Econ

Macro Term 2 notes.

Macro is bigger Picture.
Questions:
Why do economies grow and does that growth fluctuate? What causes financial crises, inflation,
exchange rates?
The circular flow of income. Firms provide goods & wages, individuals provide labour & spending.
What do we look at: GDP, Unemployment, Inflation.
GDP, Output=Income=Expenditure

Trends in the last 100 years: Spectacular growth, increases in government spending as a proportion
of GDP.
GDP excludes: Black market, non-commercial goods and services, value of leisure, quality of leisure,
rights, and environmental health. What really adds value, Exxon Valdes crash boosted GDP.
But GDP is important.
LFS vs CC
LFS: In employment 16+ in employment
Unemployed : want a job, have been seeking work and can start in the next 2 weeks.
Economically inactive: the rest.
Generally low atm.
With Fiat currencies out inflation has been positive since 1931.
Monetary Policy:
Manipulate long-term interest rates indirectly by changing short-term interest rates to banks.
Unconventional, Quantitive easing

Log(GDP)=log(GDP per capita)+log(population)
1/GDP(dGDP/dt)=1/GDP per capita(d(GDP per capita/dt)+1/pop(d(pop)/dt

Macroeconomic model:
Document the facts
Develop a model
Compare predictions of the model with the facts
Use the model to make more predictions that will eventually be tested

Parameter: Input that is fixed unless model builder changes it for an experiment
Exogenous Variables: an input that varies over change but we cannot predict or change, we must
discover them beforehand.
Endogenous Variable: In the mode and is explained by the model

Output is assumed to be a function F(K,L) of labour and capital.
We assume that these production functions have constant returns to scale because in the economy
an identical factory added next to another factory should double the output.

It is assumed that we will purchase K and L in an economy until the MPL&MPK = MCL&MCK. Since
the marginal product of both labour and capital declines with quantity, the price or (MC) that firms
are willing to pay is a downward sloping demand curve.
Cobb-Douglas production function F(K,L)=AK^alphaL^1-alpha
A is the productivity parameter

The main difference between

rich and poor countries,
roughly 75% is the difference
in efficiency of capital use,
not the amount of capital.
This is because of institutions that increase human capital, and less resources are misallocated,
fewer Einsteins are pig farmers.


Lecture 3 The Solow Growth model
The Solow growth model suggests that development and growth is a result of capital accumulation.
Capital stock is now endogenised
The accumulation of capital is a possible engine of long run growth

Cobb-Douglass production function ,
there exists constant returns to scale on labour and capital.
Output can be used for either consumption or investment. (simplification that assumes no imports
exports or government).
Capital= capital(t-1) + Investment depreciation
Investment = savings rate * Output





This graph shows that approach to the steady state, a
constant level of capital from which there is no
growth, is inevitable. Transition dynamics mean that
when above or below the steady state of capital then
the difference between investment and depreciation will force the approach to the steady state.
When capital is at steady state then GDP will also be steady.
To calculate the location of steady state, depreciation=investment, sY*=dK*
Thus So plug this back into output and we there have an equation for
output.

Understanding the steady state: investment has diminishing returns, therefore it is not possible to
accumulate capital forever as eventually depreciation catches up.


Lecture 4 Growth and Ideas
With the solo model technology plays a huge role.
The ratio of rich country to poor country depends both on the ratio of their respective technologies,
and also the ration in savings.

In the Solow model there is no long run growth, as people reach a steady state when:
The Solow model cannot predict long term growth in output per person.

The Solow Growth model dictates that:
If an economy is below steady state then it will grow
If an economy is above its steady state its growth rate will be negative
The farther below (above) its steady state the faster (slower) an economy will grow

Transition dynamics hold that poor countries grow quickly, and because rich countries are closer to
steady state they grow slower.

However, this only works with OECD countries. Average rich and poor countries grow at the same
rate, this implies: Countries have reached steady state. Countries have inherently different steady
states.

Strengths
It provides a theory that determines how rich a country is in the long run
- long run = steady state
The principle of transition dynamics
- allows for an understanding of differences in growth rates across countries
- a country further from the steady state will grow faster
Weaknesses
It focuses on investment and capital
- the much more important factor of TFP is still unexplained
It does not explain why different countries have different investment and productivity rates
- a more complicated model could endogenise the investment rate
The model does not provide a theory of sustained long-run growth

New Growth theories
Solow relies on finite rivalrous objects, capital and labour.
Ideas are infinite and nonrivalrous, can still be used to help make
objects
We can slightly alter the Cobb-Douglass production function in order
to add in that technology=ideas.

Ideas allow long run increasing returns to scale. This is one of its advantages over the Solow model
because it can explain continuing growth. This is because firms pay initial fixed costs to create new
ideas but dont need to reinvent the ideas again later.


This model explains one of the many reasons why the world does not operate under perfect
competition, because perfect competition results in Pareto optimality because price = MC
Fixed initial costs will never be recovered
If P=MC under increasing returns, no firm will do research to invent new ideas
Prices must be above marginal costs in order for firms to recoup the fixed cost of research
Increasing returns imply that Adam Smiths invisible hand may not lead to the best of all possible
worlds
Patents
Grant monopoly power over a good for a period
Generate positive profits
Provide incentive for innovation
However, P>MC results in welfare loss
Other incentive for creating ideas may avoid welfare loss, e.g. government funding and prizes

Drivers of sustainable growth (e.g in the UK past 80 years) has been growth in TFP and Capital.
And by examining the Asian tigers it can be seen that growth is mostly a result of capital investment.

We can see that UK recessions are mostly negative TFP. This makes sense, recessions do not destroy
labour or capital, they merely expose or create misallocation of capital, which means inefficiency.

There is also an equation that takes into account the ration of workers making stuff and workers in
R&D

















Romer Model Lecture 5
This model proposes constant returns to scale for objects alone.
Increasing return to scale in objects and ideas

Ideas build on the shoulders of giants.
The existence of ideas in the previous period
Unregulated markets traditionally do not provide enough resources.


Production using the existing stock of knowledge A and workers L
New ideas are produced by this equation. Z is the productivity of
workers producing ideas.


The romer model assumes that the growth rate of knowledge is constant. (probably BS)
The model produces long-run growth that the Solow model did not. This is due to the increasing
returns to ideas and diminishing returns to capital. This is basically because ideas are non-rival.
Therefore ideas are unrestricted.
This model does not exhibit transition dynamics and therefore has difficulty in explaining developing
world growth.
An increase in population will immediately and permanently
raise the growth rate of per capita output.





Combining Solow and Romer provides a rich theory of economic growth
 The growth of world knowledge explains the underlying upward trend in incomes
Countries may grow faster or slower than this world trend because of transition dynamics

Now convergence under
Solow happens not to a point,
but instead to a balanced
growth path, since A increases
continually over time.



From these equations we can derive the growth rate.
Because we assume that we have a constant rate of
growth the growth in capital=growth in output. Further
this implies that the growth rate is 3/2 times the growth rate of knowledge.

The growth rate of output is even larger in the combined model than in the Romer model
Output is higher in this model because ideas have a direct and indirect effect
Increasing productivity raises output because productivity has increased and higher productivity
results in a higher capital stock

Growth in leads to sustained growth in output per person along a balanced growth path
Output per capita depends on the square root of the investment rate
A higher investment rate raises the level of output per person along the balanced growth path
And thus shifts the balanced growth rate up vertically.




















Lecture 6 Labour Market, Wages and Unemployment
Employment rate for men and women has been converging since the 1970s and now seems to have
stabilised with a 10 percentage point disparity.
Women are particularly likely to
become economically inactive.
They tend to disappear from the
labour market rather than being
unemployed if they lose their jobs.

It is also the case that older
workers tend to be shielded from
unemployment quite well. The
unemployed tend to be young
northern men.

Inactivity rate remarkably stable at
37%
European unemployment happened because
1970s shocks oil prices, productivity slowdown
Initial failure of target wages to moderate
Hence unemployment rose
and often stayed high (poor institutions plus hysteresis?)
despite slack monetary policy and resulting inflation
Then costly disinflation
and a mixed record of labour market institutional reform

Change in unemployment is the flow out of unemployment minus the flow into unemployment. In
America both of these rates are very high and in Italy they are quite low. This is because any attempt
to cut the flow of unemployment in is to make it harder to fire people, but then this leads to firms
no-longer hiring as many people.

These are the main factors that affect the outflow rate from unemployment:
Factors affecting job separation and matching

Structural, technological and demographic change in the economy and workforce
stochastic volatility in demands and supplies
Search costs
the cost of gathering information about job vacancies and labour availabilities
The costs of mobility
geographical, housing etc
Incentives for job search
Also Structural barriers, unemployed with useless or no skills.
affected by the tax/benefit system
Employee protection regulation
Affects as well as
Real wage rigidity.
The causes of real wage rigidity might be
Exercise of market power by incumbent workers through
unions and collective bargaining
Insiders may impose externality on outsiders
with collective bargaining firms may have little incentive to resist
Unduly high minimum wage laws
especially for those entering the labour force
but moderate minimum wage laws can have advantage

Efficiency wage reasons
Better pay
greater work effort more output (moral hazard)
better quality workers more output (adverse selection)
less turnover recruitment and training cost saving


Long run people suffer hystoresis
Lecture 7
Inflation
Inflation is the percentage change in an economies overall price level.
Hyperinflation: Inflation at over 500%

Typically measured through the CPI. The CPI is a price index for a bundle of goods, designed to
represent typical consumption in a given country, excluding housing costs.

Todays money is usually fiat currency, imbued with value through the simple mechanism that others
expect it to have value.

M0: All currency, both in circulation and bank accounts.
M1: Adds Demand deposits.
M2: Adds savings accounts and money market accounts.

The Quantity equation says that GDP is some multiple of the
money supply. Y&V are assumed to be exogenously determined. Output by real forces, & velocity by
assumed to be fixed spending patterns.
The money supply is determined by the central bank so the only dependent
variable is the Price Level.

This holds pretty universally increases in the money supply that are not compensated by either
slowing velocity or an increase in real GDP result in inflation.

The neutrality of money says that changes in the money supply
Have no real effects on the economy
Only affect prices
Have to bear in mind that uncertainty caused by an erratic price level can affect the real economy
More precisely, its expected inflation that matters for
nominal interest rates = +
Ex post versus ex ante real interest rates


On the quantity theory, money growth determines . The real interest rate r is determined in the
market for loanable funds, independently of monetary policy.

Even fully anticipated inflation has
shoe-leather costs higher inflation tax lowers desired money balances, so more
trips to the bank
menu costs printing/distribution costs of more frequent price changes and
possible relative price distortions
tax distortions e.g. of savings incentives
Unanticipated inflation
arbitrarily redistributes wealth, e.g. from pensioners
Inflation volatility, which is greater when inflation is higher
creates costly economic uncertainty

Moderate consistent inflation has benefits:
Helps relieve sticky wages
Allows lower than zero real interest rates to further stimulate growth

Inflation grants the government the ultimate privilege, to levy an inflation tax.

















Week 4 lecture Consumption
Consumption
Income is the main determinant of consumption.
Depends on average propensity to consume falls as income
rises, only in the short run

Drivers and long term throughputs for consumption:
Income and (un)employment
Availability and cost of credit, debt overhang
Asset prices (housing, shares, )
Taxation now and expected
Confidence



Riccardian equivalence. Do people foresee tax rises after cuts and therefore reduce their spending?
No.
Myopia: consumers dont see that far ahead.
Borrowing constraignts: many consumers cannot currently borrow enough to achieve their current
optimal consumption.
Future Generations: Tax rises will effect future generations therefore they can safely be ignored.

Typical Microeconomic equation modelling rational consumption today and in the future

This graph shows that consumption today can

either just be income today, it can be less that,
which boosts future consumption through
savings, or todays consumption can be higher
than income which necessitates borrowing, or
digging into savings which lowers future income.

All models of consumption have it as having a
diminishing marginal utility, leading to an
indifference curve where c(today) and c(tomorrow) are complimentary.
We could do the obvious calculus or this:













A change (increase) in the interest rate shifts the angle of the budget constraint to be more negative.
There are a bunch of complex income smoothing models that rational people would follow, the
middle aged would save the young and old would borrow, expected changes in income would not
affect consumption. These all have an impact, but main fact is people are irrational (availability of
credit is an issue) biggest determinant of consumption is current income.

Takeaway:

1. Euler equation and the permanent income hypothesis provide a useful description of
consumption, particularly in households with above-average wealth
The marginal propensity to consume out of a temporary income shock is low
Consumption smoothing is effective
2. Low income households
Behave as if borrowing constrained
Engage in precautionary saving
MPC from income boost is high
3. Many departures form the classical model in the data
Are individuals really rational?











Lecture 9 (Week4) Investment

Business fixed investment
machinery and equipment
buildings and structures
Residential investment
by owner-occupiers and landlords
Inventory investment
change in value of stocks of finished goods, materials, supplies and work in progress
what happens to inventories when demand slumps?

Typically companies should invest in capital

until unless the price of capital is mobile in

which case you subtract the increase in

the cost of capital. Including depreciation gets the third and final
equation.
Thus the graph


Valuing a company, In order for someone to buy a stock

it must be the case that

A couple of theories:
Perfect Market hypothesis Informationally efficient market:
Financial prices fully and correctly reflect all available information
Its possible to make economic profits by trading on basis of information
Theory states that only unexpected news moves stock prices prices follow a random walk
Wrong empirically, bubbles.

Tobins Q:
If q>1 then invest in capital.
If q<1 firm is worth less than its capital, it should sell.

Fails to account for patents or availability of credit




Motives that govern a firms inventories:
Production smoothing costly to increase production in times of high demand
Pipeline theory firms hold inventory as part of production process itself
Stockout avoidance hold inventories of final goods to make sure they are available if a
customer wants to make a purchase
House prices should reflect the equations on
the left, however even under this model
bubbles can feed themselves. The change in
house price is based on confidence which is
based on the change in house prices.





Uncertainty is bad for current investment, it increases credit spreads, hence cost of capital, because
default risk is higher
Also increases value of wait and see strategy
Typical investment decisions are
now versus perhaps later, not
now or never
Waiting has an option value, and option values increase with uncertainty
This is another channel by which uncertainty curbs current investment decisions
So as well as the cost of capital
Expectations of future returns are crucial to investment decisions
Formed how?
animal spirits
herd behaviour
rationally
Big drop in business confidence following financial crash
What might all this mean for current policy?














Lecture 1 Andrea The short run
Long-run model:
How economy behaves on average
Determines potential output and long-run inflation
At any given time, economy unlikely to exactly equal long-run average
Short-run model:
Determines current output and inflation

Potential Output:
Definition: Amount of goods and services that would be produced if all inputs were utilized at their
long-run sustainable levels
Take long run as a given
Potential output and the long-run inflation rate (target) are exogenous
Short-run model:
Current level of output and inflation endogenous
Current output may deviate from potential because of shocks













Recession is often defined as two consecutive quarters of negative GDP growth. Also raises
unemployment and lowers inflation.

Causes of Great Crash 2008
Low interest rate environment, financial innovation supports homeownership
Many new borrowers are subprime
Poor credit records, high LTVs
Higher interest rates and overexposure make subprime mortgages unsustainable
Before crisis, subprime mortgages sold to investors through securitization
Definition: Process of pooling a group of financial instruments, slicing them up, combining them,
and selling off resulting asset
Objective: Diversify risk
Securitization hides risk exposure of individual financial intermediaries
Also allows insurance of securities income, Lehman brothers.
August 2007: Flight to safety
 Lenders put funds in T-bills
Volume of transactions in some segments of
financial markets falls sharply
Hard to value certain financial assets
Questions about overall value of firms holding those assets

World GDP actually fell in 2009
First time in many decades
Recovery underway in U.S. and U.K.
Europe still struggling

Lecture 2 Andrea the IS curve

The IS (Investment-Savings) curve is the relation between the real interest rate and short-run output
(AD)
Captures negative short-run relationship between interest rates and output
Interest rate increase decreases investment
In turn, lower investment decreases output

AD

We assume that government spending,

consumption, imports and exports are

proportional to potential output.

Investment is proportional to
potential output, but also negatively
related to interest rates.

If the cost of borrowing is high

relative to marginal product of
capital then investment will
decrease.

In the long run the return on capital should equal the real interest rate
so that companies are indifferent between investment and saving.

Parameter a bar is an aggregate demand shock

Captures changes in sensitivity of aggregate demand components to

potential output
Suppose interest rate increases

Economy moves up along IS curve Short-run output declines

Intuition: Higher interest rate

Raises borrowing costs Reduces demand for investment

Reduces output below potential

The slope of the IS curve is -1/b, where b is the sensitivity to the difference between interest rates
and MPK

Any positive demand shock (i.e a rise in a) shifts the entire curve right.

Lecture 3 the MP Curve and the Phillips Curve

Central banks set interest rates by engaging
with private banks in borrowing & at these
rates.

Short-run: Inflation does not respond

immediately to monetary policy, thus by
changing nominal interest rate, CB effectively
sets real interest rate (at least over short
run).

Sticky inflation is what allows the setting of IR otherwise the real interest rate would remain the sme
as the nominal interest rate would only affect the rate of inflation.

Sticky inflation is basically caused by time delays in the real world, time taken for inflation to feed
through:

Imperfect information Costs of setting prices Contracts that also set prices and wages in nominal
rather than real terms
The MP curve dictates that at least in the short run,
changes in the nominal interest rate transfer
directly into the real interest rate, It is therefore
represented as a flat line where i=R where I has
been set by the central bank (CB). It can then be
placed on the same graph as the IS curve.

Suppose the CB raises nominal interest rates when

R=MPK and a=0.

Inflation slow to adjust Real interest rate rises

Investment falls Short-run output falls below
potential

Now look at these two graphs that hopefully explain the entire reason for a CB. An economy starts at
potential, but an AD shock, say in consumption caused by a burst housing bubble causes the IS curve
to hift inwards. The CB can lower IRs in order to compensate and avoid recessions.

This is the problem of the zero bound, if nominal IRs are already at 0, then it is not possible to lower
them, and it is not possible to return Y to potential.

Inflation

Inflation is the % change in prices per anum.

Firms set their prices based on: Their expectations of the

economy-wide inflation State of demand for their product

Expected inflation: Inflation rate firms think will prevail over

coming year. We assume that firms think past inflation is an
indicator of future inflation. Therefore inflation rises/falls if
output is above/below potential.
A price shock, e.g Oil shock can temporarily boost inflation.

Lecture 4: The Short-Run Model

Three applications of short-run model:

1. Fiscal policy multipliers 2. Great inflation and Volcker disinflation 3. Setting interest rates
versus money supply

C is affected by temporary deviations from

trend. Its sensitivity to short run fluctuations in Y
is denoted by x, 0<x<1. Remember a is just the
proportion of output that C typically occupies.

1-x is the multiplier.

Consider increase in government spending fraction of long-run output (A underscore g) With

multiplier, short-run output increases by more than one-for-one Shock multiplies through
economy Shock directly increases short-run output for given consumption Consumption
increases because it depends on short run output Short-run output increases more (virtuous
circle)

Heated debate on Government stimulus

Positive view: Large positive effects

because economy in deep recession

Negative view: Positive effects offset

by negative consequences of future tax
increases

As can be seen, the actual case with America post 2008, unemployment remained high despite
stimulus. Economists still argue, could it have been even worse, did it do nothing. Macroeconomic
uncertainty may have contributed to dampen positive effects.

Inflation rose in the 1970s for three reasons:

1. OPEC coordinated oil price increases Oil price shock

2. Loose U.S. monetary policy Conventional wisdom maintained permanent unemployment

increases to reduce inflation

3. Federal Reserve confused trend and cycle Interpreted slowdown as negative demand shock
Actually a permanent fall in potential output

Conclusion: Lower interest rates pushed output above potential and generated more inflation

Volker Disinflation: Reducing inflation requires tightening of monetary policy Real interest rate
increases Economy enters a recession As demand falls, over time firms raise their prices less
aggressively to sell more Eventually inflation starts to fall. Graph A leads to B

Lowering inflation rate is costly Can send economy into recession High unemployment and lost
output

Once inflation has declined sufficiently Real interest rate can be lowered back to MPK Allowing
output to rise back to potential

In theory the CB could either use interest rates or money supply, as in theory they both work the
same, because the CB supplies the amount of money demanded at their nominal IR.

Nominal interest rate is opportunity cost (price!) of holding money Amount a person gives up by
holding money, instead of keeping it in a savings account

Money demand is downward sloping Higher interest rates reduce money demand because interest
rate is price of money

CBs control IRs rather than money supply, because money supply is subject to too many shocks:
change in PL, changes in Y, Financial innovation.

Summ

Three applications of short-run model:

1. Fiscal policy multipliers Quantitative change to baseline model Uncertainty on effects of fiscal
policy

2. Great inflation and Volcker disinflation Large output costs of reining in inflation if starting from
high levels

3. Setting interest rates versus money supply CBs in advanced economies set interest rates to
minimize real and financial volatility

Lecture 5 AS/AD Framework
A monetary policy rule is a set of instructions that determine the monetary policy stance for given
economic conditions. The idea is to create a systematic policy, which should respond to any kind of
shock.

A typical rule might look like this.

This changes the AD curve because IS+MP= AD.

So

We now take the reinterpreted philllips curve as

AS. Therefore

Lecture 6 AS/AD stabilisation

This is where we are.

Temporary Demand Shock: a goes up, so the AD curve shifts

right. This raises inflation, so pi(-1) is much larger. Therefore
AS rises, this increases inflation so AS rises further, until
output has returned to 0. This still leaves inflation much
higher than it was. Then the a shock disappears, so AD shifts
left, and because inflation is lower AS gradually returns to
where it was before.

In AS-AD framework, monetary policy rule only responds to inflation If CB also responds to short-
run output, stronger increase in interest rate and potentially no cycle Assumed inflation
expectations also play a role

In practice, lack of full stabilization because of Imperfect information Lags in transmission

mechanism

Temporary Supply Shock: o increases so AS rises. Next period o

is zero. However since pi is now larger AS remains higher and
only returns part way to its original position.

AS shock: Stagflation Raises inflation directly Even a single

period shock raises expected inflation persistently Inflation
remains higher for several periods Expected inflation and
economy back to normal only after prolonged slump


Permanently lower inflation target: Modeled as AD curve shifts inward Initial inflation too high
for new target CB increases interest rate, creates recession Lower output reduces actual inflation
Next period, AS curve shifts outward Process takes time as inflation is sticky Actual output
remains below potential until inflation reaches new target

Expectations

Expectations are crucial for monetary policy Firms and workers form expectations about inflation
for pricing and wage-setting decisions

CB may have incentives to pursue expansionary policies Time-inconsistency: Allow for inflation
higher than promised to obtain output benefits

Private sector anticipates these incentives and builds into expectations Higher inflation and no
output benefit

The time-inconsistency problem can be ameliorated by CB independence and monetary policy rues,
however, no CB mechanically follows a rule.

Adaptive vs Rational inflation expectations.

Adaptive inflation expectations hold that consumers and businesses expect inflation to be in the
future the same as it currently is (backed by some data)

Rational expectations hold that firms will take into account the target inflation rate and the
credibility of the CB

Rational expectations result in less inflation after an inflationary shock.

If CB lowers inflation target, AD shifts down Under rational expectations, AS shifts down
immediately to new target If CB is fully credible, inflation moves to new target without recessions
Costless disinflation

Summ

1. AD shocks: Booms followed by recessions

2. AS shocks: Stagflation

3. Policy shocks: Costly disinflation But costless under rational expectations

Expectations crucial for monetary policy CB credibility and commitment to low inflation

Lecture 7 More AS/AD

Financial crisis

 1. Fall in house prices
2. Banks balance sheets go **** up, and therefore lending falls and interest rates rise.
(increase in spread)
3. Therefore falling CB interest rates might have limited real impact as banks use the increased
spread to shore up balance sheets.

All this results in the need to change our AS/AD

analysis R is no longer simply the CB rate, it is r+f
where f is friction.

The result is that the CB cannot restore AD to

where it was, instead of a lower MP (MP) created
by a lower CB, a lower CB + friction leads to a new
MP curve MP. This results in an even deeper
recession after the initial demand shock. Real
interest rate on y axis.

This all creates the new AD curve :

Where the financial crisis can now be seen as

two consecutive shocks. First a, when consumer confidence falls and therefore demand. And then as
f rises as banks raise spreads.

Because of this intense double shock to AD, the lower bound was hit, and the deflationary spiral
became a danger. Deflation raises the Real interest rate and the CB cannot lower the nominal rate to
counteract this. Therefore: Demand falls even more, Firms cut their prices, More deflation, Higher
real interest rate. Arguably the unconventional monetary policies : Liquidity provision, Forward
guidance, Quantitative Easing helped avoid this and a repeat of the great depression.

The liquidity was the huge loans the CBs gave to banks

The forward guidance: CB promises (credibly) future expansionary monetary policy (when ZLB no
longer binds) Expected inflation increases Real interest rate falls.

The alternative was to increase the inflation target, however, there were worries that this would
damage the banks credibility.

The QE simply purchased government bonds, this lowers their yield, and should stimulate demand
for other things.

Fiscal Policy also played a role in righting the ship. Governments spent more, taxed less, and injected
capital into the banking system when they purchased banks. (Northern Rock, AIG).

This did however, did lead to the eurozone crisis and later instability as high debt is wont to do.

Lecture 8 XR and Open economy

Nominal XR: how many Euro to buy 1
Appreciation= 1 more expensive in Euros,

The Law of One Price: In the long run the same good should sell for the same price in all countries.
Therfore, EP = P. Otherwise arbitrage should occur.

LOOP is vulnerable to: different taxes, tariffs, transport costs, non-tradable costs (service industry
wages).

In the LR monetary policy should pin down PL (quantity theory). LR XR should be determined by
relative monetary policy.

So if the Euro experiences higher inflation the becomes relatively scarcer and therefore
appreciates.

On the SR transactions and short tern demand creates the XR, with CBs providing liquidity.

Monetary Policy can have SR impacts as well, flows of hot money follow increased interest rates,
leading to appreciations.

RER=E(price )/price Euro

The RER measures the number of

EURO consumption baskets
necessary to buy one UK
consumption basket. In the LR
LOOP holds that the RER=1

RER!=1 because prices are slow to

ajust, and because there are some
frictions to trade and some non-
tradable goods and services.

XR can reinforce AD movements. This is because in an open economy a rise in the IR = a rise in
exports and therefore a fall in AD,. This negative demand shock works by the same mechanism that
the reduction in consumtion should through IR.

Lecture 9 Trilemma

Only two of three may be had

1. Domestic monetary policy independence

Deals with domestic shocks

2. Stable exchange rates

Reduce uncertainty

3. Free international capital flows

 Allocate resources efficiently

A country that wants to fix their XR must hold reserves of other currencies. It buys and sells these at
a fixed price. It cannot use monetary policy without imposing capital controls otherwise flows of hot
money would deplete the foreign X reserves.

These flows of money create currency crises where countries maintain their XR until they run out of
currency, at which point they abandon the peg.

Eg. Mexican CB tried to keep exchange rate fixed against USD

USD reserves fell very low Government forced to devalue

We can calculate the deficits or surpluses that would change XRs. Private saving (Y-T-C) +
Government saving (T-G) + Foreign saving (IM-EX) = I

So the Trade balance (NX)= the net capital outflow (S-I)

U.S. ran large trade deficits Gives foreign countries financial assets

Claims to future goods in return for imports today

China ran large trade surpluses Excess of domestic savings Ships goods abroad Accumulates
U.S. financial assets

Exacerbated by China pegging RMB to USD