week 7 Flashcards
Open Economy Macroeconomics
when understanding fluctuations:
it’s easiest to imagine the economy begins in _____
LR equilibrium:
(intersection of AD+LRAS);
- output = natural output
- expected price level = actual prices
AD + SRAS curves intersect too if expected price level = ___________
expected price level = actual price level
Draw the long run equilibrium
Short run fluctuations occur due to:
- Demand Driven
- Supply Driven
Possible causes of demand driven fluctuations?
Wave of pessimism,
stock-market bust,
drop in exports (recession abroad),
monetary contraction, etc.
What happens after a demand driven contraction?
- Output falls (hence employment falls)
- Price level falls
With time, how does a d-d contraction revert back? Diagram.
With a contraction in AD… what happens to actual prices?
They drop below expected prices
with a demand driven contraction, we would expect prices to ______. It is _______
fall . It is deflationary.
What is a supply driven fluctuation?
Cost push
A shift in AS.
Possible causes for SRAS shift/supply driven fluctuation?
Sudden inc. in production costs
Increase in price expectations
What happens right after a SRAS driven contraction?
- Output falls
- Price level increases
= STAGFLATION
Define stagflation
Stagflation is like having the worst of both worlds in the economy. It happens when there’s a mix of two bad things at the same time: stagnant growth and high inflation.
Stagnation: This means the economy isn’t growing much, or even shrinking. Businesses might not be expanding, people might not be getting jobs, and overall, things feel sluggish.
Inflation: This means prices are rising rapidly. So, while the economy might not be doing well, the cost of goods and services keeps going up. This can make it harder for people to afford things, even if they’re not making more money.
When you put stagnation and inflation together, you get stagflation. It’s a tricky situation for policymakers because the usual tools they use to fix one problem can sometimes make the other problem worse. So, it’s like trying to solve two puzzles at once, and it’s not easy.
How does a SRAS fluctuation revert back to normal?
- Short-run AS shifts back to right
- Output reverts to its natural rate as price level falls
What is an example of an AD driven recession?
The great depression. Real GDP fell by 27%, unemployment rose from 3 to 25%, prices fell by 22%. Money supply decreased by 28% (this lowered AD and most scholars think was the principal cause of the depression).
Example of demand pull?
Early 1940s, boom caused by increased wartime expenditures (increases AD). Unemployment dropped from 17 to 1%, prices rose by 20%.
Cost push example?
The Oil Crisis in the 70ies
Cost pull example?
More difficult to identify, but an example would arguably be new technologies (computers) driving expansion in the 90s
Why was the COVID pandemic a special contraction?
caused markets to shut down completely
Why is 2022/23 complicated?
- There was an element of negative AS shock - higher prices of oil and gas
- BUT combined with aggregate demand already being shifted “TOO far to the right” due to pandemic policies
It caused inflation to shift AD to the left, Central Banks raised interest rates.
If we consider a shift to left in the SRAS curve e.g oil price increase… it will lead to ____?
stagflation, though over time output will revert to its natural rate and prices “drop back down”
To immediately counter the drop in output from SRAS shifting left (and employment), policy makers may elect to do what?
May elect to shift the AD curve to the right so that output returns quickly to its natural rate.
What is the cost of shifting AD to the right to combat SRAS shift to left?
Higher inflation.
Draw a diagram of accommodating an adverse shift in SRAS
How do policy makers in practice shift the AD curve? [2]
- Monetary Policy
- Fiscal Policy
What are monetary and fiscal policy?
Monetary policy is changing the supply rate + interest rates
Fiscal policy are changes in government spending + taxation
How do changes in money supply affect interest rates?
A change in the money supply shifts the AD curve (C,I, XM)
- An increase in money supply leads to lower interest rates which is expansionary (shifts AD to the right for any given price level)
- A decrease in money supply leads to higher interest rates which is contractive (shifts AD to the left for any given price level)
— Note: We can also understand this via the LM curve from the IS-LM model (“theory of liquidity preference”)
How does purchasing government bonds increase AD?
Central Banks: These are the main banks of a country. They’re responsible for managing the country’s money supply, interest rates, and sometimes, overall economic stability.
Government Bonds: These are like IOUs issued by the government. When you buy a government bond, you’re essentially lending money to the government. In return, the government promises to pay you back the amount you lent (the principal) plus interest over a specified period of time.
So, when a central bank purchases government bonds, it’s like the central bank lending money to the government by buying these IOUs. This is one of the ways central banks can influence the economy, such as by injecting money into the financial system to stimulate economic activity.
Draw diagram of expansive monetary policy
How does fiscal policy work?
This directly shifts the AD curve
(to the right if fiscal policy is expansionary; to the left if fiscal policy is contractive)
Wether a £1 increase on net government spending leads to AD rising by MORE or LESS than £1 depends on…?
The relative size of two opposing effects:
- Multiplier effect
- Crowding out effect
What is the multiplier effect?
Multiplier effect amplifies the effect on AD of an increase in NET EXPENDITURE
What is the crowding-out effect?
it diminishes the effect on AD of an increase in net expenditure
why? because Increased government spending
1.raises interest rates
- discouraging private sector spending
- and offsetting the initial boost to aggregate demand.
How does increased government spending raise interest rates?
When the government increases its spending, it often needs to finance this spending by borrowing money through the issuance of bonds. As the government issues more bonds to fund its spending, the supply of bonds in the financial markets increases.
Now, when there is an increase in the supply of bonds, it creates upward pressure on interest rates. This is because investors, who are willing to lend money to the government by buying these bonds, demand higher interest rates as compensation for the increased supply of bonds and the associated risk.
Therefore, while government spending itself doesn’t directly raise interest rates, the increased demand for borrowing resulting from government borrowing can lead to higher interest rates in the financial markets.
What do central banks do to directly change the interest rate?
most CBs adjust the Repo/refinancing/discount rate or conducts OMOs to directly change the interest rate.
adjusting the money supply or changing the interest rate are “two sides of the same coin”… what does this mean?
To achieve an interest rate target, the central bank’s bond traders are told to supply enough money (buy/sell enough bonds in OMOs) to ensure the target is met.
So changing the money supply and changing the interest rate amounts to the same!
What is the multiplier effect with a diagram?
The multiplier effect of an increase in government purchases by £20 billion:
- Aggregate-demand curve shifts right by £20 billion
- Consumers respond by increasing spending (spending multiplier) and firms respond by increasing investments (investment accelerator)
Which leads to a further shift to the right in AD, and so on and on
What does the spending Multiplier’s size depend on?
Depends on the marginal propensity to consume MPC
What is MPC?
the fraction of extra income that consumers spend on consumption
The larger the MPC…
The larger the multiplier!
If expansionary policy leads to income increases for people who are likely to spend it all (MPC close to 1), the multiplier will be ______
Higher
Due to the multiplier effect, 1£ of government purchases can…
Generate more than 1£ in aggregate demand
Crowding out effect with shifts? + Diagram
When aggregate demand curve shifts right:
- leads to an increase in income
- which leads to an increase in money demand
- which increases the interest rate thereby reducing investment spending…and the AD curve shifts back towards the left
Why does higher demand for money increase interest rates?
Increased demand for money means people are willing to pay higher interest rates to get it, pushing up interest rates.
Crowding-out also happens in the long run as we saw in the loanable funds market – but only if _____________
The government continuously runs a deficit
Draw the crowding out effect
What is active stabilisation policy?
when authorities use fiscal and monetary policy to stabilise the economy in the face of shocks to the economy
— the objective is to ensure full-employment and stable inflation
Actual effect on AD curve (how much it shifts) depends on
size of the multiplier effect relative to the crowding-out effect
What are the arguments for active stabilisation?
Keynesians: stress the key role of AD in explaining short-run economic fluctuations and so the government should actively stimulate aggregate demand
To maintain production at its full-employment level!
Obviously, this is because unemployment is a **bad **thing which we should avoid if we can!
Points against active stabilisation?
- AD difficult to control so policy affects the economy w ‘long and variable’ lags
- Policy would be based on unreliable economic forecastswhich leads to mistakes
(e.g. expansionary policy may cause overheating, bubbles or run-away inflation)
- corruption and waste
hence better to LEAVE ECONOMY ALONE + let market mechanisms deal w short-run fluctuations
instead - policy instruments should be used to achieve long run goals
waht happened in 2008-09?
financial crisis.
severe downturn in economic activity
worst macroeconomic event in more than half a centrury
What were the large contractionary shifts in AD during FC?
- Real GDP fell sharply — By 4% in 2007-9
- Employment fell sharply — Unemployment rate rose from 4.4% to 10.1% 2007-9
(in May 2007 to 10.1% in October 2009)
What were the 3 policy actions that were aimed in part at returning AD to its previous level during FC?
- The Central Banks in US, UK and Europe cut their targets for the repo rate (essentially to about 0 in late 2008)
- Started buying government bonds, mortgage-backed securities and other private loans
- In open-market operations
- Provided banks with additional funds
- October 2008, In the US, Congress appropriated $700 billion
- For the Treasury to use to rescue the financial system
- To stem the financial crisis on Wall Street ~ make loans easier to obtain
- Equity injections into banks
- U.S. and U.K. governments – temporarily (?) became a part owner of some banks
January 2009, Barack Obama did what?
Increased government spending
$787 billion stimulus bill, February 17, 2009
Even without active stabilisation policy, what will always stabilise fluctuations?
automatic stabilisers will to a greater or lesser extent always stabilise fluctuations
Automatic stabilisers are?
Automatic changes in spending that stimulate aggregate demand when the economy goes into a recession
Eg progressive income tax
As income decreases during an economic downturn, individuals move into lower tax brackets, reducing their tax liabilities.
automatic stabilisers operate principally through _____ and ______
auto stabilisers operate principally through TAXES and TRANSFERS
How do automatic stabilisers operate through taxes + transfers?
– Fewer taxes collected in a recession (AD↑)
– More unemployment benefits paid out in a recession (AD↑)
– The opposite happens when there is a boom (automatic stabilisers become contractive)
But the issue with automatic stabilisers?
- Are not sufficiently strong to prevent business cycles completely
- how strong they are depends on public sector’s size relative to GDP
(so strong in, say, Scandinavia, weak in the US with the UK somewhere in-between)
but without automatic stabilisers what would be the effect on output + employment?
Output and employment would be more volatile than is the case
in the long run Inflation depends only on ______
growth in the money supply
in the long run unemployment will tend to its natural rate which depends on —-?
minimum wages, unions, efficiency wages, search, etc.
in the short run in the AD/AS model, the classical dichotomy breaks down:
Inflation and output/unemployment are related how?
expansionary policy increases output and inflation
What does the phillips curve show?
short-run trade-off between inflation and unemployment
a clear negative correlation between unemployment and the rate of (price and/or wage) inflation
Draw the phillips curve
What does this show?
What does the long run Phillips curve look like?
Vertical. Like the LRAS
Draw the LR Phillips curve
How does AD/AS curve and phillips curve relate?
AS curve slopes upward due to actual prices differing from expected prices
Thus, Phillips curve slopes downwards only when actual inflation is different from expected inflation
SO, when actual = expected inflation, phillips curve (like AS) will be vertical
it’s important to realise that the REASON why economic policy in the AD/AS model has any effect on output is that ___________
it generates “surprise”/unexpected inflation or disinflation
A monetary expansion can create surprise price increases (inflation) in the short-run and therefore raise output and employment
What happens in long-run?
In the long-run, people expect this higher level of inflation to persist, and so expectations will catch up with actual inflation…
And that’s NOT good (a move up the long-run Philips curve).
Draw a diagram of Expect Inflation + Phillips Curve
Shifts in the short-run Phillips curve are primarily influenced by…?
changes in expectations, supply shocks, and monetary and fiscal policy
Phillips curve can be summarised in an equation:
Unemployment rate = Natural rate of unemployment – a(Actual inflation – Expected inflation)
(actual > expected → lower unemployment)
In light of the Phillips curve equation, it is _____ to view the PC as offering a menu of choices between inflation and unemployment
Wrong
