guest lecture

Question 1

Real interest rate

Answer 1

=nominal interest rate minus expected inflation rate

Question 2

monetary tightening = restrictive policy

Answer 2

requires central
banks increasing policy rates more than increases in expectedinflation.

Question 3

• Central banks can only determine

Answer 3

(very) short-term interest rates

Question 4

Economic decisions are primarily affected by….

Answer 4

long-term interest rates(think of mortgages, corporate loans)

Question 5

Long-term rates (partly) reflect

Answer 5

expected future short-term rates

Question 6

Delay or insufficient increase in current policy rates will imply

Answer 6

bigger increasein CURRENT and future longer-term rates (due to higher inflation
expectations) which implies a sharper negative effect on economic growth

Question 7

• Conventional:

Answer 7

using prices (interest rates) as the primary instrument.
Works as long as interest rates are not substantially negative

Question 8

• Unconventional:

Answer 8

using quantities as the primary instrument:
CB transactions of financial assets, usually government bonds
* CB asset purchases are financed by liquidity that is created our of nothing (!)
* This additional liquidity greases financial markets and (hopefully) the real economy.
* It works symmetrically: CB selling gov. bonds reduces market liquidity

Question 9

Goal monetary policy

Answer 9

price stability: inflation rate of 2% to be achieved in the medium term. CB focuses on general price level, not relative prices andignores temporary movements in general price level.

Question 10

• On impact, the energy price hike is a what price change

Answer 10

relative

Question 11

In a frictionless world there is no impact on the general price level because

Answer 11

nominal prices of other products decline, leaving price level unchanged
* 𝑃 = 𝜔𝑃e + (1 − 𝜔)𝑃0

Question 12

However, prices are sticky

Answer 12

do not adjust immediately

Question 13

and are rigid

Answer 13

eg due tocontracts, menu/transaction costs, economic slack)

Question 14

So a relative price change can be a

Answer 14

source of inflation (change in general pricelevel)

Question 15

Direct effect

Answer 15

consumers of final energy products
confronted with increasing prices of energy (eg our heating bill)

Question 16

Indirect effect=

Answer 16

: higher energy prices feed intoproduction chain: higher costs of energy as intermediate input pass
through into consumer prices of other goods and services (eg air fare).

Question 17

• Alternative pass through mechanism:

Answer 17

higher inflation feeds into higherwages >
wage-price spiral

Question 18

3 types of energy price hikes

Answer 18

temp spike
perm jump
perm rise

Question 19

temp spike

Answer 19

Question 20

perm jump

Answer 20

Question 21

perm rise

Answer 21

Question 22

Alternative transmission channel of energy hike:
Wage-price spiral

Answer 22

• When an (energy) price increase leads to higher wage demands of
  employees leading to higher wages leading to higher wage costsfirms, and (ultimately) higher prices.
• Higher prices induce more wage hikes, leading to higher prices etc* Corporate sector confronted with erosion of profitability, erosion of
  competitiveness leading to lower investment, lower economic
  growth, unemplosyment. Example: 1980

Question 23

STAGFLATION

Answer 23

permanently higher inflation rates and lower economic
growth:
RESULT OF WAGE PRICE SPIRAL

Question 24

• DEMAND management:

Answer 24

Influencing AD line
* Budgetary (fiscal) policy
* Monetary policy

• Goal=influencing the business cycle: aimed at the short/medium run* Can have (perverse) long run effects.

Question 25

ECONOMIC DIAGNOSIS OF ENERGY CRISIS

Answer 25

* Negative aggregate supply shock * Impact: higher prices, lower output * Simple textbook solution: counter negative supply shock with positiveshift in demand

Question 26

PROBLEMS WITH NEGATIVE SUPPLY SHOCK

Answer 26

* Lower output and higher price level * Expansionary budgetary policy increases gdp but also prices * Persistent higher inflation requires restrictive monetary policy which reducesinflation and gdp * Either monetary policy accepts higher price level, possibly violating its mandate, or reacts and budgetary policy effects will be reduced (why???) * CB accepting higher price levels might induce more cost increases (higherwages due to higher inflation expectations) implying further negative supplyshock (wage price spiral) and permanently higher inflation

Question 27

financial stability andprice stability

Answer 27

AS: cost of (production factor) capital. AD: wealth effect, availability of credit, housing. * Asset prices, credit creation and balance sheets important: are financial conditionssustainable? Balance sheet recession.

Question 28

Financial conditions make economies more

Answer 28

procyclical

Question 29

procyclical

Answer 29

more intensive booms, but also more intensive busts.

Question 30

* Higher inflationary pressures alongside elevated financial vulnerabilities, specifically high indebtedness and surging house prices

Answer 30

s= risky: output costof tighter financial conditions could be larger than in the past

Question 31

The funding of expansionary budgetary policy might create financial instability in the form of

Answer 31

Tax hikes, expenditure cutbacks, debt issuance

Question 32

Recent example UK: Financial vs Price stability

Answer 32

* High indebtedness consumers, firms and governments makes market liquidityvery important (determines ability to refinance debt) * BoE (as most CBs) in tightening mode, selling government bonds and reducingliquidity in the market in order to combat inflation * Reduced market liquidity implies larger volatility and more impact of fire sales* UK: fiscal plans Tuss government reduced market confidence in government bonds: decrease in price and sharp increase bond yields * Liability driven investment strategy UK pension funds caused huge losses on theirderivative positions, eliciting large margin calls and dash for cash, leading to firesales * Downward spiral. Risk to FS * BoE forced to intervene: buying bonds, providing market liquidity * This contradicts its tightening mode: inflation requires less liquidity

Question 33

Role of monetary policy (in general)

Answer 33

* CB’s mandate is to deliver low and stable inflation. This enables people todistinguish between general and relative price changes (improving allocation) * But also responsibility for economic growth (although in varying degrees)

Question 34

why is monetary policy on the lookout for signs of second roundeffects:

Answer 34

: higher energy prices becoming engrained in the behaviour of economic agents leading to (cost increases and) persistently higherinflation expectations.

Question 35

example of second round effects

Answer 35

indexation

Question 36

what do second round effects imply

Answer 36

unhinged inflation expectations and thiswill elicit a tightening of monetary policy

Question 37

The problem with supply shock: monetaryfiscal policy mix

Answer 37

Fiscal expansion and monetary tightening tension * Pressure on central banks to delay tightening * But delay might imply higher long-term rates (why?) and more output loss * And higher long-term rates reduce the effects of fiscal expansion* Correct diagnosis in real time of type of price shock crucial but difficult * Incorrect diagnosis has serious macroeconomic consequences

Question 38

covid

Answer 38

Exogenous shock * Loss of lives * Loss of productive capacity * Breakdown of global value chains * Both demand and supply negatively affected (why??) * Substantial income support by governments * On top of secular demographic developments (ageing) *  economies operating at capacity.

Question 39

Energy crisis (2022-?)

Answer 39

* Political origin: reaction to Putin’s invasion of Ukraine * Putin uses natural resources (oil and LNG) as a political weapon. * This crisis came at a time we were still recuperating from earlier problems (see earlier slides) * This has a bearing on resilience and (in some countries) availablepolicy space (room to maneuvre) * Massive income support by government impacted public finances * Massive monetary support from unconventional policies led to loose financial conditions (low rates, massive liquidity, high indebtedness) * Economies were operating at capacity

Question 40

Policymakers should constantly assess their policy measures along three dimensions:

Answer 40

Necessity effectiveness side effects

Question 41

Necessity

Answer 41

* Monetary policy tightening required by mandate because of evidence of second round effect of energy price hike on costs and inflation (see graphs) * Necessity expansionary budgetary policy depends on objective policy (income support, energy transition, …) * Expansionary budgetary policy may be required for supporting some consumers and firms (micro economic perspective)

Question 42

effectiveness

Answer 42

* History: Restrictive monetary policy is effective in combatting inflation. Macro-economic instrument for a macro-economic problem. Clear mandate of CB. * Budgetary policy can be effective if directed towards targeted groups. Is however difficult to make operational and politically sensitive. * Multiple objectives of budgetary policy reduce its effectiveness: Supply side strengthening? * The tension between expansionary budgetary policy and restrictivepolicy implies reduced effectiveness of both types of policy. Need forpolicy consistency. IMF (2022).

Question 43

side effects

Answer 43

Monetary policy: can contribute to financial instability. Current financial fragility makes it difficult to fine-tune the output effects of monetarytightening. * Expansionary budgetary policy may shield the economy from the relativeprice change that is crucial for transitioning to a less energy intensive economy * Expansionary budgetary policy reduces the public funds available tocounter longer term challenges such as sustainability (greening) anddemography