Back to notes

Transcript for:
Overview of Macroeconomic Analysis

Title: NEKG41-Macroeconomic Analysis URL Source: file://pdf.5e0c11b01c1fbafc72b15b880cd2d270/ Markdown Content: # NEKG41-Macroeconomic Analysis Nationalekonomi: Makroekonomisk analys (Lunds Universitet) Skanna fr att ppna p Studocu Studocu r inte sponsrat och fr inte std frn ngot college eller universitet # NEKG41-Macroeconomic Analysis Nationalekonomi: Makroekonomisk analys (Lunds Universitet) Skanna fr att ppna p Studocu Studocu r inte sponsrat och fr inte std frn ngot college eller universitet Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 # NEKG41-Macroeconomic Analysis Exercise sessions: After lecture 6 & 9 Prepare exercises for the exercise sessions and participate in exercises In the weeks for exercise sessions, there are office hours Examination: total 40p Written assignment: 7p Peer review: 3p Exercises: 2p Final Exam: 28p Pong frn uppgifter bara applicerbart p frsta och omtentan Final exam: essay on given topic Deadlines: Written Assignment:1 dec Peer review: 7 dec Final exam: 14 dec (14-21) ## Introduction: Macroeconomic Models IMF Definition Why Models: Most policy actions have conflicting effects: What is the output effect of financial regulation? Regulation reduces the probability of crisis => Output People & firms can borrow less, they consume and invest less => Output Which effect is stronger? What is the output effect of increasing government spending? Increased demand =>output Higher taxes and uncertainty about possible fiscal solvency =>output Which effect is stronger? > Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 DSGE - Dominating paradigm in quantitative macroeconomics Riksbanken pionjr i att anvnda den i policymaking Today almost all central banks have their own DSGE model for policy experiments and forecasting Highly criticized after 08 Dominates the field, but no real alternative yet DSGE - Stochastic Exogeous shocks hit the economy Fukushima 2011 Monetary policy shocks DSGE - General Equilibrium General - Different markets and their interplay Equilibrium - Markets are in equilibrium, supply meets demand Feedback effects at the macro level e.g, everything households does affects firms The Evolution of DSGE models Before DSGE: large-scale macroeconometric models, estimation of historical correlations between large numbers of variables, backward looking > Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 Problem: Stagflation Recession and inflation models did not predict them because that had not happened before (backwards looking) Lucas Critique 1976 Estimated parameters not policy-invariant people have forward-looking expectations => DSGE - a response to Lucas critique Macro models based on micro principles deep (policy-invariant) parameters impatience level depreciation rate of capital People build expectations about future Some Peculiarities of DSGE models Internal consistency limits the size and complexity of models Very few results can be shown with pencil and pen Need computing power The simpler, the better - We want to understand the transmission channels Assumption that the economy is in steady state (stable equilibrium) Only small size shocks give reliable results => DSGE models not suitable for analysis of huge deviations from steady state After the 2007 crisis Focus on housing and financial markets in DSGE Housing got a more central part in economic models (pre-07 not considered a major part of the economy) Summary Economic Models Models help us simplify complex world, but they also help us avoid thinking in too simplistic terms help us to get numeric answers and tell stories (explain mechanisms) Sometimes data-driven models give information about the economy that we might miss otherwise Models are a simplified and an abstract version of reality We should understand their shortcomings and account for them when we use them It is good not to rely on one specific model > Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 # Lecture 1: Labor and goods market Artikel: Why do we work more than Keynes expected Keynes trodde att r 2030 skulle folk arbeta 15h/veckan. I sjlva verket minskade arbetade timmar fram till ca 2000 Lnder med jmnare lner (Tyskland,Frankrike) jobbar mindre n UK och US Kvinnor arbetar mer idag 3 Faktorer som drivit p substitutioneffekten av arbete Under slutet av 1900 talet brjade workaholics tjna mer n the idle rich He missed the boat by failing to appreciate the power of economic incentives to induce people, even those with high standards of living, to work long and hard Strre inkomstskillnader driver p mer arbetade timmar Inequality, after all, involves not only a more uneven distribution of earnings, which most citizens view as undesirable, but also greater incentives to rise in the earnings distribution through hard work Populariseringen av prestandaorienterade incitamentsprogram Ytterligare 2 faktorer Internet gr s att man kan jobba verallt (inkl. hemifrn) Global konkurrens, med billig arbetskraft stter press arbetare i vstvrlden Artikel: The lost leisure time of our lives Inleder lika som ovan artikel, felaktig prognos av Keynes i minskad arbetstid. En naturlig tanke: Reklam och kade mjligheter till konsumtion gr att vi vill jobba mer och ha rd med hgre levnadsstandard Friedman hade ett annat perspektiv: Hushllens medianinkomst stagnerade redan 1970, medan ekonomin vxte med hg tillvxttakt i USA => Frklarar fortfarande varfr hginkomsttagare arbetar mer Svrt att bli hginkomsttagare utan att lgga ner mnga timmar Hginkomsttagare har inte tid med att bo en bit utanfr stan och pendla => De kper centrala lgenheter => Driver upp priser => Mste arbeta mer > Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 ## Video lecture part 1 Long run equilibrium in the labor and goods market Labour market Relation between: W= Real Wage (Realln) L= Supplied Labour Goods market Relation between Y=output L=Labour Assumptions about the Long Run Representative agent Full price flexibility Agents are rational and maximize utility given budget constraints Money neutrality Full information Goods market equilibrium determined by supply Money Neutrality Agents base their decisions on real not nominal variables Do you prefer USD 100 or 100 SEK? > Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 Equilibrium in the labour market Households face a consumption-leisure trade-off Households consumption leisure choice Labour supply Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 Upward sloping labor supply Alltid upptlutande? Nej- inte alltid nedan fljer ngra undantag Backward bending Nr vi blir s rika att vi hellre kar vr leisure time Inverted S shaped supply curve Nr lner blir s lga att barn och kvinnor mste brja arbeta i U-lnder, kar Labour Supply Compared to the individual labour supply curve, the aggregate labour supply curve is.. less elastic because of transitions between being out of the labour force and being in the labour force Labor elasticity =the percent change in amount of labor supplied due to a percent change in wages . If the elasticity is higher than 1, then the supply of labor is "elastic", meaning that a small change in wages causes a large change in labor supply. If the elasticity is less than 1, then the supply of labor is "inelastic". Vrt antagande i hela kursen Upptlutande Men som ovan, finns det undantag > Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 Keynes pstende om mindre arbetstid, fast frn videon: ## Lecture 1, part 2 Labour Demand Avtagande marginalproduktivitet nr vi anstller fler Fretag vill vi vinstmaximera => Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 Labour demand: Example K=Capital A=Technology Better technology does not shift labour supply Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 Labor Market Equilibrium Shocks to Market Equilibrium Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 Exempel Shock 1: Brexit Invandrare kade Labour supply och snkte lnerna fr arbetare Denna modell har antagandet att mer/bttre teknologi kar lner Vissa tror motsatsen Tnk AI, kan gra vissa jobb obsoleta ## Lecture 1, part 3 Labor market equilibrium with a Trade Union Equilibrium at B when union represents wage negotiations Equilibrium at A when individual wage negotiate (L s-L tak )=union-voluntary and individual-involuntary unemployment Unemployment > Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 Anledning till arbetslshet: Unioner/facket/kollektivavtal: Deras syfte r att maximera vrdet fr dess medlemmar => Skapar en insider-outsider problematik, dr insiders vill hja sina egna lner All stages for an working age citizen / Alla stadier en person i arbetsfr lder kan vara Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 Dynamic Unemployment Model Equilibrium Rate of Unemployment Unemployment rate that would occur in the absence of cyclical disturbances Equilibrium Unemployment= Frictional unemployment + structural unemployment Equilibrium unemployment job separation rate: 1% Job finding rate: 10% =>E quilibrium unemployment rate: approximately 9% Frictional unemployment: Unavoidable, matching process Structural unemployment: Wages not at market-clearing levels (institutions, regulations) > Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 Pga starkare institutioner i Euro-omrdet, kan vi se en svagare korrelation mellan Employment och Real wages Goods Market Equilibrium Goods market shock Flyttar Ld till vnster # Lecture 2, Money Additional obligatory reading: Deflation and monetary policy in a historical perspective: remembering the past or being condemned to repeat it? Conceptual issues Deflation can be confusing for policy makers Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 Definition= falling price level Types of deflation Bad deflation =Associated with recession Good deflation Arise from positive supply shocks Ugly deflation periods of steeply declining prices associated with severe recession Moreover, it is important to note that while deflation has the possibility of making an undesirable condition worse, it is also true that inflation can do the Conclusions Deflation was common in pre WWII due to low inflation environment and monetary regime that led to waves of inflation and deflation If you take the complete timeline in thought, today's concerns with deflation can seem overblown The perceived costs of deflation are also important. The possible asymmetric nature of the costs associated with deflation has been used to justify asymmetric monetary policy approaches to deviations of inflation around a centra Our discussion of monetary policy highlights several key trade-offs for monetary policy makers. First, what is the optimal inflation rate for a particular central bank? Most banks have chosen low average inflation. Theory and history suggest going lower may be even better 2nd, Choice of low inflation rate and future with low to moderate deflation rate would generally dictate the adoption of a mixed strategy towards the conduct of monetary policy. Finally, if policy makers were contemplating a shift to a low-to-moderate deflation policy, various uncertainties would represent potential costs that they would have to factor into their decision making. One key source of uncertainty would arise from changing private sector behaviour. The historical record is clear that when low inflation regimes were replaced with high inflation regimes, private sector behaviour changed dramatically > Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 ## Lecture 2, Money, part 1 Money Neutrality In the long run, the supply of money does not matter for the real side of economy Nominal variables grow at the same rate as money Dichotomy principle: nominal variables do not affect real variables in the long run Money and Inflation OnMoney by David Hume, 1752 Money is not, properly speaking, one of the subjects of commerce... Its just a measurement Only short term effects Money and Prices Notations M = Money P = Price level Y = Real Output k = constant V = Velocity, how often one unit of money is used during a time period > Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 Hyperinflation: Inflation exceeds 50% per month Measuring the inflation alternative 1: GDP deflator Prices everything purchased or purchasable with money GDP Deflator=nominal GDP/real GDP Alternative 2: Consumer price index cost of maintaining a certain utility level. Only a subset of all consumer products is included in the index Low inflation Previously, hyperinflation was a big fear for many banks. Now, after the COVID-crisis, there is a fear for too low inflation Low inflation and velocity of money > Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 Monetary base uppe Inflation nedre Varfr kar inte inflationen lika mycket som monetrbasen? =>During crisis velocity decreases dramatically (people sit on cash) (Velocity) Low inflation and velocity of money Decreasing velocity of money may be surprising: credit cards, electronic payments Low interest rates: lower opportunity costs of holding idle money Banks holds excess reserves Lower consumer confidence Low inflation environment, will we turn to a long term equilibrium of low inflation? Or temporary shock ## Lecture 2, part 2 Exchange Rates Nominal exchange rate 1. European notation=domestic / foreign 2. British notation = foreign / domestic (i.e. 0,11 USD/SEK) Real Exchange rate Domestic prices in relation to foreign prices in the same currency Nominal exchange rate: s British notation: s : appreciation s: depreciation 1 SEK can buy 0,11 USD prior to this event > Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 After s 1 SEK can buy 0,12 USD goods abroad will become relatively cheaper Import Export Nominal Exchange Rates STEP 1 TOLKNING Logarithm of Exchange rate = Lg nominal exchange rate + Lg domestic price level - Lg foreign price level Step 2b Tolkning Change in real exchange rate = Change in nominal exchange rate(delta s/s) + difference in inflation(pi - pi*) Nominal exchange rate = (Change in monetary supply (=Monetary policy)) - (difference in GDP abroad & domestic) (=Potential GDP)) + (difference in velocity)(=consumer sentiment)) Purchasing Power Parity > Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 Model 1: Relative PPP Implication of money neutrality weak purchasing power parity condition (PPP) / = 0 Model 2: Absolute PPP Implication of Law of One Price Strong purchasing power parity condition (PPP) = 1 ## Lecture 3: Budget Constraints and Private Sector Demand Intertemporal Budget Constraints Lump sum tax: Does not change your behaviour/wealth etc Nominal, Absolut tax may change your economic incentives e.g. labour tax on income (hgre% efter 39k) In this course we generally talk about lump sum tax (at least in the beginning) Rational Expectations Different kinds of rationality: i) Perfect foresight: know everything that will happen in the future (unrealistic but commonly assumed in simple mathematical models). ii) Strong rationality : future prediction is conditioned on what you know. And you know everything there is to be known. However, there could be unexpected events. iii) Weak rationality: future prediction is conditioned on what you know. But you dont know everything. Discounting > Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 Household intertemporal budget constraint Y=income C=Consume S=Save Om man vill konsumera mer idag, rr man sig mellan A och B Borrower Om man befinner sig mellan A och D (t.ex M) Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 Saver Real wage: 0D/0B A/Y 1=real wage income Governmental Intertemporal Budget Constraint Lik den fr hushll Terminologi T1= Taxes collected today Discounted value of taxes collected tomorrow G1 =Government consumption Discounted value of government consumption tomorrow Deriving government intertemporal budget restriction We assume that government does not inherit debt Terminilogi B1= Bonds issued by the government Governments intertemporal budget restriction with inherited debt > Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 Consolidated Public and Private Budget Constraint Hennes anteckningar: VL fr Private sector & Public Sector = HL fr Private sector & Public Sector Vi stryker T1 i VL( en + en -) Under antagandet att r=r G Kan vi stryka T2 => => We exclude taxation completely Ricardian Equivalence Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 Does not hold in reality due to number of reasons: Different interest rates Governments tend to have lower interest rates All citizens are not alike when it comes to taxes if youre gonna die in 15 years, you will spend it regardless of taxation levels => Heteregenous agents Distortionary taxation Behavioral reasons different types of rationality Imperfect credit markets: borrowing constraints some people Private Sector Demand (LECTURE 3: Part 3) (Chapter 8 in textbook) Wealth = Disposable income = Y d Life Cycle Consumption Theory Vi konsumerar lika mycket som vr inkomst om den r permanent > Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 Om vi fr en tillfllig kning Permanent versus temporary changes in income Case 1: a temporary increase in income (Crusoe) Unusually plentiful harvest, rising to Y 1. In the next periods harvest Y2 is expected to remain unchanged Consumption is increased in both periods (point R) Consumption today rises less than windfall, since part of it is saved and spread over time a temporary increase=> permanent, but smaller increase in consumption Case 2: a permanent increase in income now and in the future (permanent) Both Y 1 and Y 2 will rise by equal amounts Consumption increased in both periods to R No borrowing or saving a permanent increase => permanent increase in consumption of similar size Case 3: an expected increase in income Borrow today against future income to afford better standard of living today. => consumption smoothing => random walk theory of consumption The relationship between Consumption and Wealth & Consumption and Income Nstan linjr, perfekt Keynesian Consumption Function > Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 Consumption determined by Wealth or Income => By both! Intertemporal=in case of consumption, choice between between present or future goods Intratemporal=among goods at a particular point in time The consumption function (8.2.4, sida 204) Consumption is primarily driven by wealth wealth is based on current and future incomes of households ## Investment, Lecture 3 part 4 Investment and Interest Rate We assume that labor input is constant Firms use capital to produce Interest rate represents the opportunity cost of investing cost to a borrowing firm Eftersom det r konkurrens kommer vinstmaximering=0 > Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 Marginal cost of capital=marginal productivity of capital Investment and Tobins Q Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 Tobins Q = Market Value of the firm / replacement cost of capital Om q=1,2 Jag alla bestndsdelar av en firma kostar 100kr, men nr jag assemblat och startat fretaget blir det vrt 120kr q-theory relation to interest rate Aktiemarknaden vrderar fretag genom DCF =>kning av rnta leder till kraftigare diskontering som i sin tur minskar aktiepriser q-theory also incorporates: Gains in productivity of capital raise future income T.ex IT-boomen Expecations Ocks volatilt eftersom fretag investerar med kapital fr att sedan ha frvntade inkomster mnga r in i framtiden, vilket skapar stor oskerhet The investment function Investment is inversely related to the interest rate due to its oppurtunity cost Accelerator mechanism captures the long-run relationship between capital stock and output Since the rate of proportionality is greater than 1, increases in output lead to magnified increases in investment expenditures Tobins q Reflects the fact that some firms finance investments by issuing shares on the stock market high stock market prices mean that the market places a high value on existing, installed capital, so that firms can raise more resources per share issued, and this encourages investment # Lecture 4 Money, Banks and Monetary Policy Probably the lecture that differs the most from the textbook Sweden 2020, around 10% of purchases are used with cash In some countries ratio of cash to GDP is increasing, e.g. Germany > Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 What is money Definition quite complex Definitions of money (essay question 9.1) Jevons definition Means of payments, unit of account, store of value, standard of deferred payment Central bank and this book: currency plus bank deposits Money in the modern economy - How money evolved to what it is today IOU= I owe you Functions of money Means of payment Unit of account store of value Different types of money > Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 Commodity money copper crown worth the value of the copper it weighs Fiat Money Used as an IOU Majority of money today is fiat money Outside money - created by CB Inside money - Created by commercial banks The majority of money today is inside money Commercial Banks Financial intermediaries Create money through lending Engage in maturity transformation, providing liquidity services Balance sheet for a commercial bank: Central Bank Public agency with the mandate to control money and its value over time The bank of banks (bank hold bank reserves at the CB) Lender of last resort Some CBs have the mandate of controlling financial stability as well > Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 Riksbanken is the oldest in the world, founded 1668 Different measures of the money stock Currency in circulation: Bank notes and coins held by general public M0 : currency in circulation + bank reserves also sometimes called high-powered money, base money or CB money M0 = liability for CB M0 = Assets for consolidated government and nonbank private sector M1 : M0+demand deposits (with swedish institutions) (current accounts of swedish banks) M2 : M1+time deposits (sparkonto med rnta och bindningstid) M3: M2 + fixed income securities with maturity up to 2 years (longer term assets) > Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 Inside Money - How do banks create money? Two approaches Traditional: Money multiplier, starts from deposits Needs a deposits that is then loaned Starts from the liabilities side Modern: Bank creates money through extending loans (out of thin air) The loan taker approaches the bank, and then the bank is creating a corresponding deposit. Starts from the asset-side The money multiplier This happens on-and-on (multiplication effect) > Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 ANSWER=10 000USD Reserve Ratio Requirements are in some countries In sweden there are none Traditional vs Modern Approach 13:34 i part 2 Kritik mot traditional approach av Riksbanken: Money multiplier has no relevance for todays situation in sweden, due to no reserve requirements Modern Approach Bank Deposits (inside money) are the main form of money Each time a bank extends a loan to a consumer, it simultaneously creates a corresponding deposit, hereby creating money Infinite money creation? Lending does not create new money if: volume of new loans=volume of loan repayments Bank issues bonds in proportion to its lending Limits to lending: Limited demand Regulation: capital requirements, liquidity ratios, reserve requirements (none in sweden since 94) Profitability of banks Modern approach - Is CB helpless? Limited control of inside money Interest rate as a tool to steer demand => Can use this Crisis times: support lending through asset purchases, looser collateral requirements => can also use this Interest rates ( part 3) > Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 interest rate= price of money Repo rate In Sweden, the rate of interest at which banks can borrow or deposit funds at the riksbank for a period of 7 days) Interbank interest rate: STIBOR (Stockholm/Sweden) EURIBOR (European) LIBOR (London) Demand for money M*V=P*Y M=P*Y/V = k*P*Y Is velocity constant? No it moves positively with interest rate k decreasing in interest rate Supply of money Base money is supplied by CB CB can have differents objectives and choose: Fixed money supply Vertical money supply line S M Fixed interest rate Horizontal money supply line S i Variable money supply and interest rate (inflation rate targeting) Upward sloping money supply line S V Most frequent in modern advanced countries > Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 CBDC - The future of money? Central Bank Digital Currency Universally accessible to everyone Electronic banknote Many advanced economies CBs work on this issue Different issued still to be considered : interest bearing, anonymity, direct access Monetary Policy and Financial stability (part 4) Inflation targeting ECB: below, but close to 2% over the medium term UK: 2% (+/- 1pp) USA: dual mandate: promotes effectively the goals of maximum employment, stable prices (2% inflation) and moderate long-term interest rates Sweden: 2% (+/- 1pp) To Annas knowledge no proof that 2% is perfect. But proof that deflation is bad no spending and decline positive inflation=> consumption Taylor Rule Inflation and output stabilization Denote by i , the interest rate set by CB Hgra rda inringade delen: Inflation gap Vnstra rda inringade delen: Output gap Financial Stability > Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 How to ensure financial stability? Micro- vs Macroprudential regulation Crisis 2007-2008 Design of regulation Market Failure to Address 1. Strategic complementarities a. Bank interactions leading to excessive risk (betting on bail-out) 2. Pecuniary externalities Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 a. Indebted agents do not internalize their impact on asset prices 3. Externalities related to interconnectedness a. Risk of contagion Regulating banks Swedish Banks have increased their capital/risk-weighted assets (REA) Capital / total assets ratio stagnant This ratio is more significant in a banks ability to handle a big shock Financial crises (Part 5) => The reason why we want to regulate banks Banking crises (e.g. subprime mortgage crisis 2007) NINJAS No income no job no assets Repackaged mortgages of high-default rate loans, going around the financial systems and then going back to to banks balance sheet, even if they started the repackaging people did not know what were in the repackaged, complex financial assets MBS = Mortgage backed securities > Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 When the value of assets fall, the capital ratio decreases, in some cases under the threshold (10%) => Banks have to fix the situation through two alternatives: 1. Raise equity 2. Decrease deposits Decrease leverage of bank Have to decrease loans as well Banks decrease deposits => also decreasing Loans (Assets) =>Falling asset prices => aggravate the crisis How the bank can increase Capital Ratio The problem: A 1% decrease in Loans lead to a 10% decrease in assets If it instead was a 20% Capital Ratio threshold. Deposits =80 Equity= 20 A 1% decrease in deposits => 5% decrease in Assets > Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 => The risk of a bank crisis can be mitigated with capital ratio rules/Capital ratio requirement Risk weights and deleveraging 1% fall in lending => 20% decrease in Assets Banks holding risk weights less than 1 => enables them to hold less capital =>more pronounced crisis Banking Crisis 1907 in Sweden, Predictors and guidelines for policymakers today Financial Crisis More than banking crisis Too much leverage Increases profits Increases vulnerability to shocks On the bank, but also household side Obligatory reading lecture 4: Money and monetary policy in times of crisis three functions of money: (a) a means of payment, (b) a unit of account and (c) a store of value. > Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 Why kronas? The state determines that kronor should be used when paying taxes => citizens must obtain them => kronor are naturally used to be used in functions a,b,c Commercial bank money is created when banks give loans Created from balance sheets Commercial bank money is destroyed when loans are repaid The banks can create money to buy securities, goods and services The banks can also create commercial bank money when they buy goods and services, as they can pay with a deposit in the sellers account. However, in this case the size of the balance sheet is unchanged. The liabilities item deposits grows and the liabilities item equity declines by the same amount, and on the bank's asset side nothing changes. Monetary policy and legislation govern how much money the banks create Demand Banks cannot force customers to take loans Capital ratio liquidy regulation liquidity coverage ratio Limit bank lendings Little relation between CB money and amount of money commercial banks can create Most important factor in determining volume of money= demand for loans) => interest rate most significant tool in crisis, programme of loans to companies (funding for lending), eased for collateral requirements and purchase of government bonds can also be used An untested measure : Helicopter money Concluding summary CB primarily uses repo rate to control volume of money(demand for money) exceptions in crisis Monetary policy and legislation govern how much money the banks create (2nd obligatory article, lecture 4) Quantitative easing monetary policy whereby a central bank purchases at scale government bonds or other financial assets in order to inject money into the economy to expand economic activity. Conclusion > Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 Most of the money in circulation is created, not by the printing presses of the Bank of England, but by the commercial banks themselves: banks create money whenever they lend to someone in the economy or buy an asset from consumers. CB has no direct control of either base or broad money CB can still influence the amount of money By controlling interest rates through monetary policy Recently CB of England used an asset purchase program due to the constraint of the effective lower bound (vill inte g till negativ repornta) => affects prices and quantities of a range of assets in the economy, including money # Lecture 5 Macroeconomic equilibrium (chapter 11) This lecture: Derive the IS-LM (IS-TR) Model Focus on short-run disturbances originating in goods and money markets Assumptions: Prices are constant (sticky) - Keynesian assumption We focus on the goods market an the money market Goods Market: Equilibrium Condition > Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 Demand drives output What drives demand? Exogenous forces(outside our model) Let us assume that the behaviour of public sector is exogenous: Consumption Function Investment Function Higher interest rates, higher opportunity cost and higher cost of borrowing (-) q=Market expectations When market is doing well, expectations does as well=> Investments(+) Indirect of r = when interest affects q Net Exports NX= X-Z Imports Z increase with income Imports Z increase with exchange rate appreciation Z=Z (Y,) Exports increase with foreign income > Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 Exports decrease with exchange rate appreciation X=X(Y* , ) X will be denoted as PCA(Primary Current Account) Desired demand In equilibrium, the Desired Demand=supply Y=GDP Note that Y is affecting both supply and demand, short term deviations possible When Y increases by 1, desired demand increases by less than 1 Some income is saved, some is used for taxes, some for imports(leakage) All income is not spent, YDD Y-DD=Leakage Relation between Y and demand components Vi skriver om Consumption funktionen och importfunktionen (Z), C=> cY+a (dr c och a r en fraktion av total output och fraktion av total wealth Z=> za+y, dr vi anvnder en del av konsumptionsfunktionen som antagande fr importfunktion => DD=(1-z) cY +(a-za)+ I(r,q)+G+X(Y*,) - y > Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 Keynesian multiplier (red): If autonomous expenditures affected by exogenous variables increase, by how much will increase output? KEY TAKEAWAYS A Keynesian multiplier is a theory that states the economy will flourish the more the government spends. According to the theory, the net effect is greater than the dollar amount spent by the government. Critics of this theory state that it ignores how governments finance spending by taxation or through debt issues. > Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 If r output Nr rntan minskar => dlig avkastning p att spara=> vi vill investera mer=> DD skiftar uppt (frn rd till bl linje) Vi rr oss lngs med IS-kurvan eftersom det r en endogenous variabel Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 Liknande effekter kan ses nr Household Wealth kar() DD skiftar uppt IS-kurvan skiftar ocks uppt (nedre grafen) => Y IS-Curve Summary Every point on the IS curve corresponds to the equilibrium on the goods market If any of the exogenous variables changes, the IS curve shifts Exogeneous variables are: Wealth, taxes, Tobin's q, foreign income, real exchange rate If the endogenous variables (Y,r) change, we move along the IS curve Innan pratade vi om goods market med IS-kurvan Nu tittar vi p Money market med LM kurvan > Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 Money demand: Md= k(i)PY k=velocity of money/our preference for liquidity i=interest rate PY= nominal income If income also M d Md=Nominal supply-deflation 2. Taylor rule Variable money ( TR) and interest rate (flexible inflation target) ( ISTR) OBS!! Fixed money supply Nr output minskar, minskar efterfrgan p pengar Demand and output fljer varandra (om M d ner s gr ocks Y ner) > Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 LM kurvan skiftar nr M s eller M d rr sig TR Curve Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 Output (Y) p x-axeln Lutar uppt Summary Closed economy can be explained by ISLM (left) and ISTR (right) Olika anledningar varfr de lutar uppt LM curve is upward sloping because higher income results in higher demand for money, thus resulting in higher interest rates. The intersection of the IS curve with the LM curve shows the equilibrium interest rate and price level. TR Curve slopes upwards because when Output (Y) increases, so will > Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 nominal Interest rates (i) Visar varfr bde finansiell och penningpolitik r potent, in the short-run ZERo LOWER BOUND (for interest rates) Kan en CB som fljer Taylor rule lower interest rate infinitely Likely not, it will face ZLB We can choose to save cash under the mattress to avoid negative interest rates In the world without cash with only CBDC, the ZLB problem is eliminated ## LECTURE 6: MUNDELL-FLEMING (Chapter 12, 15) Equilibrium on the Foreign Exchange Market Driven by the interest parity condition Arbitrage possibilities i>i* : Arbitrage profits possible by borrowing in foreign and investing in domestic => => capital inflows => Appreciation in the exchange rate i<i* : Arbitrage profits possible by borrowing in domestic and investing in foreign => capital outflows => depreciation of the exchange rate i=i* : stable equilibrium exchange rate We assume that this condition is satisfied at ALL TIMES, even in the very short run > Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 Mundell-Fleming Model We add the IFM line to the IS/LM or IS/TR model We examine effects of shocks in the goods and money market on equilibrium How to model the money market Fixed supply: only use LM (book excludes money market) We will use the LM-curve Flexible s: use LM or TR depending on monetary policy target Notation Goods market shock Can be caused by exogenous change in aggregate demand Assume that (wealth) (households may expect higher incomes in the future) Shift in the IS-curve I fallet av fixed exchange rate CB kar money supply nr vi r i point B som i sin tur skiftar LM1 till LM2 > Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 Vi hamnar i punkt C (skrningspunkt fr LM2 och IS2) In the case of the flexible exchange rate, demand impulses neutralized via exchange rate change Output insulated from foreign and domestic demand disturbances In reality, temporary effects possible because not everything adjusts instantaneously 1:1 Money Market Shock Fixed s : central bank changes the money supply to have a fixed exchange rate > Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 Case flexible S: Vi brjade p A rrde oss mot B och sen till C Foreign Exchange Market Shock Assume that i* Moves the IFM Line up The Policy Trilemma Sweden: Has free capital flows & monetary policy independence Denmark: Has free capital flows & fixed exchange rate Fixed DKK to EUR EU countries: Free capital flows & fixed exchange rate Gave the power of monetary independence to EU CB (If you look at EU as a whole, exchange rate is not fixed, EUR/$ not fixed) > Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 China: fixed exchange rate & monetary policy independence Fixed or Flexible Exchange rates in a small open economy (frn sida 320) CB can control interest rate or money supply, but not both (chp 11) CB can either have its own monetary policy or fix the nominal exchange rate, not both If it chooses to fixed exchange rate: gives up the ability to conduct an independent monetary policy Represents a commitment to refrain from active use of monetary policy. => TR curve useless Leaves the economy vulnerable to demand disturbances (domestically and foreing) Any exogenous shift of IS curve determines a new equilibrium Mundell-Flemming Exchange rate regime fast eller rrlig Vxelkurs lathund Summary chapter 12 Mundell-Fleming model is the logical extension of the IS-TR model to an open economy Describes the simultaneous equilibrium of three markets: goods and services domestic money market international financial market Like the IS-TR model, it adopts the Keynesian assumption that prices are sticky Under these assumptions, output is determined by AD Under floating exchange rate: CB has monetary policy autonomy but, exchange rate becomes endogenous, and its movements affects the economys competitiveness=> affects the position of the IS-curve Exchange rate movements are such that the IS-curve moves to meet the TR and IFM curves > Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 The fact that the IS curve does not determine the equilibrium outcome, means that the economy is shielded from demand disturbances Under fixed exchange rates: Demand disturbances affect domestic GDP Committed to upholding the declared exchange rate parity, CB can not conduct an autonomous monetary policy TR curve useless Equilibrium described by intersection of IS and IFM Exercises chapter 12 1. Reducing target inflation floating exchange rate 2. Reducing target inflation fixed exchange rate 3. Demand shock fixed exchange rate 4. Austerity measures in order to save budget deficit 5. Increase in foreign rate of return, fixed and flexible exchange rates 6. exogenous reduce of money demand effect on money supply, interest rate and income under fixed exchange rate (due to economic or political instability) 7. UK leaves EU, effects of reduced AD on interest rates, GDP and exchange rate 8. Exchange rate revaluation on a fixed (but adjustable) exchange rate 9. Tax cut on fixed and floating 10. Safe haven (t.ex Schweiz) i kris effect on exchange rate, fixed and flexible 11. Domestic Price level decline, fixed exchange rate 12. Domestic price level decline, floating exchange rate 13. Fixed exchange rate, Danish CB selling domestic currency, buying foreign effect on balance sheets Essay questions chapter 12 3. Adopting an exchange anchor is a mixed blessing On one hand, exchange rates are now predictable for firms and households and transaction costs are thus lower. Moreover, fixed exchange rates protect from an expansionary foreign monetary policy, see the case of Switzerland described in Box 12.4. On the other hand, the central bank gives up an independent monetary policy. Though it is shielded from monetary shocks as long as it can keep the exchange rate fixed, the country is susceptible to speculative attacks and real demand shocks. Foreign Exchange Market and the interest Parity Conditions Chapter 15 in the book (much more extensive than lecture) Verkar som det i frelsningen enda som krvs Foreign exchange market - Definitions Spot exchange rate (s) rate of an immediate transaction Forward exchange rate (f) rate of a future transaction agreed today > Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 Interest rate parity: Covered (CIRP) Eliminates all exchange risk Uncovered (UIRP) unhedged, uncovered Covered Interest Rate Parity Uncovered interest rate parity Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 What should you know Lecture 6 Use the Mundell-Flemming model to explore the effect of a money market, goods market and IFM shock Explain why the IS curve is endogenous when we have a flexible exchange rate and why the LM curve is endogenous when we have a fixed exchange rate Discuss the pros and cons of fixed/flexible exchange rate using the policy trilemma figure Explain how the risk premium and exchange rate expectations affect the general equilibrium > Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 # Lecture 7: Aggregate Supply Neoclassical = Long term model Mundel-Flemming (Keynesian model) = Short term model Neoclassical Synthesis Long term model Long run: the economy returns to the optimal levels by itself Can deviate in the short-run due to shocks (unexpected events) such as animal spirits (expectations) Policy circles: DSGE (Dynamic Stochastic General Equilibrium Models) Our lecture: a much simpler approach, based on graphical analysis Conducting the Neoclassical synthesis with some steps: Re-introducing the supply side Supply side assumptions Profit maximizing firms Wage contracts set in advance Firms can adjust prices at any time Wages adjusted to shocks => Economy by assumption always returns to the long-run equilibrium > Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 Supply side is modelled either using the Aggregate Supply curve (AS) or the Phillips Curve (PS) We start from the latter The Phillips Curve Shows a negative relation between unemployment and inflation Trade off between inflation and unemployment Move from B to A, we would have to accept increasing inflation useful for helping us think about the short-run behaviour of inflation Deriving the Phillips Curve > Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 Aggregate Supply Link between the Phillips curve and aggregate supply Okuns Law: LEFT SIDE: Unemployment gap RIGHT SIDE: Output gap Output gap and unemployment gap co-moving Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 Labour unions in US much less powerful Labour market more rigid in Germany => Relationship between unemployment and change in growth rate weaker The underlying inflation (~) has increased due to workers demand higher wages to compensate for higher prices => Shifts AS and PC curves upwards In the long run this happens with a 0 output gap and unemployment gap, resulting in a vertical line(LRAS & LRPC)=>inflation is permanently increased overstimulation of economy may result in hyperinflation > Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 LRAS and LRPC=Long run AS and PC=short run A shock has an immediate direct effect on inflation Essay questions chapter 13 3. flexibility of wages and prices policy. Fr- och nackdelar 4. Phillips Long-run curve is vertical - Should governments never attempt to reduce unemployment with expansionary policies? Detta pstende stmmer om unemployment r i eq. Om man har en hg arbetslshet r expansiva tgrder effektiva # Lecture 8: Aggregate Demand What have we learned so far? In the last lecture we brought inflation back in to the picture We derived the Aggregate Supply and the Phillips curve > Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 Aggregate Demand Recall from lecture 5 that we Desired Demand = consumption+investment+government spending + Primary Current Account Aggregate Demand For Fixed Exchange Rate Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 in this case The domestic inflation rate=the foreign inflation rate => Inflation in Denmark and Europe area comoving Aggregate demand for flexible exchange rate ## Lecture 9: AS/AD MODEL When does the AD Curve Shift? Under Fixed exchange rates any exogenous variable that shifts IS curve, shifts AD Government spending Taxes Wealth Tobins Q Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 foreign income nominal exchange rate Change in foreign interest rate shifts AD Under flexible exchange rates: AD shifts when TR and IFM curves do IT does not shift when IS curve does Textbook assumption, p.373, in reality not completely true Before we start How should you proceed? Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 Aggregate Demand Shock Fiscal policy most effective in fixed exchange rate regime =wealth inflation expectations goes down because workers realise if they demand higher wages it will lead to high unemployment => back at long run general equilibrium Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 Small business cycle, coming back to the general equilibrium in the long run Aggregate Supply Shock Happens when conditions of production change suddenly Usually problematic for policymakers equipped mainly with tools to stimulate demand Examples: Sudden loss of capital due to war IT revolution Oil shocks Alternative a: Alternative b: Stagflation Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 This time (alternative b:) it also affects underlying inflation due to demand for higher wages, in addition to s (same as in alternative a) The second round effect causes the AS to stay in position at AS 2 , point B. This causes an unemployment gap, which eventually cause AS to shift back, but it takes a long time Aggregate Supply shock in a monetary union Countries in a monetary union do not have independent monetary policy Fixed exchange rate Country A: Since it focuses on fighting inflation it will decrease G, shifting AD to the left. Results in an output gap Country B: does not care about inflation, but want to protect its people from losing jobs => increase G Resulting in inflation, but no unemployment increase (or no output gap) > Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 Country A had a temporary recession, but came back to general equilibrium Country B : Shock was only temporary s, but the inflation expectations adapted, so people will demand higher nominal wages, leading to AS not shifting back. However, we are not on LAD What can country B do? 1. Increase G to compensate for losses in international competitiveness. however, causes major budget deficits and accelerating public debt 2. Devalue the currency to restore competitiveness. However, only a temporary solution. Inflation still to high 3. Allow for recession to get back to the equilibrium, i.e. change in policy focus Sweden was in Country Bs situation in 1970s and 1980s Was in a monetary union through the Bretton woods system (currencies pegged to dollar) > Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 Asymmetric Shocks in the monetary union Two countries A: starts out in recession B: starts out in equilibrium Property boom in B, Only in one of the countries => Asymmetric shock In country B: workers will demand higher nominal wages, raising underlying inflation rate Asymmetric shocks in the monetary union Very difficult to deal with without fiscal union shock differently affect competitiveness of various countries Not a fault of one country - it is so by construction Solution? 1: Europe as a true federal state or 2: return to national currencies (or at least a few) Disinflation > Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 ## Lecture 10: Demand Policies (Chapter 16) Business cycles Periodic fluctuations around the long-run growth path or steady state boom-bust cycles It is clear that policy makers respond to business cycles and they try to alleviate (lindra) them Origins of business cycles Different approaches: Deterministic approach present depends on the past The stock market crash happened due to overinvestment by institutions and investors Stochastic approach Random, stochastic factors generate cycles E.g Coronavirus Real Business Cycle theory (RBC) Real factors, productivity shocks long-run approach, ignores institutions effect New Keynesian Models Considers other shocks (nominal), impact of rigidities Short-term oriented, also considers small impacts e.g wages impact on GDP Mainstream macroeconomics: Neoclassical synthesis: Shocks are random occurrences, cause temporary deviation from long-run equilibrium due to frictions and lags DSGEs Dynamic Stochastic Equilibrium models Dynamic Over time Stochastic Exogenous shocks General > Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 different markets and their interplay Equilibrium markets are in equilibrium, supply meets demand Feedback effects at the macro level RBC Exclude nominal rigidities, ignore inflation and the presence of central bank NK include nominal rigidities, give role to demand policies, incorporate financial sector DSGE- dominating paradigm in quantitative macroeconomics Riksbank was the pioneer in using the DSGE for policymaking Today almost all central banks have their own DSGE model used for policy experiments and forecasting Highly criticised after 08 crisis Dominates the field, but no real alternative yet Neoclassical vs. New-Keynesian approach Neoclassical approach Rational expectations, forward looking agents Economy adapts quickly to shocks Economy mostly on the LAS curve e.g Corona causes exogenous shock The market will handle it by itself, vaccine will be developed etc New-Keynesian Approach Rational expectations, forward looking agents Economy adapts slowly to shocks because of frictions Economy is away from the LAS curve a lot Demand policies justified to avoid output below potential e.g Corona causes exogenous shock => Demand policy to avoid output below potential, to bring economy back out of recession Neoclassical synthesis > Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 Why would we want to affect business cycles Business cycles reduce welfare by: increasing uncertainty and volatility of variables (e.g unemployment) Introducing volatile inflation which destroys the price signal (not good for transactions) Policymakers can affect business cycles by: fiscal policy monetary policy Lecture 10: part 2 Goods market demand shocks Conclusion: goods market shock only has a temporary effect on output, unemployment and inflation Demand Management Policies > Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 Government will need to correctly foresee the shift in AD-curve to increase government spending in order to counteract the decrease in wealth not easy to predict effect of shocks in reality Does it work in practice? Yes and no used active demand management policies since the 1930s. Policy makers have sometimes been successful in stabilizing the economy, sometimes not. Sometimes they have even increased the size of the shocks What is the problem? Many potential problems: 1. Political business cycles (increase Government spending before elections no matter what, usually fiscal policies, which is a reason for CB being independent 2. Not all business cycles caused by shocks can be caused by policies itself, caused by past actions 3. Supply shocks difficult to respond to slightly more difficult to respond to 4. Could be a change in the long run eq. instead of a temporary shock Can be hard to determine. E.g Covid-19, vaccine may not be approved, doses mismanaged and many people die would cause long-term effects 5. Policy lags Policy Lags > Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 1. Recognition Lag: must observe that there has been a shock 2. Decision Lag: how to respond 3. Implementation lag: implementing the decision 4. Effectiveness lag: waiting for the policy to take effect These lags could cause the policy to be too late and increase volatility in the economy in this case, policy caused more damage than help How to reduce policy lags Use leading indicators, surveys use forecasts introduce automatic rules and automatic stabilizers use experts to analyze the economy (avoid political cycles) Use forward guidance (monetary policy) Inflation targeting anchors inflation expectations Lecture 10 part 3 Forecasts Difficult: Forecast errors (bad model, human error) Continuous shocks, difficult to make right predictions > Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 E.g Repo rate forecast have high uncertainty balance good that they are open about limitations good that they are forward looking Riksbank Forecasts 2007-2020 For many years, 3 models were used: RAMSES (Riksbank Aggregate Macromodel For Studies of the Economy of Sweden) BVAR (Bayesian autoregressive model), since 2003 MOSES (Model for studying the economy of Sweden, dynamic error correction model), since 2011 Plus several short-term forecasting models How the actual economy, the business cycle evolves is very difficult to forecast. => Demand management policy based on such a forecast to offset external shocks difficult Final published forecast : Judgemental They listen to all the different types of models and forecasts, but in the end, the Riksbank uses its own judgement in the final published forecast According to analysis, generally, model based forecast more accurate than the published forecast: BVAR more correct than DSGE DSGE better for storytelling (which CB likes, it eases the interpretation and presentation) DSGE model comes back faster to the steady state BVAR model estimated more frequently perhaps why it is able to respond to changes in the economy better than the DSGE model Judgemental forecasts The effect whether easter weekend falls in Q1 or Q2 has effect on household consumption expenditure and GDP, consequently an adjustment for this is needed Energy prices fluctuate sharply in connection to supply shocks, which Riksbank macro models cannot fully capture, because they do not contain an energy sector, leading to they have to use supplementary methods, e.g partial models based on forward prices of oil and electricity to adjust the inflation forecast Riksbank forecasts since 2020 A new model instead of RAMSES MAJA (Modell fr Allmn JmviktsAnalys) Model with 2 regions Includes energy sector > Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 includes trend in interest rates Explains the dependance of swedish economy on foreign shocks Background: 14:00 i part 3 videon, lecture 10 Sweden is very dependant on global economic developments Even larger dependance than many other small open economies Trade (export+import) as a share of GDP: 82% UK 54% , Canada 69% Strong co-movement between swedish and foreign variables Globalisation has increased dependance Capturing the foreign dependance is crucial in a model of the swedish economy Many models in literature have difficulties Riksbank forecasts have not considered foreign developments enough No off-the-shelf alternatives in literature Improved forecast accuracy with MAJA Changing nature of monetary policy Right now most CB use DSGE and data-driven models to produce forecasts, and targeting inflation but who knows how it will be in 10 years 16.4 Beyond controversies: The synthesis The evidence is in the middle The truth is probably something in between keynesian and neoclassical Macroeconomic policies face limits > Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 effectiveness not guaranteed consumers will alter saving decisions to offset government actions budget constraint limits government freedom expectations may move faster when the public anticipates interventions lags might undermine what governments want to achieve supply-side shocks brings trade-offs Costs of inflation (from exercise 16.4) (a) Redistribution of income: Inflation lowers the real value of wages, pensions, transfer, and interest income. While unions have the power to fight for a higher nominal income which compensates for the higher inflation, retirees and dole reci loss of real income. In the short run, inflation also may also lead to a real exchange rate appreciation and a decline of income in the export sector; this can be rapidly reversed when the inevitable devaluation occurs. (b) Redistribution of wealth: inflation, lenders receive a lower real interest rate than expected. The present discounted value of their capital decreases. In contrast, borrowers benefit from higher inflation since they have to pay back less capital in real terms. Moreover, households which hold real assets are not affected by inflation whereas households which hold money or bonds suffer a loss. (c) Distortion of relative prices: In case of high inflation, inflation volatility increases, too. Market agents may no longer be able to separate changes in relative prices due to shortages or changes in production costs from changes due to inflation. As consequence, production and consumption may slow down because resources are spent on gathering information and because economic opportunities are missed. (d) Trust in money as an institution: Inflation punishes those who hold money since the real value of money declines. In the extreme case of hyperinflation, the value of money rapidly approaches zero as market agents lose trust in the national currency and use others monies (dollars, euros). poorer members of society may suffer from inflation when transfer payments such as pensions and social security payments are not indexed. BENEFITS allows the government to reduce the real value of its debt Chapter 16 Exercise 1. Keynesian activists motivation for demand policies a. Since it believes prices and wages are sticky=> Demand policy moves the economy faster back to eq. Does however, increase inflation A neoclassical activist would answer, since prices and wages are flexible & expectations are back-ward and forewardlooking in addition to policy lags => The economy would adapt more reliable and quicker with a laissez-faire approach 2. Why is the behaviour of underlying inflation critical to evaluating the effectiveness of a policy? Since keynesian measure results in inflation (16.1), it should only be chosen over > Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 laissez-faire if it brings back the economy to equilibrium faster, Both neo- and keynesian suffer from policy lags Keynesian policy lags: recognition lag, decision lag, implementation lag and effectiveness lags Neoclassical (laissez-faire) policy lags can only be as fast as the speed with which underlying inflation adapts to actual inflation. => the effectiveness of demand management policy needs to be evaluated in comparison to the (behavioural) determinants and in particular the speed of adjustment of underlying inflation The determinants of underlying inflation are, among other things: whether expectations are rational or whether systematic errors are feasible, whether expectations are forward-looking or backward-looking, whether agents tend to be locked into contracts where price and wage increases are fixed or indexed, the level of current inflation 3. Slope of AS-curve for evaluating effectiveness of demand policy 7. Friedman critique The presence of policy lags 8. Leading, lagging and coincident indicators ## Lecture 11: FISCAL POLICY Demand management policies: Fiscal Policy Budget balance is often decomposed into two components Budget balance=structural+cyclical > Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 Structural budget balance=budget balance when economy is in equilibrium Cyclical budget balance=budget balance due to business cycle (and automatic stabilizers) Demand management polices: fiscal policy It is ok to borrow during recessions as long as the structural balance is healthy In the long run: key is to stabilize debt level Can stabilize nominal debt or debt ratio (debt/GDP) Nominal Debt Stabilization Notation B= outstanding government bonds (i.e the government debt) g=GDP growth rate r=interest rate Relative debt stabilization Debt ratio: B/Y (debt in relation to GDP [income]) Not required to be able to derive the equation > Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 Relative debt stabilization with independent monetary policy Seignorage the difference in face value of money, such as a $0.25 quarter coin, and the cost to produce it Kan ibland vara negativt, t.ex kopparmynt, men oftast positivt, sedlar r relativt billiga Relative Debt Stabilization Focus on the swedish Case Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 During world wars, debt to GDP usually increase however, in WW1, there was strong inflation, offsetting the relative debt. Pre 1970s there was a neoclassical emphasis, with lower government debt. post 1970s there was keynesian emphasis, and fiscal policyleading to higher debt ratio meanwhile, the state expanded with big government spending Since 1995 we have decreased by debt, with demand management with monetary policy since floating exchange rate was implemented Swedish debt stabilization Debt Stabilization If we would like to decrease debt levels we can: Short Run > Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 Austerity (fiscal stringency) (tstramning) Skapade konflikt och spnning mellan Grekland och Tyskland nr de inte kunde betala tillbaka ln Inflationary finance Minska genom inflation, det reala vrdet p lnet minskar ju om det r inflation Dessutom fr staten in pengar genom seignorage (mynt/sedelpress intkt genom skillnad i tillverkningskostnad och vrde p betalmedlet) Outright default on debt Skuldsanering, avskrivning av ln Usually some kind of market punishment, increase in interest rates Long Run Reducing the rate of interest Raising the long-run rate of growth not an easy task, needs supply side policies High Debt Levels - To consider Do not compare nominal sizes of government debt across countries - potential to raise taxes We looked at gross debt to GDP What about net debt to GDP? Can even be negative if a country has many assets (oil-exporting countries) More assets than liabilities Consider domestic vs foreign investors Domestic debt financing more stable (Japan) Still a problem: population ageing Before we conclude : Supply-side policies Policymakers stimulate demand, but what about the supply side? Not covered in this course Much more difficult for policy makers, take very long time to have effect Obligatory reading Lecture 11: Are the Effects of Fiscal Policy Asymmetric? Economic research on the size of the fiscal multiplier has assumed that the effects of changes in government spending are symmetric a dollar of fiscal stimulus has been assumed to have the same multiplier as a dollar of fiscal contraction > Nedladdat av NIKLAS HELENEFORS ([email protected]) > lOMoARcPSD|17117796 research indicates that this is not the case; the fiscal multiplier does vary according to the direction of the fiscal action and also varies with the stage of the economic cycle. This finding sheds light on likely outcomes of fiscal policies and helps account for inconsistent estimates of the multiplier in the literature. Nedladdat av NIKLAS HELENEFORS ([email protected])