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1
Q

Give a definition of money

A

Money is an asset that is a generally accepted means of payment

2
Q

What are the three uses of money?

A

1) Money can be used as a unit of account
- It reduces the need for many relative prices

2) money can be used as a medium of exchange
- it is more efficient than either barter or commodity money. It encourages trade and specialisation.

3) it can be used as a value store or deferred payment
- Used for debt contracts to be written in.

3
Q

What are the early forms of money?

A

Cowrie: The molusc shell found in the indian oceans and pacific oceans.

First coins were made from base metals used in china

Precious metals help to make counterfeiting harder.

4
Q

Explain the parable of bank notes and convertibility

A

You have gold which you give to a goldsmith to keep.

You get an IOU for notes

You buy cow and pay with IOU

Cow dealer now owns ur coins.

The goldsmith must give coins to whoever has the IOU.

The banknote is an IOU which is a liability for the goldsmith.

Goldsmith will only hold a small fraction

5
Q

What are the three types of money?

A

Commodity money: This is money that has intrinsic value.

Fiat Money: Has no intrinsic value and authorities can get seigniorage from it.

Electronic Money: They facilitate larger transactions.

6
Q

What are the definitions of money?

A

MB= Currency + Reserves
M1= Currency + Sight deposits
M2=M1+ time deposits
M3=M2 + large fixed term deposits+accounts at non-banks

7
Q

What are the tools of the Monetary policy?

A

1) reserve requirement ratio
2) short-term interest rate
3) monetary aggregates

8
Q

How to derive the balance sheets of the economic parties>

A

See notes

9
Q

What happens if the CB do and OMO from a bank?

A

Securities of the bank go down by 100 but their reserves go up by 100.

Overall: R 100 MB 100

10
Q

What happens if the CB do an OMO from the public who deposit the check?

A

They have a security of -100 but a deposit of 100

Overall: R 100 MB 100

11
Q

What happens if the CB do an OMO from the public who cash the check?

A

The deposit just becomes a currency 100

Overall: R 0 MB 100

12
Q

Draw how a deposit is created

A

See notes

13
Q

Derive the richer money multiplier model

A

see notes but it should be; (c+1)/(rd+c+e)

14
Q

What are the conclusions from Friedman 2008?

A

The demand for money is unstable so that money supply is not a reliable guide to monetary policy.

15
Q

What does RR depend upon?

A

Currency demand
Interest Rate
Legally defined deposit ratio

16
Q

What is a discount loan?

What is the equation for M including delays?

A

It is where the borrower will only receive the principal of the loan once interest amounts and financing are taken away.

M= m x (MBn+DL)

17
Q

What is the exchange equation?

A

mv=py

18
Q

What is Fisher’s view?

A
  • V is constant
    PY (nominal income is determined by M)
    -Classical economists assume that Y is constant.

Therefore the relationship will say that P is determined by M.

M = kPY

K is fixed here.

Interest rates have no impact.

19
Q

What is the Cambridge approach?

A

Looks at the motives for holding money;

1) A medium of Exchange.
- Higher Y means there is more exchange
2) Store of wealth
- higher y means more wealth to store.

In this approach, K can fluctuate due to changes in i and RETe on other assets.

This implies money does depend on interest rate.

great depression proves non-constant velocity.

20
Q

How does velocity deviate with Y

A

It is procyclical.

21
Q

Explain Keynes liquidy preference theory.

A

1) Transaction motive for holding money.
2) Precautionary motive.
- hold excess reserves in case of unexpected expenditure
3) Speculative motive
- Wealth is held in money

So positive relation to Y and negative relationship to i.

The interest rate mechanism works for speculative motives.

22
Q

Explain the Baumol-Tobin model of transactions

A

See notes for graphical.

Mathematical Transaction demand.
costs=bto/c + ic/2

dcosts/dc= bto/c^2 +i/2

Remeber to adjust for average money holdings.

gives the square root rule from notes.

There is no money illuson

23
Q

In Baumol-Tobin, explain the speculative and precautionary motivtes

A

i goes up opp cost goes up, hold less money precautionary money

24
Q

What is Tobin’s problem?

A

There is no spec demand for cash as treasury bills dominate.

This means money faces inflation risk.

25
Q

Expain the Friedman Quantity theory model of money demand.

A

Real money demand is a function of;
Yp - permanent income
rb-rm: return on bonds minus return on money
re-rm: return on equity minus return on money
piee-rm: inflation minus return on money.

So the motives include more assets than the other.

It suggests that interest rates have little effect on Md.

Md is a stable function.

26
Q

What does the empirical evidence say about money demand?

A

1) veloctiy is constant if the interest rates cannot predict money demand.
2) moneyD was stable till 1973 then unstable.

27
Q

Explain the differences between real and nominal interest rates.

A

Real is the interest expressed in terms of goods, nominal is the interest expressed in terms of currency.

28
Q

What does nominal interest rate represent?

What is real investment and exchange a function of?

A

Nominal interest is the opp cost of holding money.

Real invest and exchnage and functions of real interest rate.

29
Q

What is the equation for DD in the keynesian cross?

Can you draw the keynesian cross?

A

Y=C(Y-t) +I(i) + G

See notes the curve should cross the 45 deg line. DD y axis Y y axis.

30
Q

How to derive an IS curve?

A

DO the keynesian cross for different interest rates and find Y and I and y’ and i’ and plot for IS.

31
Q

What does it mean if you are to the right of the IS or the Left?

A

Right: Supply of goods > demand
left: demand of goods >supply

32
Q

How would you derive the LM curve?

A

Set real money supply constant and perfectly inelastic.

Then Move money demand for different Y values and find the I value. Similar to IS.

33
Q

What does it mean if you are to the right of LM or the left?

A

Right; Demand for money>supply
Left: supply for money >demand

Opposite to IS

34
Q

How does the IS curve (GOODS MARKET) affect the LM curve (MONEY MARKET).

vise-versa?

A

Income from the IS curve influences money demand

Interest rates affect agg demand through investment channels.

35
Q

When is monetary policy effective but fiscal not>

A

When Money demand is insensitive to interest rates.

The LM curve is vertical.

36
Q

When is fiscal policy effective bu monetary not?

A

1) When investment is insensitive to interest rates.
IS is vertical.

2) During a liquidity trap; injections of cash fail to decrease interest rates.

The LM curve is horizontal. So LM is ultra sensitive to interest rates.

37
Q

When would you target

a) Money supply
b) interest rates

Show using a diagram.

Which is most applicable in the real world?

A

a) When the IS curve is more unpredictable than LM.

Draw IS LM and show there is less Y variance with LM target.

b) When the LM curve is unstable.

Draw and IS LM and show that the is more variance from the LM target. There is only one IS LM Y* point for which there is equilibrium and interest rate target.

You are not at the interest rate target at the other points.

In the real world;

OMO from CB is money supply target. Lecture 2 examples.

Buying and selling bonds affects the interest rates.

Money demand is unstable so LM is unstable. So there is a preference for interest rate.

38
Q

How is the AD curve dervied?

A

Assume there is money supply targets.

Then any P increase causes M/P to fall which causes Money supply to shift back and LM to shift back therefore Y falls.

So plot the P and Y combos for the AD.

P is real prices.

39
Q

What happens if AD1 shifts positiviely to AD2?

A

Y and P rise.

Y>Yn. Wages will rise which means AS will fall and shift back. until Y=YN.

Therefore Y is unchanged and prices are higher.

40
Q

What if M/ P rises form ISLM

What if G rises for ISLM

A

1) LM shifts out. Y2>Yn therefore P goes up, M/P goes down. this means LM shifts back to point 1.

2) G increases IS shifts out.
Y2>YN therefore P rises and M/P falls shift LM shifts back to LM2 and interest rates rise.

41
Q

What happens to the AD curve when interest rate targets are being used?

What happens under dynamic adjustment for interest rate control?

A

AD is vertical, WHy?

AD does not shift. AS changes will just keep prices falling.

42
Q

What is meant by the neutrality of money?

A

Money does not affect the natural rate of output in the the long-run.

43
Q

What is the formula for the agg supply curve?

A

Y=Yn+a(P-Pe)

44
Q

What is a and what is 1/a

A

a is how output responds to changes from the price level.

1/a is the slope of the AS curve.

45
Q

Explain the Wage and Price setting model.

A

There a two curves.

1) Wage setting curve.

Know that unions bargain for W but they want W/p so they bargain for W/Pe which is expected Prices.

W/Pe=F(U,Z)

U is unemployment and negative related.
Z is catch all of positively related terms.

2) Price setting curve.

Firms have monop power so set prices mew above costs
Assume that firms will only employ labour.

P=(1+mew)W –> Price setting curve.

Times Wage setting curve by (1+mew)Pe, giving a phillips c curve.

(1+mew)F(u,z)pe=p

46
Q

What is the wage setting phillips curve?

What is it’s implications?

A

(1+mew)F(un,z)pe=p

If prices are stable it is:
(1+mew)F(un,z)=1

So if competition increases mew goes up. Un will have to go up for F to go down.

47
Q

Explain the Lucas supply curve.

A
  • Model assumes that the markets clear.
  • Known as the imperfect information model.

–> Suppliers monitor their own prices but not others.

Consider;
-A single wheat producer who earns income only from wheat.

If relative price is high they will produce a lot if relative price is low they will not produce a lot.

The farmer only knows the nominal price of wheat.

Farmer will estimate the relative wheat price based off price level expectations.

If there is an increase in the price level the farmer doesn’t know if it’s a price change or just a change in wheat.

Assume it’s the relative price of wheat increasing.

Y=Yn+a(P-Pe)

Output deviates from natural rate if price level deviates from expected.

48
Q

Explain the Traditional model.

What is the impact of an expansionary policy?

A

1) Assumes that prices and wages are sticky.
- Labour contracts
- Menu Costs
2) There are adaptive expectations so the policy is not anticipated.

M will increase causing AD to shift right to AD2.

Unanticipated so AS will stay at AS1.

Y goes to Y2’ and P goes to P2’

49
Q

What is the response to unanticipated policy for all models?

A

M will increase causing AD to shift right to AD2.

Unanticipated so AS will stay at AS1.

Y goes to Y2’ and P goes to P2’

50
Q

Explain the New classical model.

What happens from an expansionary policy for Anticipated?

A
  • Rational Expectations
  • Perfectly flexible wages and prices.

AS will shift to AS2 as the change is expected.

So no Y increase, only an increase in P.

51
Q

What is the difference between rational and adaptive expectations?

A

Adaptive: Pe=Pt-1 you cannot predict the future.

Rational: Agents will use all available information to them in an optimal manner.

52
Q

Explain the New Keynesian Model and the predictions that it gives.

A
  • Rational expectations
  • Rigid wages and prices (only move a little bit)

AS will shift to ASA not all the way to AS2 because of the rigidity.

Means there will be higher Prices than unanticipated, but there will be some Y increase.

53
Q

Which models does stabilisation policy work for?

A

Traditional it does.

New classical no. It will agg output.

New Keynesian: Anticipated will have no impact on output.

54
Q

What is the impact of anti -inflation policy?

A

See notes for diagrams;

Trad: Y will fall and pie will fall.

New Classical: Unan: same as above

An: As stays so no P change. pie=0.

Traditional:
UN: Same as above.
AN: AS to AS2’’; go to 2’’, Y ↓ by less, π↓ by more

55
Q

What is the rational expectations revolution?

What does it mean for credibility in inflation fighting?

A

Formations of expectations will change when the behavior of the forecast variable changes.

Credibility is essential for the success of anti-inflation policy.

The public must expect the policy to be implemented for the inflaiton to be fought. Shown in the new keynesian and classcial models.

56
Q

Changes in what influence changes in aggregate demand?

A

Changes in M/P will influence a change in Agg demand.

Yd=Yd(M/P)

Where M is a positive relation.

57
Q

What is Agg supply in a phase diagram context?

A

Y=Yn+a(pie-piee)

If there is adaptive expectations we say

Y=Yn+a(piet-piet-1)

58
Q

How do you do AS AD system dynamics for ADAPTIVE EXPECTATIONS?

A

Start with inflation. Use the AS curve.

  • Yt=Yn then piet=piet-1
  • Yt>yn then Piet >piet-1 so the pie is increasing.
  • Yt Money growth grows with mew and falls with pie.
  • Mew>pie: Y increase
  • Mew=pie: Y constant
  • Mew
59
Q

How do you do AS AD system dynamics for Rational Expectations?

A

With rational expectations, agents can use all information optimally to make predictions.

Therefore you will move straight from the first to the second equilibrium.

60
Q

What is the velocity of money and what is assumed about it in QTOM?

A

It is the number of times a unit of currency is spent in the economy in a certain period.

It is assumed constant

M/P =kY

where k=1/v

61
Q

Why is velocity pro cyclical?

A

Because if there is a boom interest rates will go up so less money is held and the money that is held is spent more often.

62
Q

How does Baumol -Tobin link money to inventory theory?

A

it says that consumers hold cash as an inventory until they need to spend it.

it is a stock of the medium of exchange.

63
Q

Derive the Square root rule

A

See notes

64
Q

What happens if brokerage costs are b+kC

A

The KC term will differentiate out of the equation.

65
Q

What happens if brokerage terms are just kc

A

The square root rule breaks down. There is now only a corner solution.

66
Q

What is the transactions velocity of circulation?

What does it imply for cash injections acording to Baumol (1952)?

A

T/C =V
TiC^2/2B

Therefore V = ic/2B

It implies that cash injections have a bigger impact on the economy than they otherwise would have had.

People have more cash and velocity so there must be greater spending than before.

67
Q

Which is more realistic, friedman or baumol.

A
  • Friedman does include a greater array of assets.

- Friedman suggests that money demand should be predictable

68
Q

What happens to the LM curve if there is an increase in money demand?

A

The LM curve will shift to the left as there is a higher interest rate.

69
Q

Why will fiscal policy be ineffective when money demand is interest-inelastic?

A

Show on the diagram the vertical LM curve, but then back up by saying that the fiscal policy in this time has crowded out both investments and net exports.

70
Q

Why does the IS curve not change from a change in the price level?

A

because the quantities are given in real terms.

71
Q

What effect do fiscal and monetary policy have in the long run?

A

None, neither will have any effect in the long-run.

72
Q

What have the LM and AD curve got in common?

A

Any factor which shifts the IS curve will also end up shifting the LM curve in the same direction. Holding the price level constant.

73
Q

Define AS and AD

A

AS: The total quantity of final goods and services that an economy will supply at differing price levels

AD: The total quantity of the economy’s final goods and services that are demanded at different price levels.

74
Q

Why is short run AS upward sloping>

A

Because, in the short run, higher prices mean higher profits because many factors of production are fixed.

Increasing production costs will cause the AS curve to shift to the right. Lower production costs will cause the AS curve to shift to the left.

75
Q

What is the Natural Rate of Output?

At what point is long run AS vertical?

A

Natural rate is the level of agg output that is produced at the natural rate of unemployment.

It is the highest level of output that could be sustained in the long-run .

It will be vertical at the natural rate of unemployment.

76
Q

Why when Y>YN does the AS curve shift left.

A

It is because it causes a tight labour market. Essentially, wages and production costs will rise. This causes a raise in the expected price level.

This means the cost of production will raise and the AS curve will shift to the left.

77
Q

What is the main argument behind the Lucas Critique?

A

The argument suggests that; structural models are required over reduced form models when you are performing policy evaluation.

78
Q

What is a structural model.

What are the pros and cons of one?

A

A structural model examines how one variable affects another by using data to explain the channels through which the effects are had. It focuses on the transmission mechanism.

Pros:

  • You can be more confident with causation
  • You can give more accurate predictions
  • You can perform better policy prediction.

Cons:
-It is only as good as the model that it is based on.

79
Q

What is a reduced form model?

What are the pros and cons?

A

-A reduced form model only looks at the correlation between two variables. It doesn’t seek to observe the specific transmission mechanisms.

Pros:
-It imposes no restrictions on the way monetary policy impacts the economy.

Cons:
-A correlation does not imply causation.
It can work the other way.

-There could be an outside driving factor to consider.

80
Q

Give a historical example of a causality debate

A

The debate is whether the great depression was caused by;

  • tight monetary policy or
  • a lack of autonomous expenditure.

Argument 1:

  • There were low interest rates which indicates that monetary policy had no impact on the economy.
  • Studies found no link between nominal interest rates and investment.
  • Business surveys confirm that investment was not based on interest rates.

–> Siggests it was lack of auto expen

Argument 2: Friedman and Schwartz:

  • It was during a period of inflation that the nominal interest rates were low.
  • They said that there may be a real interest and investment link

–>suggests it was many other channels which we haven’t observed.

81
Q

What is Goodhart’s law?

A

When a measure becomes a target, it ceases to become a good measure.

it then uses the parable of PhD students as an example.

82
Q

Give a lucas Critique example

A

-Policy maker will observe a relationship and make a policy based on that.

The public then observe this policy which changes their expectations.

The policy no-longer applies.

Try to derive and check the PDF online to see if you were correct.

83
Q

What is the important point about Structural Models?

A

they will anticipate between the anticipated and the unanticipated effect.

84
Q

Explain the interest rate channel.

A

M goes up, I goes down, r goes down so more investment and output (Y).

85
Q

Explain the interest rate channel under liquidity trap

A

M goes up, pe goes up, pie e goes up, r goes down, Investment goes up and Y goes up.

86
Q

Explain the stock market effect

A

M goes up, Ps goes up. equity price increases probably from positive stock effects.

87
Q

Explain tobin’s q:

A

M goes up, Ps goes up, q goes up i goes up y goes up.

This is because the stock market value becomes greater than the base value so they invest more.

88
Q

Explain the wealth effect

A

M goes up, stock price goes up, wealth goes up, so consumption goes up and y goes up.

89
Q

Explain the Credit Micro conditions

A

See Kasyap & Stein.

1) Sticky prices are needed to observe real effects.
2) Banks must be special. i.e; the bank loans and open market operations must not be perfect substitutes.
3) Central Banks must be able to affect loans supply by changing the monetary base.

90
Q

Explain the bank lending channel.

A

M goes up, deposits goes up, bank loans goes up, investment goes up, Output goes up.

91
Q

Explain the Balance Sheet Channel:

A

Firms that have a high net worth can offer collateral to make the cost of external finance less.

M goes up, Ps goes up, Cost of finance goes down (probably because of higher equity avaliable as collat), lending goes up, investment goes up and output goes up.

92
Q

Explain the Cash flow channel.

A

If a firm has high profit, they can interanlly finance their projects.

M goes up, Ps goes up, Finance cost goes down, lending goes up, investment goes up and output goes up.

93
Q

Explain household Liqudity effects.

A

M goes up, Ps goes up, financial asset values go up cash flow goes up, liabilities fall, likelihood of financial distress falls, Expenditure goes up and so does Y.

Expenditure is consumer durable and housing expenditure.

94
Q

What are the Ideas of Kashyap and Stein 1993?

A

The lending view boils down to;

  • OMO affect the supply of bank loans.
  • The loans supply will affect the magnitude of agg output and composition.
  • There needs to be imperfect substitutability of bank loans and publically issued bonds to get an idea of the lending view
  • Both the lending view and the typical monetary view may coeexist.
95
Q

What is term-strucure?

A

Relates the long-term interest rate to the past and current values of the short-term interest rate.

Short-term interest rate rises are expected to only be temporary.

96
Q

What are rules?

A

Rules are binding plans which specify how a policy will respond.

Such as;
-Constant money growth rate. Where money growth is kept growing at a constant rate.

-Taylor Rule: The fed should set a fund rate that considers both output and inflation gaps.

97
Q

What is the case for discretion?

A
  • Rules can be too rigid
  • Rules do not consider the point of judgement
  • No one knows the true model of the economy, so the rules will be at least a little misset.
98
Q

What is constrained Discretion?

A

There is conceptual structure and inherent discipline on policy makers, although they still have flexibility.

99
Q

In which models is money neutral in the long-run?

A

In all models

100
Q

Which models is money not neutral in the short-run?

A

Traditional and New Keynesian

101
Q

What does it mean if money is non-neutral?

A

It means a change in the money supply will cause a change in output in the short-run

102
Q

Why is money neutral?

A

The idea of neutral money is that the change in the money supply will only impact the nominal variables. Not the real variables.

This is because any rise in the money supply will be met by an increase in wages and prices, therefore diluting the real effect.

103
Q

What is the view of the new classical model on neutrality of money?

A

It suggests that:

  • Unanticipated Model: The change in money will change output in the short-run.
  • Anticipated Model: There is no short-run impact because AS reacts.
104
Q

What is the evidence on long-run neutrality?

A

Walsh and /Mccandless and Webber

Find an almost 1 correlation between money growth and inflation.

They find no link between money growth and output growth.

105
Q

What does the Fischer effect mean for money neutrality>

A

Nominal rates should be positively correlated with inflation.

If real returns are independent from inflation.

106
Q

What should monetary policy be used for if it is neutral in the long-run but not the short-run?

A

It should be used for stabilization policy.

107
Q

How can causality of SR Netruality effect be proved?

A

There should at least be a correlation between SR M and SR Y.

There should not be reverse causation or another driving factor involved.

108
Q

Give two examples where the change in M was not exogenous

A

M increase could be from more deposits being made at the bank which is a result of higher output. Therefore, reverse causation.

A rise in output will lower the currency ratio. This will increase m, the money multiplier, and then M, money supply will rise.

109
Q

What is Friedman and Schwarz Timing evidence?

Give the critisim of using Timing to prove causation

A

SR Money affects output
LR money affects prices

They said the peak in Ms growth was around 16 months before the peak in Y on average.

  • only valid if the original event was exogenous.
  • Ms and Y follow each other.
110
Q

Explain the Process of Granger Causality

What is the evidence of Granger Causality

A

You generate a model of y with m y and z lagged values.

Then you say that M is only said to granger cause y if and only if lagged values of m have marginal predictive content in the forecasting equation.

You need to test their statistical significance.

Stock and Watson(1989) find no evidence of granger causality.

BERNANKE AND BLINDER (1992): find that federal fund rates have more predictive output power than money.

111
Q

How can Historical Evidence be used to Help?

What is the historical evidence?

A

Uses the post hoc ergo proper hoc idea.
It is only vaid if you assume that the first event is exogenous.

You want to indentify a change in money growth that is exogenous.

Freidman and Schwarz (1963) document timing evidence criticizing keynes evidence on the great depression.

WALSH P.39:

Hyperinflation in Austria, Germany and Hungary all end abruptly after a credible change in monetary and fiscal policy. The Sacrifice Ratio was low.

This is the loss of output due to inflation reduction.

The output loss was little.

MISHKIN:

1936-37: The FED rise reserve requirements

1937-1938: There is a recession?

112
Q

What can monetay policy be used for if it is neutral in long run but not short run?

A

It can be used to stabilise booms and recessions.

113
Q

What do we need for monetary policy to be truly useful?

A

We need to identify a causal link between aniticipated M changes and output (Y)

114
Q

What is the evidence for DSGE and VAR models?

A

Vars have show unanticipated shocks will cause positive improvements in output.

it is difficult to indentify anticipated effects as it is difficult to find the correct structual model for the anticipated model.

115
Q

Why can’t you just use unanticipated policy?

A

It will cause uncertainty for the public to increase.

This will impact output and make it difficult to use monetary policy for stabilisation.

116
Q

What does the New Classical model say about monetary causality?

A

That only unanticipated changes in M will cause a change in Y.

117
Q

What are for the CB

  • Tools
  • Instruments (operating targets)
  • Intermediate targets
  • Goals
A

Tools

  • OMO
  • Discount policy
  • Reserve requirements

Operating targets

  • Reserve Aggregates
  • Short-term interest rates

Intermediate Targets

  • Monetary aggregates
  • long-term interest rates

Goals

  • Price Stability
  • Financial Stability
  • high employment (low unemployment)
118
Q

What is the difficulty of controlling M?

A

You can control MB but m is determined by a number of endogenous factors.

119
Q

Draw the diagrams for interest rate and money supply targets (not ISLM)

A

M is x axis i is y axis see notes for diagrams

120
Q

What criteria is there for choosing targets?

A

1) Measurability
2) Controllability
3) Ability to predictably affect goals

Intermediate targets
Ms better for 1 and 2, easier to control than real rates

interest better for 3

Operating Targets
Reserves and interest equal for 1 and 2,

If ms is intermediate target then you should use a reserve target

121
Q

What is the Theil-Tinbergen Framework?

A

A policy rule must be maximised or minimised, where what is being maxed or mined is the endogenous variables.

See notes for ideas.

122
Q

How do lags factor in to the policy problem?

A

All variables need to be forecast at th epolicy horizon. If you are changing interest now, you need to forecast the effect it will have on inflation at the horizon. (the number of lags before an effect is seen)

123
Q

What are the two uncertainties, what are the policies to fix them?

A

PARAMTER: If you are unsure, do Brainard’s rule do what you were going to do but to a lesser extent

Model: Blinder’s policy is to use as many models as possible and not trust each one too much.

124
Q

IN a loss function setting what are the two objectives and how many instruments are their to acheive?

A

Output and Inflation

Only one.

There should be n instruments for n objectives

Therefore you will use a loss function to create the best outcome.

L=(pie-pie)^2 +b(y-y)

The aim being that you want to minimise L as it gives symetric loss.

Bean suggests that most independent central banks set y=y* so the time inconsistency problem will disappear.

125
Q

Give examples and evidence on choosing the optimal rate of inflation.

A

1) Why should we have a negative rate of inflation?

Money is costless to produce so should have zero price. The opportunity cost of holding money should be zero.

if nominal interest rate is zero then real rates will be positive unless inflation is negative enough.

2) Why should they be positive?

it wages are sticky downwards it will help the markets to clear.
It will help to avoid a liquidity trap
inflation can be more efficient than other taxes.

126
Q

What are the three models in the three equation model?

Draw the curve

What is the policy rule?

What happens if inflation rises?

A

IS curve: y-yn= -a(r-rn)
Loss function: L=(pie-pie*)^2 + b(y-yn)^2
EAPC: piet=piee+a(y-yn)
assuming adaptive expectations

piee=piet-1

piet=piet-1+a(yt-yn)

See notes for the diagrams and assumptions

The policy rule is that if inflation rise, the policy maker can raise interest rates to reduce output.

The curves will become flatter, output is reduced more when raising interest rates further.

127
Q

What is the role of a nominal anchor?

A

To tie down inflation expectations.

Avoids the time-consistenc problem and avoids the political pressure which causes it.

128
Q

What causes the Time-Consistency Problem?

A

The pursuit of short-term goals tends to lead to bad long-term outcomes.

129
Q

What is the evidence for inflation targetting for UK, Canada and New Zealand?

A

For all three, after inflation tragetting began, rates fell.

Although some were already on a downward path.

130
Q

How did the US adopt inflation targetting?

A

Moved on 25th Jan 2012

Adopted a 2% target measured by PCE.

(personal consumption expenditure)

131
Q

What are the five elements of inflation targetting?

A

1) publically announce a medium term target
2) make a commitment to price stability
3) use an information inlcusive strategy
4) Increase the transparency through public announcement
5) Monetary policy become more accountable for outcomes.

132
Q

What is the big problem with reducing the rate of inflation (disinflation)

A

you will cause unemployment to rise

If CB cares alot about Unem they will slowly disinflate,

If not then they will very quickly disinflate

133
Q

What is B.Friedman’s argument about inflation targetting?

A

The framework for targetting does not give an idea of how much the CB cares about unemployment. So it is a less transparent policy.

134
Q

What is Blinder’s idea for setting a policy?

A

1) estimate how much you need to do and do a little less
2) observe
3) a) if it’s good use as much as you needed
b) if it’s bad then reestimate the policy.

135
Q

What are the pros and cons of inflation targetting?

A

Pros:

  • Allows a focus on domestic considerations
  • Doesn’t need an M-agg inflation relationship.
  • Performs well as inflation and expected tend to stay low even in a boom.

–> could be argued that world inflation was already low or
that monetary policy with implicit nominal anchor is just as useful

Cons:

  • The policy can be too rigid.
  • Prevents monetary policy being used for other goals.
  • There can be delays to the signalling.
  • There was the financial crisis.
  • The policy is not as transparent as is made out.
  • Friedman (2004): the remoit is never clear on b weight
  • Bean (1998) changing b has little policy impact
  • Henry (2006): Changing b will have little impact if the mpc members discount the future too highly.
136
Q

What is the paper evidence for inflation targetting?

A

Inflation and output:
Lopez-villavicencio and mignon:
inflation targeting has a negative effect on output growth.
But only above a threshold 3% industrialized
17% emerging economy

Inflation tragetting and inflation Reduction:
-Ball and Sheriden (2005):
Control for mean reversion find that no strong impact of inflation targetting up to 2001.
-Willard (2012):
Finds little effect. Suggest that central banks have little control over the inflation rate

inflation targeting in emerging economies:
Brito and Bystedt (2010): Found some evidence for inflation targeting on inflation and the volatility of inflation.

Also found that inflation targetting has negative effects on output growth.
Lin and Ye (2009):

Inflation targetting causes a 3% fall in inflation

Goncalves and Salles (2008):

Find overall mixed evidence.

FILL THIS OUT WITH MORE DETAIL ONCE THE SEMINAR QUESTION IS DONE.

137
Q

What did Mervyn King’s speech say about inflation targetting?

A

-Inflation targetting has reduced inflation in the UK.

There is no evidence of poor output growth.

It caused stability in gilts and and index link gilts

But

It does take power away from other monetary goals

138
Q

Name the Alternative types of monetary policy.

A

1) moNetary policy with an implicit nominal anchor
2) Monetary targeting
3) Exchnage Rate Targetting
4) Currency Boards
5) Dollarization
6) Tragetting Nominal GDP
7) Quantitiative Easing

139
Q

Explain the Pros and Cons of Monetary Policy with an implicit nominal anchor.

A

It differs from monetary targetting because it does not imply that controlling the money supply is the main instrument of the policy

Pros:

  • Forward looking to deal with long-lags
  • Domestically focused.
  • Worked well in the US

Cons:

  • There is no accountability or transparency because there is no set goal
  • Depends on whether the public trust the central banker head.
140
Q

Exlplain the pros and cons of targetting money

A

Pros:

  • The central bank is more accountable
  • There are immediate signals
  • Domestic issues are considered.

Cons:

  • There is a poor communicator mechanism to the public.
  • Will not work unless there is a strong relationship between the monetary aggregate and the end goal of the central bank.

Germany and Switzerland
-Didn’t have a ridgid rule and allowed the agg to target to change over time.

UK, Japan and Canada had more problems along the way.

141
Q

Explain the pros and cons of Exchange-Rate targetting

A

Pros:

  • Pie is fixed for goods traded abroad.
  • pie expectations are fixed
  • Helps to aid economic integration.
  • Avoids time inconsistency.
  • Reduced inflation in France, UK and Mexico.

Cons:
-You no longer have independent monetary policy.
You become open to a speculative attack.
-You lose the exchange rate signal so become less accountable.

142
Q

Explain the pros and cons of currency boards.

A

This is where a monetary authority fixes a peg with a foreign currency.

- Pros 
Economic integration
no Time inconsistency 
pie expectations anchored 
pie is fixed for goods traded abroad. 

cons:
All exchange rate targeting cons
-You can no longer be the lender of last resort

143
Q

What are the pros and cons of dollarization

A

Where your domestic currency is aligned with the US dollar.

Pros:
No plausibility of speculative attack. –but why

Cons:
Normal fixed exchange disadvantages.

You now lose the power to use seigniorage.

144
Q

What are the pros and cons of targeting nominal GDP.

A

You can target either nominal income or nominal income growth.

Pros:
It may allow an expansionary policy at times which inflation targetting will not.

Cons:
Not as flexible as MPINA
Not as effective at inflaiton control than inflation targetting.

145
Q

Explain Quantitative Easing

A

After the financial cirsis:

  • Zero-lower bound issue
  • Break down of official and market interest rate link.

Tinbergens law of instruments to objectives meant that CB’s have augmented their tools to achieve more goals.

SO QE is where CB’s buy securities in an OMO.

This will cause the cash reserves of these banks to increase, this means that lending to the broader economy should then increase.

Kiyotaki and Moore (2012): If a CB purchase illiqiud assets from the OMO they will improve financial investment.

long-dated assets can be exchnages for short dated ones . This lowers the term premia for the long-dated assets.

146
Q

Explain the transmission mechanism behind quantitative easing

A

1) BOE buys gilts
so deposits and liquid assets will increase.
Bank credit will increase and domestic demand increases

2) boe buys gilts
Yield on gilts fall 
cost of credit down 
term premia down 
long-term asset yield down. 
risk premia down 
wealth up

Domestic demand up

147
Q

Give two papers that explain some part of QE;

A

Bameister and benati (2010); suggest qe helped to avoid deflation and declines in output.

Kapetaios et al (2012): The peak effect of QE on UK GDP was 1.5% and on inflation was 1.25%

148
Q

What happens in time -inconsistency?

A

This is where the polic make targets a reate of inflation that is higher than the natural rate.

If output is kept above the natural rate, inflation will be forever increasing.

149
Q

Explain the Hijackings idea for commitment>

A

The idea is that you say you wil not negotiate with terroists in a plan jacking.

However; if a plane is jacked you would like to to save the passengers.

If you break the rule, hijackers will expect you to do it again and will hijack more planes.

150
Q

What is the outcome under commitment?

A

The policy maker will credible commit to a certain inflation rate.

This will determine the expected inflation expectatitions of the private sector.

optimal to announce pie star.

151
Q

Explain discretion under adaptive expectations

A

The policy mkaer does not credible commit to inflation rate.

The private sector sets piee.
Policy maker will set pie to minimise loss function.

Draw the graph and show at piee1 at point A.

Y*>YN,

In the next period, inflation expectations increase so we go to point B piee2

Y*>Yn still so inflation expectations increase again.

So eventually end up at C, with output at natural rate and inflation way above target.

In commitment you will get output at natural rate and low inflaiton.

The short term goal of higher than natural rate of output has caused excedingly high inflation.

152
Q

Explain discretion under rational expectations

A

Similar to adaptive expectations but as soon as public realise they are tying to set Y*>Yn they will raise inflation expectations and move straight to point C.

Points A and B do not exist in rational expectations because they are points where the agent is not using the information available to them in the optimal manner.

153
Q

Explain Central Bank Independence.

A

You can have either
1) Instrument independence where the government sets the goals but you decide how to achieve them (bank of England 2013 remit)
or
2) Goal independence where the central bank sets its own goals , (ECB is given goal of price stability but interprets in its own way).

The central bank will want a reputation to be tough on inflation. This will lower expectations and inflation as a whole.

Central banks independent will have lower b so they have flatter indifference curve and lower C, show grpah.

bean (1998) and Vickers (1998) argue that the central banks will target the inflation at the natural rate.

154
Q

What is Blinder (1998)’s view on Central Banks Independence?

A

Pros:

  • CBIs have longer policy horizons
  • Reducing inflation should be a long term investment

Cons:
-Central banks are less open and accountable

-The process is less democratic.

155
Q

What is evidence of the impact of CBI?

A

-Alesina and Summers 1993:
Made a CBI measure and correlated it with;
-av and var inflation,GNP growth, Unemployment and real interest rate

Found negative effect on average and variance of inflation
and real interest variance

-Temple (1998)
used more explanatory variables to deal with A&S ommited variable bias
Finds that using a larger sample will see the negative CBI effect dissapear.

-Hayo and Hefeker (2002):
Correlation doesn’t imply causality
CBI is endogenous, so the lower inflation is from ‘inflation culture’
weak evidence for political business cycles.

-Crowe and Meade(2007/2008):
Uses instrumental variables to address the endogeneity issue.

Find that CBI does lower inflation

156
Q

Explain some of the charts for the financial crisis.

A

Chart 1: Labour Productivity

  • Shows that UK,Germany and france fell, Spain and US rose.
  • It began tp rose again in 2009.

Chart 4: Showed UK having the biggest deviation from pre-crisis productivity

4B: Showed UK having the biggest deviation from pre-crisis output

4c: Germany was the only economy where employment increased.

Chart 5: Labour productivity compared to previous finical crisis. UK and German below US and Spain above.

157
Q

What were the causes of the Financial Crisis?

A

Subprime Mortgages
-Mortgages given to people who are more likely to default on them.

These were then securitisied then the mortagages started to default after the low interest at the started rose.

-Subprime mortgages had received Triple AAA ratings.

158
Q

What is a credit default swap?

A

where the buyer of the swap will make payments to the seller until the maturity of the bond. In return, the seller agrees that if the debt issuer defaults, the seller must pay the buyer’s security premium as well as alll of the interest payments back.

The problem was that the CDS on SPM meant there were more CDS than SPM around.

159
Q

What are the arguments of taylor, bernanke and bean on the financial crisis?

A

Taylor (2007): excessively low interest rates led to the housing bubble.

Bernanke (2010) and Bean et al (2010) disagree with this idea.

160
Q

What are Mishkin’s nine Principles?

A

1) Inflation is always and everywhere
2) Price stability has important benefits
3) There is no trade-off between unemployment and inflation in the long-run.
4) Expectations play crucially on the macroeconomy.
5) The Taylor principle is necessary for price stability
6) The time-inconsistency problem is relevant for monetary policy.
7) independence of the central bank improves macroeconomic performance
8) Commiting to a nominal anchor credible will give price and output stability
9) Financial frictions are important for the business cycle.

161
Q

What are the Amplification Mechanisms outlined in Blanchard?

A

1) Bank run:
- If the probability of default on an asset increases then the uncertainty of the asset side will increase.
- Modern banks will finance through whole sale, but will not be able to if they are deemed to be too risky.

they will have to sell assets at low prices, this decreases the value of assets on other banks balance sheets.

2) Banks are mandated to hold adequate capital ratio to remain solvent. However if this is lost, then they will have to sell assets to preserve their ratio.

Causes the above effects.

162
Q

What are the thoughts of Mishkin (2011)?

A

Financial sector developments have a bigger impact on the macroeconomy than first realised.

  • There is a high cost from financial crisis.
  • the zero-lower bound problem is worse than first thought.
  • price and output stability do not ensure finanical stability.

Credit driven bubbles are best fixed by macroprudential policy -this aims to mitigate risk to financial system as a whole.

163
Q

What are the thoughts of Blanchard, Dell’Ariccia and Mauro (2010)?

A

-Stable inflation is not sufficient as a target. Having it too low will be bad in a crisis. -We should raise it

  • Financial Intermediation is important
  • Countercyclical fiscal policy is important
  • regulation does have an impact on the macroeconomy
  • the great moderation does have alternative interpretations.

Monetary and regulatory policy should be combined.

inflation targetting should be used and there should be intervention in foregin exchange markets.

There should be broader provisions of liquidity.

-There should be more fiscal space in good times.

There should be better automatic fiscal stabilisers