Week 2 Flashcards

1
Q

The natural interest rate is the interest rate where…

A

…the economy is stablized in the absence of output gap and when inflation equals its target.

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2
Q

The deflation trap is:

-“a thing we teach in school to keep you busy, but will never really happen”

-something that happens when the economy is going at full speed

-a potential reason for using Quantitative easing

-none of the above

A

a potential reason for using Quantitative easing

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3
Q

In the 3 equation model there is NOT an equation for:

  1. the goods market
  2. the stock prices
  3. the monetary policy
  4. Inflation
A

the stock prices

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4
Q

Why would a central bank want to ever raise the inflation target

  1. so it is further away from the Zero lower bound
  2. so it can work less
  3. so it looks like it is always right
A

so it is further away from the Zero lower bound

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5
Q

Potential output is:

A

… Output at its full employment level

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5
Q

Which of the following is NOT an explanation for deficit bias in fiscal policy making?

1.There is intergenerational conflict

2.Growth forecasts are uncertain

3.The central bank is not sufficiently independent

4.The output target is overly ambitious

A

The central bank is not sufficiently independent

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6
Q

Why do governments hand over inflation targeting to the central bank?

A

Govs hand over inflation targeting to CBs mainly for 2 reasons:

  • Governments have political pressure to manipulate interest rates for electoral gain.
  • Monetary policy is preferred over fiscal policy to stabilise the economy since it is quicker and more fair.
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7
Q

How would CB respond to rising inflation?

A

In response to an upward inflation, central banks would raise interest rates.

The cut back in investment, due to higher financing cost, would lead to a lower aggregate demand.

Output would fall, unemployment would go up and inflation would go down.

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8
Q

In which situations in you cannot rely on the central bank to stabilize shocks by changing the interest rates?

A

There are two situations in which you cannot rely on the central bank to stabilize shocks by changing the interest rates:

  • When there is such a large negative demand shock that even when the central banks changes the nominal interest rate to zero, this is not low enough to stimulate a revival of aggregate demand through investment. (Zero Lower Bound)
  • When the economy has a fixed exchange rate in for example a common currency area such as the Eurozone. There is an overall ECB, so countries cannot stabilize shocks that are specific to their countries as they do not have their own monetary policy maker.
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9
Q

Claim: Rising inflation is often followed by painful periods of disinflation where output is below equilibrium, accompanied by high unemployment.

A

TRUE

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10
Q

What is the Shoe-leather-cost?

A

Shoe-leather-cost is the cost of time and effort people spend managing their financial assets to minimise the effect of inflation on the eroding purchasing power.

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11
Q

Why target low and stable inflation?

A

The CB targets low and stable inflation because:

  • Periods of high inflation are accompanied with inflation volatility which distorts resource allocation.
  • Firms incur costs due to the need for frequent price changes if there exists volatile inflation, called menu costs.
  • When inflation is high, people want to hold less money as inflation erodes value over time (shoe-leather-costs).
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12
Q

What is Fiscal Policy?

A

A government policy trying to raise revenue through taxation and distributing that revenue as public expenditure.

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13
Q

The MR curve shows …

A

…the central bank’s preferred output-inflation combination for any Phillips curve it faces.

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14
Q

If β > 1, the CB is…

A

…inflation-averse.

It would trade a small fall in inflation for a large rise in unemployment.

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15
Q

If β < 1, the CB is … : the CB is willing to trade off a given fall in inflation for a small fall in output (and thus a small rise in unemployment). Adjustment in this case takes longer as small reductions in inflations (and hence PC shifts) are achieved each period.

A

…unemployment-averse

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16
Q

A rise in the unemployment benefit will shift the WS curve …, as it reduces the cost of job loss.

A

upwards

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17
Q

Labor market equilibrium WS = PS is where…

A

…the wage level secures sufficient labor (WS curve) and for production to be profitable (PS curve).

18
Q

Based on the PC curve there is … relationship output and inflation

A

Positive

19
Q

Based on the PC curve there is … relationship inflation and unemployment

A

Negative

20
Q

Why target low, stable but also positive inflation?

A
  1. to avoid deflation trap
  2. to prevent the rise of real value of debt
  3. it is more easy to adjust nominal wages
21
Q

Claim: Under adaptive expectations, current inflation depends on inflation in previous period and the output gap.

A

TRUE

22
Q

A natural disaster, decreasing agricultural output and raising prices can cause a…

A

inflation shock

22
Q

In an inflation shock PC swifts…

A

…upwards

23
Q

Claim: A temporary positive demand sock will leave the π and y unaffected but result in a lower r.

A

FALSE!

temporary:
same π, same y, same r

24
Q

3.3 SOS What are the advantages and disadvantages of a target inflation rate of 4% as compared with one of 0% per annum?

A

Having a low but positive inflation target, like 4%, helps the central bank deal with economic challenges and prevents the risk of a deflationary situation.

However, a higher that 0% inflation level thought leads to shoe-leather cost for the households and menu cost for the firms.

25
Q

Explain the Lucas critique in maximally three sentences.

A

Lucas critique, states that it is naive to try to predict the effects of a change in economic policy entirely on the basis of relationships observed in historical data.

26
Q

What curve imposes a contains for the CB when deriving the MR curve?

A

the PC, Philips Curve

27
Q

The PC shows … by the central bank, for a given …

A
  1. combinations of output and inflation which are attainable
  2. inflation expectation.
28
Q

What is the deficit bias?

A

Deficit bias is the tendency for the budget deficit to rise during recessions but not fall sufficiently in booms

this causes:
* Over-ambitious output target
* Over-optimistic growth forecast
* Intergenerational conflict

29
Q

Adaptive Expectations are …-looking.

A

Backward

29
Q

Rational Expectations are …-looking.

A

Forward

30
Q

Claim: Under rational expectations, there is always upward pressure on inflation if output is above its equilibrium level

A

False:

Under ADAPTIVE expectations, there is always upward pressure on inflation if output is above its equilibrium level

31
Q

Lending rate mark-up (μB ) … with risk and … with risk tolerance and bank equity

A

increases…

decreases…

32
Q

In response to an upward inflation, central banks would … interest rates

A

raise

33
Q

Why define the CB’s role to be mainly that of controlling inflation?

A

Because unemployment is determined by the supply-side; The CB lacks supply- side policy instruments, and thus is not the right policy maker to reduce equilibrium
unemployment.

34
Q

When does the CB do a “bad job?”

A

The central bank is worse off the further inflation (𝜋𝑡) is away from its target level (𝜋𝑇), and the further output
(𝑦𝑡) is away from its equilibrium level (𝑦𝑒)

35
Q

The central bank’s constraints from the supply side is the … curve

A

Phillips Curve (PC)

36
Q

In the 3eqs model the PC curve shows …

A

all combinations of output and inflation which are attainable by the central bank, for a given inflation expectation.

37
Q

Claim: The PC forms a constraint
faced by the central bank.

A

True

38
Q

Once the optimal output-inflation combination is determined using the …, the central bank uses the … curve to implement its choice (by setting the interest rate).

A

MR,

IS, Yes, the IS, don’t get confused with PC at this stage, look at the 3 eqs model

39
Q

For a given PC, the MR
shows …

A

…the desired output-inflation combination.

40
Q

Monetary rule (MR curve) determines the …

A

…output gap the central bank should set to stabilize the economy following an economic shock.