Business cycles, IS-TR and the zero lower bound Flashcards
(17 cards)
OKUN’s Law
negative relationship between the change in real GDP and the change in unemployment
increase output leads to increase in employment
GFC- low growth high unemployment
short run gdp and unemployment
fluctuation in GDP -> lower demand -> declining production -> job losses
more unemployment lower ad for goods ..
Key assumption week 8
prices and wages are fixed (no inflation) in the very short run
long run flexibility of prices and wages
Output, Okun’s law and price stickiness
more employment when output rises
keynesian model in week 8, assuming there are un(der)employed people prepared to supply extra labour at the real wage offered
IS curve
Allows us to consider the short run merits of fiscal and monetary policy
lower interest rates, higher investment, higher output
𝑌 = 𝑐_0 + 𝑐_1 (𝑌 − 𝑇 bar)+ (𝐼 (bar)− 𝑑𝑖)+ 𝐺 (bar) + (𝑁𝑋_0bar) − 𝑚𝑌
slope IS - beta/d
TR curve
CB announce a nominal interest rate
changing the interest rate is pays on commercial bank reserves
modelling monetary policy
model setting interest rate by having a horizontal LM curve
CB is choosing some appropriate point on the IS curve
short run TR (taylor rule) curve
i= i (bar) + b((Y-Y (bar)/Y (bar))
Y bar natural rate of output about which the economy fluctuates
TR curves say that if output increases relative to trend the central bank increases interest rates
and vise versa
gives rise to combinations of output and interest rate consistent with the cb monetary policy
TR determines the interest rate and money demand which requires the money supply to be set endogenously
intuition of Taylor Rule
adjust interest rate to keep output closer to y bar
CB sets higher interest rate if economy too hot and lower if in recession
according to its taylor rule
(CB may not do this as doesnt know exactly how world work, changing interest rates frequently incur costs such as uncertainty on investment decisions etc)
changing money supply and how this affects interest rates
Central bank reduces the money supply ( selling bonds)
sucks money out of the economy (cash turn to bonds)
increased supply of bonds depresses bond prices
lower bond prices mean higher yields (interest rate increases)
IS-TR model
model of several interacting markets
brings together two ways of determining the interest rate
-determined by supply of loanable funds (investment)
determined by supply and demand for money set by the central bank
level of Y that reconciles loanable funds with s and d for money
IS- set of points in output interest rate space for which the goods market is in equilibrium
TR- set of points in output interest rate space consistent with the cb monetary policy
Macro economic shocks increase in G, explain
IS shifts to the right
if r unchanged economies stays at point c (see diagram) where CB increases money supply as mpney demand increases to maintin interest rate peg
however CB follows its Taylor rule, as output moves above Y (bar) it increases the interest rates according to its taylor rule
higher interest rate, investment lower
potential increase in output is crowded out by lowe investment due to high interest rate
CB offsets fiscal expansion adopted by the govt an economy to end up at point B
when b larger, fiscal multiplier smaller CB will more vigorously offset policy that moves away from trend
Macroeconomic Shocks: TR Shocks – CB
believes long-run interest rate has permanently
fallen so decreases 𝑖 (bar)
see diagram
initially A, CB cant move economy back to Y bar with its current monetary policy
new, lower long run neutral interest rate (i bar) is appropriate under govt
TR shifts rightwards
for any level of output the CB is now sets lower interest rate
economy moves to B
any new level of income, interest rates are lower, stimulating increased investment spending
impact of the austerity is offset by increased investment
Liquidity Trap
Keynes suggested that if AD was severely depressed there might come a time when monetary policy would no longer be effective
Zero Lower Bound ZLB
short term nominal interest rates is at 0 causing a liquidity trap
IS-TR suggests at the zero lower bound increasing money base would do nothing as interest rates cant fall extra liquidity becomes ineffective (liquidity trap)
what is qe response to
ZLB problem
IS TR model suggests at ZLB
Monetary policy will be very ineffective
Fiscal policy extremely effective
austerity would be extremely detrimental to getting economy back on track when at ZLB
