity shock.

This means that Y will increase.

W/P increases and so does r.

as K is fixed, MPK increases only lead to r increases in the short run.

Ls is elastic for employment to increase.

As this L increases so does Y, therefore propagation.

Do remember to mention the effect of sub and income for labour choice.

89
Q

What are the axis in the labour and capital stock diagrams.

A

Capital:

K stock (x)

Real interest (y)

MPK curve dws

K stock curve

Labour:

L supply(x)

W/P real wage (y)

MPL DWS

L supply with varying elasticity.

90
Q

What is the main objective of monetary policy?

List the other potential objectives.

A

Main;

Price stability.

Secondary;

  • Short-term growth.
  • Exchange rate stability.
91
Q

What are the instruments used by the monetary policy committee?

A
  • Setting a required reserve ratio
  • Controlling the monetary base
  • Refinancing rate of the banks.
92
Q

What do banks target to achieve their objectives?

A
  • inflation
  • exchange rate
  • Monetary aggregates
  • long-term interest rate.
93
Q

Describe the money supply curve when

  • money targetting
  • interest rate targetting.

Also; what are the axis on those diagrams?

A
  • MT Perfectly inelastic
  • IT Perfectly Elastic

x = nominal money

y = money targetting

94
Q

What are the role of CB (central banks)

CmB’s (commercial banks)

A
  • CB’s are where CmB’s store their reserves.
  • Inflation Control
  • Banking supervision
  • Economic Forecasting
  • Currency Issuence.
95
Q

What is ‘high powered money’

A

This is the monetary base. It is made up of;

  • currency in circulation
  • Bank reserves.
96
Q

What is the commerical bank balance sheet?

A

Assets;

Securities

CB deposits

Loans issued.

Liabilities;

net worth (paid to share holders)

Liabilities to CB

Consumer deposits

97
Q

What is the central bank balance sheet?

A

Assets;

Securities

Foreign assets

CB loans

Liabilities;

CmB deposits

Circulating currency

Net worth

Government deposits

98
Q

From balance sheet analysis, what makes up M0?

A

Reserves of commerical banks at CB

Banks notes held by non-banks

99
Q

Explain commercial bank money creation.

A 
A deposits 1000 at bank 1. 
Bank 1 lends to B 1000. 
B buys car for 1000. 
Car salesman and A own the 1000. 
Car salesman banks at bank 2.

The process continues.

Bank estimates that A will withdraw only 10% at a time.

They then hold 10% reserves.

Therefore 900 created, then 810 then 729 etc.

100
Q

What does money base demand depend upon?

A

MBd=P*L(y,i)

P*Y is nominal GDP

101
Q

What determines many interest rates in the economy?

A

The inter-bank market interest rate. i.e; the rate at which different banks lend to each other.

102
Q

What is the formula for the Taylor rule?

A

i=i+a(pie e - pie) + b(y-Y/Y)

a shows how much the CB cares about inflation.

a>1 should be, because real r has big effect on investment.

103
Q

What are the three fundamental monetary policy equations?

A

IS curve

(y-Y/Y) = c(Y-T) + I(i-pie e)

Phillips Curve;

pie = pie e + d(Y-Y/Y)

Taylor Rule;

i=i+a(pie e - pie) + b(y-Y/Y)

104
Q

What is inflation targetting?

A

It is where interest rates are used to control the level of inflation in the economy.

Inflation is targetted to a certain level and then it is worked towards wit interest rates.

105
Q

What is the role of fiscal policy?

Why doesn’t the market provide public goods?

A

Micro; providing public goods and redistribution income.

Macro; Providing Macroeconomic stabilization.

Market will not provide public good because;

  • does not value externalities.
  • they have increasing returns.
  • public goods are non-excludable.

Once they are provided they cannot be taken away.

Increasing returns are that AC falls as more people use it,

Unfortunately the start cost is too high for the market to provide.

106
Q

How does fiscal policy provide redistribution?

A

if factors paid their MP they are efficient but not equitable output.

  • Progressive taxation.
  • Government transfers.
107
Q

What is an automatic stabiliser?

A

it is an automatic change to fiscal policy as a result of a business cycle.

e.g; recession will cause incomes of families to fall. Automatically tax revenues will fall.

Transfers will increase also automatically as more people become unemployed.

108
Q

Draw a diagram showing the fiscal poilcy.

A

Upward sloping curve.

x axis = output gap
y axis = budget surplus

FP shift is a change in the fiscal policy position.

109
Q

What is a cyclically adjusted Budget deficit?

A

It is when the BD has been adjusted to see what it is when the economy is at full employment.

110
Q

How to finance a deficit?

A

Accumulating public debt will allow you to finance a deficit.

111
Q

What three conditions is debt stable under?

A

No growth or inflation
change B = G-T + rB

Growth with no inflation

Change in (B/Y) = (T-G)/Y -(r-g)B/Y

Both growth and inflation

This is where seigniorage causes inflation.

Change in (B/Y) = (T-G)/Y -(r-g)B/Y - change in (M/P) / Y

112
Q

How to cut a deficit?

A
  • Tax people more.
  • Seigniorage:
    Only works if inflation is unexpected. Danger of hyperinflation.
  • Default:
    People lose confidence in the government and will not lend to you again.
113
Q

What is the keynesian and neoclassical debate?

A

it is a debate about how quickly the AS reacts to a shock.

114
Q

What is demand management?

A

IS the fine tuning of AD in order to bring the economy to full employment.

115
Q

What is the effect of an expansionary policy in;

  • SR
  • LR
A

SR; Output gain AD - AD’

LR: Only inflationary.

Core inflation catches up so AS shifts back up.

Overall just inflationary effect,

116
Q

What are the arguments regarding AS adjustment for

  • Keynesian
  • Neoclassicalists
A

Keynesian; Slow adjustment therefore economy is below capacity.

You should used AD policies to prevent unemployment.

Neo-Classical; Economy is close to full, quick adjustment.

Aim to achieve low inflation, allow economy to correct unemployment.

117
Q

What should the economy do under neoclassical policy. (flexible exchange rates)

A

Do negative AD shift, will cause short-term unemployment.

But as AS reacts quickly, the inflation rate lowers significantly.

Short-term cost; Unemployment

118
Q

What should you do in keynesian policy is we are off trend, from lagging AS?

A

Instead of waiting for it to adjust which can take a long - time.

We should just use expansionary AD policy to shift it back to LAS long-run equilibrium.

119
Q

What are rational expectations?

A
  • That an agent cannot make a systematic error and on average their predictions are correct.
  • Agents are only forward looking.
  • Depature from LRAS is only due to unexpected shocks to the economy.
120
Q

What do New-Keynesians say about RE?

A

They recognise equilibrium in the long run and rational expectations.

Although nominal rigidities prevent SR equilibrium.

121
Q

Policy Lags

A

Recognition lag; recognising the problems

Decision lag; formulating a policy

Implementation lag;

putting policy in action
(longer for FP)

Effectiveness lag;

Time taken to impact on the economy.

(Longer for MP)

122
Q

What are the Neo-Classical conclusions?

A

Do not take action.

Government will cause uncertaintly to become worse.

Causes Business Cycle fluctuations to become greater.

Better to find leading indicators for macro models.

123
Q

What is the rational expectations revolution?

A

Means that agents will anticipate the policy, effectively rendering it useless.

124
Q

What does RE imlpy?

A

Ricardian Equivalence; You cannot use FP to change AD

Lucas Critique; Policy maker cannot anticipate the actions of a private agent.

125
Q

What can be a policy if RE holds?

A

Announcements can be a policy if RE holds.

e.g; CB announces r increase, agents anticipate and reduce their spending.

Causing AD to fall and inflation to reduce.

The announcement has desired effect in itself.

126
Q

What is credibility of CB

A

It ensures that the policy actions will yield the desired effect.

If not credible, agents will suspect that they wont do what they say and the policy will become inefficient.

127
Q

Explain the time inconsistency problem.

A

Government makes an announcement.

Agents change their expectations.

Policy is then no - longer optimal

Government can cheat and apply another policy.

128
Q

When is time inconsistency not a problem?

A

When you bound gov/CB to a certain rule.

When they have perfect credibility.

129
Q

What is true under fixed rule demand management?

A

Un=U pie = pie e

So if you announce pie = 0

the outcome is;

(pie,U) = (0, Un)

You can cause disinflation costlessly.

130
Q

What is the role of the financial system?

A

It is to match households and firms with people who have surplus funds and those with investment opportunities who need the funds.

131
Q

What is the difference between direct and indirect finance?

A

Direct; borrowers sells financial instruments on markets which lenders will buy to provide investment funds.

Indirect; Financial intermediary will firstly obtain the funds and then find someone to lend them to.

132
Q

Give some examples of financial intermediaries.

A

Banks

Pension funds

Insurance companies;
- Acquire peoples premimums and invest them so they can cover them in case of claim.

Mutual: Sell shares to people and invest money to give share holders a return.

Hedge Fund; same as a mutual but more complex investment principles.

133
Q

Why is it better to have financial intermediaries?

A

Because banks cut out the problem of asymmetric information.

The market does reflect information through prices however.

134
Q

What is asymmetric info in the banking sector?

A

It is where one party in the trade has less information than another party.

Adverse selection: less creditworthy borrowers are more likely to demand funds. The lender may mis - allocate their credit towards the risky asset.

Moral Hazard: The risk of the borrower who uses the funds to do risky things as the lender cannot monitor them.

People could also free - ride on the info that you find out about other borrowers.

135
Q

How do banks solve the problem of asymmetric info?

A

Private loans through banks are private so no free riders.

FI’s are dominant lender as they have a lot of information.

Screening; Banks credit score to see if you can borrow what you say.

Monitor; they watch current accounts to check you aren’t being risky.

Restrictions; legal covernants will restrict what you can actually do with your money.

FI’s improve efficiency.

136
Q

What is Loan - Equity Ratio?

A

It is the ratio between what you borrowed and the collateral that you put up.

137
Q

What causes a financial crisis?

A

It is where the banking system fails.

Credit flow stops working properly.

asset prices fall

GDP contracts.

An intial shock becomes propagated.

138
Q

Explain the stages of a financial crisis.

A
  • Stochastric shock (oil, interest rate)
  • Loans default
  • uncertainty increases on creditworthy consumers.
  • Activity of banks reduce and interbank market dries up.
  • Less economic activity.

Failing institutions

Bank-runs occurs as people panic.

Fire- sales of assets cause banks to fail.

139
Q

Explain the causes of the 08/09 financial crisis?

A
  • UK and US have large CA deficit. China and Japan with large surplus.
  • Low world interest rates.

Excess liquidity

Assets prices boomed.

So lots of cheap credit

Packaging mortgages into securities.

FED INCREASED interest lots of mortgage fails.

Confidence crisis.

Panic swept.

Institutions failed

QE and Bail outs.

140
Q

What would happen If the government kept G and T at 80, what would happen to Y and π in the long run, and the current account? Suppose instead the government cancels the fiscal expansion so G and T revert to their original values as in part b), but by the time it has done this core inflation has risen to 4. What values will Y and π then have in the short run?

A

In the long run, Y reverts to the natural rate 180. Subbing into the AD curve, pi=3.3333. Inflation has increased further causing the current account to deteriorate further. If the fiscal expansion is cancelled and core inflation = 4, then setting AS=AD again gives pi=2.5, Y=165.

141
Q

Is A included in the fundamental equation?

A

Only if it is not equal to 0.

142
Q

How would you answer an inflation targeting question?

A

a) Fixed Rule.

Pie = Pie expected.

This means U = Un.

For the inflation the expected is the inflation target of the cb

(Un, pitarget). i.e pie*

b) For discretion; the government will choose their inflation level by minimising their loss function.

The loss function shows the trade off between Unemployment and inflation.

Sub U curve into loss function and partially derive with respect to pi.

Then solve for inflation.

Result will be (Un, Solve inflatio).

The idea is that the government will annouce an inflation. Agents will set their expectations. The policy is no longer optimal. Government will then cheat and apply another policy.

If agents know the loss function under discretion, they will set their pie = Pie e which will mean that U = Un even for discretion.

c) Fixed rule is the pareto optimal out of the two. This is because in both scenarios they result in unemployment being equal to Un.

Where in the fixed rule there is a lower level of inflation so it is pareto optimal. (PARETO OPTIMAL)

143
Q

What has the higher change in output from balanced budget change?

A

Keynesian cross will increase output more. This is because the government spending multiplier works on the keynesian cross model. The effect of the government spending multiplier is higher than the taxation multiplier.

144
Q

How to answer question where you want C to equal something and G=t what is Y-G and I and r?

A

C=0.5(Y-T) = Y-G

So time C by 2 to get Y-g

then sub into Y=C+I+G to get I then into I function to get r, then into MS=MD to get Y and from there find G=T

145
Q

In an AS AD economy, why is aggregate demand unaffected by monetary policy?

A

This is because monetary policy is focused on keeping domestic and foreign interest rates equal through the UIP condition.

146
Q

In LR core inflation is equal to x, what do you think world inflation will be in a fixed exchange rate economy?

A

World inflation will equal core inflation in order to keep the real exchange rate equal. So world inflation will be equal to x.

147
Q

In the steady state. What is the growth of;

  • Y and K
  • Y/L and K/L
  • Y/AL and K/AL
A
  • n+a
  • a
  • 0

EC 502 Macro (2 decks)

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