Theories Of Financial Crisis- New Keynesian

Question 1

Liquidity trap

Answer 1

Normally Ms/P=L(Y,i)

But when nominal interest rates are close to 0, we reach ZERO LOWER BOUND, below which interest rates can’t decrease

Monetary policy becomes ineffective

Nobody is willing to lend £100 unless they get £100 back,
So Ms/P>L(Y,i)

Question 2

Including expectations

Answer 2

Assuming all output is consumed, AD=
Yt=EtYt+1 - (parameter o thing)(it - Et(pie)t+1-rt^e)

Equation says current demand depends on expectation of future output and real interest rate

More general –> demand depends on entire expected path of future interest rates and inflation

Question 3

Monetary policy effectiveness

Answer 3

Demand depends on current and future ST interest rates which means that demand depends on LT interest rates

Monetary policy works through ST no,I always interest rates and is constrained by it>/0

Modern framework: m policy can still be effective even when ST rate is 0, if m policy can change agents’ expectations about future interest rates when zero bound is no longer binding

E.g, Cbank could commit to maintain lower future nominal interest rates for any given price level even when deflationary expectations are over

Question 4

Example

Answer 4

Bank of Japan 2003
- promised to keep ST nominal interest rates low until inflation was in stable positive territory

FED mid 2003
- (when there was fear of deflation and low interest rates) announced that it would keep interest rates low for a ‘considerable period’

–> according to modern view: during a liquidity trap, a successful m policy ( I.e. Aiming at getting lower future nominal interest rates) implies committing to higher money supply in future, even when interest rates have become positive again

Question 5

Conclusion - monetary policy

Answer 5

Keynesian liquidity trap = only true liquidity trap if c bank can’t change public’s expectations about future interest rates

Krugman 1998: if public expects money supply revert to constant value as soon as interest rates depart from 0 bound, QE will become ineffective in changing expectations on LT interest rates

Eggertson 2016: the same ineffectiveness applies both when gov follows Taylor rule m policy and when gov is discretionary (unable to commit to future policy) because it will have an incentive to renege on its inflation policy

Question 6

Taylor rule

Answer 6

Have target of inflation

Raise interest rates when doing well, lower when struggling

Fine tuning economy

Been adopted by many c banks last 20 years to avoid inflationary/deflationary pressures

Bad for economy: c bank should commit to expected future interest rates but Taylor rule conflicts with this

Question 7

Conclusion: fiscal policy

Answer 7

Modern view: m policy regains effectiveness, but there may still be role for f policy

If Gov lacks credibility to commit to lower interest rates in future, it can ISSUE DEBT by increasing gov spending

If future, gov reneges commitments with public to keep lower interest rates and raises them, the burden of debt will become heavier, unless the gov increases taxes, but this is politically costly

Or, gov can buy foreign exchange, implying that with no inflation the exchange rate will appreciate and gov lose

Question 8

Krugman 1998

Answer 8

If public expects Ms to revert as soon as i increases from zero lower bound, QE is ineffective in changing expectations on LT i

Question 9

Eggertson 2016

Answer 9

Same ineffectiveness when gov follows Taylor rule m policy (discretionary so unable to commit to future policy) as is incentive to renege inflation policy