ECON 2 Macro Notes PDF

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ECONOMICSGofries reading notes Chapters 10-18.Second Year Macroeconomics.GOTTFRIES CHAPTER 10Monetary Policy:The primary goal is to achieve price stability but a secondary goal of keeping producion close to its natural level is also pursued.How should the central bank react to shocks?To analyse this...

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ECONOMICS Gottfries reading notes Chapters 10-18.

Second Year Macroeconomics.

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Contents GOTTFRIES CHAPTER 10........................................................................................................................4 GOTTFRIES CHAPTER 11.............................................................................................................11 GOTTFRIES CHAPTER 12......................................................................................................................16 GOTTFRIES CHAPTER 13......................................................................................................................22 GOTTFRIES CHAPTER 14......................................................................................................................29 GOTTFRIES CHAPTER 15......................................................................................................................35 GOTTFRIES CHAPTER 17......................................................................................................................39 GOTTFRIES CHAPTER 18......................................................................................................................42

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GOTTFRIES CHAPTER 10 Monetary Policy: The primary goal is to achieve price stability but a secondary goal of keeping production close to its natural level is also pursued. How should the central bank react to shocks? To analyse this we need to think back to the ISLM model from Chapter 8. IS: LM:

e e e e Y =C ( Y ,Y ,i−π , A ) + I ( i−π , Y , K )

Y M = P V (i )

PC: π = π e +

n β ( Y −Y ) +z Yn

An exogenous increase in money demand: Suppose that there is an increase in money demand for exogenous reasons - that is, an exogenous decrease in velocity. This means that for a given level of money supply there is now excess money demand. Lenders want their money back and there is an upward pressure on the interest rate. For a given level of production and money supply, the equilibrium interest rate in the money market increases, so the LM curve shifts up. If the central bank allows this to happen by holding the money supply constant there will be an increase in the interest rate and production will fall below the natural level. Such a situation would not be desirable and therefore the central bank controls the money supply and attempts to hold interest rates rather than the money supply constant. It does through the buying and selling government bonds at a particular rate.

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A demand shock: Suppose that consumers become more optimistic about the future, so expected future income, Y e , increases. We assume that expected inflation does not change but remains equal to the inflation target. When consumers become more optimistic, they consume more, so aggregate demand increases. The IS curve shifts out; if the interest rate is kept unchanged, production will increase and inflation will increase. In order to stabilize production and inflation, the central bank should counteract the aggregate demand shock by increasing the interest rate. In this way it prevents inflationary pressure from building up. The nominal interest rate is higher in the new equilibrium, and so is the real interest rate for given inflation expectations. This is consistent with analysis in Chapter 4. There we found that an exogenous increase in consumption raises the natural rate of interest. In this case the central bank's action can be described as follows: In order to stabilize inflation and production, the central bank should adjust the nominal interest rate so as to keep the real interest rate equal to the natural rate of interest.

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A cost-push shock: Suppose, instead, that there is an unexpected cost-push shock in the form of an increase in the price of oil. Let us assume that this shock is perceived as a permanent, one-off occurrence. The cost-push shock shifts the Philips Curve upward so inflation will be higher for a given output gap. It is less clear how the IS curve may be affected; if oil is imported, the IS curve may shift inward because an increase in the world price of oil makes the oil-importing country poorer. If oil is produced in the country, the oil price increase redistributes income, so the effect on aggregate demand is less clear. For simplicity, we assume that the natural level of production and the IS curve remain unchanged. The move in the PC creates a dilemma for the central bank who cannot affect the price of oil. They must now make a decision; they could increase interest rates, creating a negative output gap and putting enough downward pressure on wages in order to decrease other prices and return inflation to target or they must temporarily accept higher inflation. If the IS curve has not shifted, this implies that the interest rate should be kept unchanged. In such a scenario, the actions of the central bank may be determined by the credibility of their inflation target, and therefore its ability to anchor long term inflation expectations, as well as the importance that the central bank places on keeping production as close to the natural level as possible.

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An unexpected and permanent increase in productivity: A permanent increase in productivity, such as that brought about by the advent of computers, raises the natural level of production and expected future income. From consumption theory we know that a permanent increase in production should lead to an increase in consumption of similar magnitude, and the accelerator effect will lead to an increase in investment. The IS curve will shift out and inflation will be reduced so the Philips curve will shift down. Depending on the shift in the IS curve and the increase in the natural level of production, either and increase or a decrease in the interest rate may be required. If demand increases more than supply, the interest rate should be increased so as to keep production at the natural level. On the other hand, the unexpected increase in productivity increase has a negative effect on inflation, which calls for a lower interest rate. The appropriate response is therefore dependent on the magnitude of changes in supply and demand. In the case illustrated below the IS curve shifts more than the natural level of production and therefore an increase in the interest rate would be called for.

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An increase in the expected rate of inflation: So far we have assumed that expected rate of inflation and the target rate are one and the same. Effectively, we assumed that the inflation target of the central bank was known and credible. Now the question is what happens when expectations of inflation begin to rise above this target level?

The figure above represents this situation; we start from a situation when inflation expectations are in line with the target, so the IS curve intersects the vertical line showing the natural level of 8|Page

production at an interest rate equal to the natural rate plus the inflation target, and the PC intersects the vertical line showing the natural level of production at the rate of inflation. In response to an increase in the expected level of inflation the central bank must raise rates but it faces a dilemma; increasing the interest rate to r n + π e will bring production back to the natural level but leave inflation running at π e which is above target however raising rates to i₁, the level required to return inflation to target, will create a large negative output gap. Although price stability is the primary objective it is still undesirable to create such a large negative output gap as production stability is also important. The likely result is that the central bank will adopt a rate somewhere inbetween these two levels in order to re-establish the credibility of its inflation target while at the same time preventing the creation of an excessively large negative output gap. As we see here, the increase in the interest rate must be more than the nominal inflation rate if it is to be effective in returning inflation to target. This is because an increase in real interest rates is required to create the negative output gap. This principle is known as the Taylor Principle. The Taylor Rule In 1993, the American economist John Taylor shows that US monetary policy in the period 1982-1991 could be described reasonably well by following the simple decision rule:

i=´r + π +0.5 ( π − π ⊗) +0.5 ^ Y Here ´r is an estimate of the normal real rate of interest and π ⊗ is the inflation target of the central bank. If we assume that expected inflation is equal to observed inflation, the implication is that the expected real rate is equal to:

r=i−π =´r +0.5 ( π−π ⊗ ) +0.5 ^ Y The real interest rate is higher if inflation is above target. Taylor assumed that the normal real interest rate and the inflation target were both 2%, leading to the decision rule:

i=0.02+ π +0.5 ( π−0.02 ) +0.5 ^ Y =0.01+1.5 π +0.5 Y^ The importance of the Taylor Rule is to show that a central bank must respond strongly to deviations in expected inflation if it is to achieve its goal of stabilising the price level. It also shows how nominal rates must rise a level greater than one to one with inflation in order to create the increase in real interest rates required to bring about a negative output gap and lower aggregate demand. Rational Expectations We argue that rational individuals should form expectations in a way that is consistent with how inflation is actually determined. This means that expectations will depend on how policy is actually conducted. Such model-consistent expectations were originally proposed by American economist John Muth in 1961 and he called them rational expectations. The macroeconomic implications of rational expectations were formulated in the 1970s. The key policy conclusion that they derived was that, although monetary policy may be able to raise aggregate demand and employment in a particular period, any attempt to affect production by a systematic, and therefore predictable, monetary policy will be fruitless. The reason is that any predictable monetary policy will affect inflation expectations and hence it will be incorporated into 9|Page

wage and price setting. Only unpredictable monetary policy can affect the real economy. This may seem like bad news for stabilization policy that pursues a specific target but even if wage setters have rational expectations, monetary policy can still be effective because it can respond to unexpected shocks while wages and prices may be somewhat rigid. Monetary policy can be used to ease the adjustment to shocks when wages adjust slowly. In this way, monetary policy can help to stabilize production and employment and compensate for the lack of flexibility in wages and prices. The Instruments of Monetary Policy In our analysis of monetary policy, we have assumed that the central bank can control the money supply, and thereby the interest rate. But exactly how does the central bank go about controlling interest rates? In short, the central bank controls the short-term interest rate by offering to lend money at an interest rate which is decided by the decision-making board at a central bank. Since the central bank can create new money, or more specifically monetary base, it can always lend enough money to get the interest rate to where it wants it to be. The interbank market for overnight borrowing: The monetary base includes currency and banks' accounts in the electronic payment system that is managed by the central bank and used to transfer money between banks. Every day, banks make a large number of transactions and people deposit and withdraw money from their bank accounts in a way that is not perfectly predictable. Depending on the amount of withdrawals and deposits that come in, a bank may end up with a deficit or a surplus on its account in the payment system. A bank can have a deficit on its account during the day but it is not allowed to maintain this overnight. Therefore banks that are in deficit at the end of the day must borrow money overnight to bridge the gap. They can borrow from each other in the interbank market for overnight loans. In the US, this is known as the Federal funds market. If a bank has a deficit at the end of the day and has been unable to borrow in the interbank market, it is automatically converted to overnight borrowing from the central bank. This is usually seen as an unattractive option as the central bank will normally charge a higher interest rate than what is on offer in the interbank market. This is known as the marginal lending facility. Banks with excess reserves that have been unable to lend during the day can also deposit money at the central bank and they are paid an interest rate on this money by the central bank, again below the market level. This is known as the deposit facility. Together the interest rates on these facilities define an interest rate corridor within which the overnight bank rate must be. The Federal Reserve does not pay interest on overnight deposits and therefore the floor of this interest rate corridor in the US is 0. The central bank can influence the interbank rate further through open market operations, that is the buying and selling of government securities. The simplest form of pen market operation is an outright open market operation where the central bank buys or sells government securities, thereby increasing or decreasing the monetary base. Repurchase agreements are a more sophisticated form of open market operation whereby the central bank agrees to purchase a government security off of a bank on the condition that bank repurchase the security from the central bank at a set date in the future. The bank receives cash for the security during this period in which it can use the additional liquidity to make payments, the bank then pays a higher price for the security than it sold it for when the repurchase occurs thereby creating an interest rate. This cost is converted to an annualized rate and is called the refinancing rate by the ECB and the repo rate by the BoE. The central bank sets this rate by offering to make repurchase agreements at a specific rate of interest. The decision about the refinancing/repo rate is the main policy decision of the central bank. We can think of the repurchase 10 | P a g e

agreement as a short-term loan with the government security as collateral and the refinancing rate as the interest rate on the loan. The main advantage of such an operation is that it reduces the risk taken by the central bank. It is only if the bank goes bankrupt and the price of the security falls at the same time that the central bank will lose some of its money; if the bank goes bankrupt before it can pay the central bank can still redeem the bond with the government and if the price of the security were to fall during the period of the agreement the bank still has to buy the bond back from the central bank at the price stated in the contract. Since this is an alternative to borrowing in the interbank market the interbank rate will often track the repo rate and this is how the central bank is able to exercise further control over this rate in addition to the interest rate corridor it had already created. An increase in the spread between the repo rate and the interbank rate reflects a perceived increase in the risk of unsecured lending to commercial banks. In a situation where there is a general excess of liquidity in the market, where all banks have excess reserves and will be forced to deposit them in the central bank, the central bank has another option that it can use. It can issue its own certificates (short-term bonds where the central bank is the issuer) in order to sock up this liquidity and reduce the monetary base. Reserve requirements: Some central banks require banks to hold a certain proportion of their deposits in the form of cash or deposits with the central bank. An increase in the reserve requirement will increase the demand for monetary base and, if the monetary base is left unchanged, this will result in an increase in the interest rate. However if the central bank targets interest rates then the reserve requirement will have little to no impact on monetary policy, the monetary base will adjust to meet demand. Reserve requirements are generally costly for banks as the interest rate paid on deposits by the central bank is normally lower than the rate on repurchase agreements and therefore these reserve requirements could be seen as a tax on the banking system. The correlation between the interbank rate and other interest rates: The connection is that expectations about the interbank rate determine other market interest rates. For the bank, an alternative to lending for three months to a firm, or holding a three-month treasury bill, is to keep lending money overnight in the interbank market. If banks expect the interbank rate to increase in the coming months they will require higher returns from the loans they make to consumers and to firms. Therefore, the interest rate in the interbank market is a baseline interest rate, which determines the level of all the interest rates in the economy. The spreads between different interest rates depend on the credit risk, time to maturity and other differences between assets. The central bank can therefore affect the real economy by unexpectedly increasing the repo rate, this in turn will increase the interbank rate and as a result increase the rates offered by banks to consumers - this should decrease the level of demand for credit and as a result lead to a decrease in aggregate demand. The key is that the change must be unexpected, if the change was expected the market will have already priced these changes in to the three and six month interest rates. While the central bank is often able to exercise near perfect control over these shorter term interest rates its ability to control interest rates in the longer term is not as good. Central banks mainly operate on the short side of the market however they do also purchase government securities with longer maturities and in this way they can affect the longer term interest rate by affecting the supply and demand of such products although the correlation between central bank action and interest rates remains far stronger in the short term.

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Addendum (not in the textbook): The TED spread is the difference between the interest rates on interbank loans and on short term US government debt; it is equal to the 3-month LIBOR rate minus the interest rate on a 3-month T-Bill. It is an indicator of perceived credit risk in the general economy since US T-Bills are considered to be 'risk-free' while LIBOR reflects the credit risk of lending to commercial banks. An increase in the TED spread is a sign that lenders believe the risk of default on interbank loans (also known as counterparty risk) is increasing. Interbank lenders, therefore, demand a higher rate of interest, or accept lower returns on safe investments such as T-Bills.

GOTTFRIES CHAPTER 11 Fiscal Policy Sustainability: The public sector is usually divided into three sub sectors; the central government, local government and the social security system. In federal states, there is a distinction between federal and state governments. Public sector expenditure consists of consumption, investment, transfers and interest payments and public sector income consists of taxes and social contributions. The difference between gross and net government debt is that gross debt includes intradepartmental lending and excludes government assets, i.e. government spending on student loans is expected to be repaid by these students in the future and so net debt is lower than gross debt. As a generally rule, government spending/debt is sustainable as long as net debt grows slower, on average, than GDP. Note that this does not need to be the case every year but must be the average in order for the debt to remain sustainable. A simple equation for the sustainability of government d...