6 - The Central Bank and the TEM Flashcards
(16 cards)
What are the costs of output being above equilibrium?
Causes inflation to rise above expectations.
What are the costs of output being below equilibrium?
Deflation possibly
Costs of unemployment
What are the costs of uncertainty?
May cause AD to fall (precautionary saving)
Costs of borrowing may rise (inflation risk premium)
What are the costs of business cycles?
Costs of output above equilibrium
Costs of output below equilibrium
Uncertainty costs
What is summarised in the IS equation?
Demand-side
Shocks to autonomous consumption, investment or G shift the IS curve.
What is summarised in the PC?
Supply-side
Demand shocks move the economy UP the PC.
Demand shocks cause people to adjust inflation expectations, causing the PC to shift as there is a new future level of inflation expectations.
Temporary demand shocks lead to permanent shocks in inflation. T/F?
Possibly true.
Depends on if inflation expectations are fixed or variable.
Draw the effect of a positive demand-side shock in the economy with adaptive inflation expectations using the TEM.
Draw the effect of a positive demand shock in the economy with fixed inflation expectations using the TEM.
What is the loss function for the Central Bank?
L = -(y - ye)2-β(π-πT)2
L = central bank utility, β = relative importance of inflation deviation
Draw the effect of an increase in μ in the TEM.
Increasing μ causes PS to shift down, causing wages to fall to W1.
Causes employment to fall to E1*.
To maintain inflation at current target π0, the MR shifts to a lower level of output y1e to do so.
Result:
Wages fall, employment falls, output falls, inflation constant
BAD!!
Draw the effects of a demand shock on an economy with adaptive inflation expectations.
Draw the effects of a demand shock on an economy that cannot reach their desired interest rate.
Why does the deflation trap get worse in an economy with adaptive expectations?
The adaptive inflation expectations causes the PC to continue to shift down making it even more difficult to get inflation back up from deflationary levels.
r = i - E(π) => as the nominal rate, i, is 0 and the central bank can do no more, the real rate of inflation increases as inflation expectations become negative, driving the economy further up the new IS curve.
How did the great depression affect the AD?
Initial fall in investment adjusted people’s wealth => house prices fall, unemployment etc.
The initial fall caused a shift down in the AD, and the multiplier effect caused AD to fall down again as individuals save more.
