Macro Semester 2 Flashcards
(202 cards)
1
Q
What is money?
A
Money is a medium of exchange, accepted without question, that is used as a means of payment for goods and services.
2
Q
What is the main problem with a barter economy?
A
A barter economy requires a double coincidence of wants, making trade inefficient.
3
Q
How can cigarettes function in an economy?
A
In some contexts (e.g., a POW camp), cigarettes can function effectively as money.
4
Q
What is the downside of using a commodity like gold or silver as money?
A
When a commodity is used as money, society may have to cut back on other uses or devote scarce resources to produce more of it, making it costlier than other methods of generating a medium of exchange.
5
Q
Why are paper notes (like a £20 note) considered token money?
A
A £20 note has a manufacturing cost much lower than its face value, meaning it’s symbolic and requires controlled supply (fiat currency) to maintain its value.
6
Q
List the main functions of money.
A
Money serves as a medium of exchange, a unit of account, a store of value, and a standard of deferred payment (unit of account over time).
7
Q
What does it mean when money is described as ‘legal tender’?
A
Legal tender means money must be accepted as a means of payment by law. This typically includes paper currency and can extend to bank cheques or debit cards.
8
Q
What role do banks play as financial intermediaries?
A
Banks connect depositors with borrowers by accepting deposits and then lending a large portion of those deposits to firms and households.
9
Q
What are the two primary components on a private commercial bank’s balance sheet?
A
Assets (mainly loans and financial securities) and liabilities (mainly customer deposits, both sight and time deposits).
10
Q
How do banks make money?
A
Banks make money through the spread—the difference between the interest rate paid to depositors and the interest charged to borrowers.
11
Q
Aside from banks, which other institutions serve as financial intermediaries?
A
Insurance companies, pension funds, and building societies also function as financial intermediaries, taking in money from the public and lending it out.
12
Q
What is fractional reserve banking?
A
Fractional reserve banking is the system in which banks hold a fraction of deposits as reserves and lend out the remaining portion, creating additional deposits in the process.
13
Q
In the context of fractional reserve banking, what is the ‘reserve ratio’?
A
The reserve ratio is the percentage of deposits that banks are mandated to keep in reserve; for example, a 10% reserve ratio means banks must hold 10% of deposits as cash reserves.
14
Q
How does the money creation process work with a bank that has a 10% reserve ratio?
A
If £100 is deposited and banks lend out 90%, then the borrower’s spending becomes deposits at another bank, which can then lend 90% of that deposit. This cycle continues, leading to a money multiplier effect.
15
Q
What is the money multiplier and how is it calculated?
A
The money multiplier is the amount by which a change in reserves will change the amount of money in circulation. It is calculated as 1 divided by the reserve ratio (e.g., 1/0.10 = 10).
16
Q
Who is the monopoly supplier of cash in an economy?
A
The central bank is the monopoly supplier of cash, but its cash is circulated intentionally through asset purchases and sales.
17
Q
What is the difference between the monetary base (narrow money) and broader money aggregates (M1, M2)?
A
The monetary base is directly controlled by the central bank, while broader aggregates like M1 and M2 depend on the lending behavior of commercial banks and the borrowing behavior of the private sector.
18
Q
What factors does the money multiplier depend on?
A
The money multiplier depends on banks’ willingness to lend, the reserve ratio they maintain, and the public’s willingness to hold deposits rather than cash.
19
Q
What role do central banks play in the economy?
A
Central banks set and manage monetary policy, influencing interest rates, money supply, and controlling business cycles.
20
Q
What are two traditional means of monetary control used by central banks?
A
Alter the cash reserve ratio for commercial banks
Perform open market operations (buying/selling bonds) to manage the money supply.
21
Q
How do open market operations work as a form of monetary control?
A
When a central bank buys bonds, it injects cash into the banking system, increasing reserves and potentially expanding lending. Conversely, selling bonds withdraws cash from the system, reducing the money supply.
22
Q
What is the significance of the central bank acting as the ‘lender of last resort’?
A
As a lender of last resort, the central bank provides emergency funds to financial institutions facing liquidity crises to prevent bank runs and systemic collapses.
23
Q
What is the difference between liquidity risk and insolvency risk in banking?
A
Liquidity risk is the inability to meet short-term obligations due to lack of cash, while insolvency risk is when a bank’s liabilities exceed its assets.
24
Q
How does deposit insurance help in the context of banking?
A
Deposit insurance protects depositors from losses in the event of a bank run or bank failure by guaranteeing deposits up to a certain amount, thereby reducing panic.
25
What is meant by 'Too big to fail'?
'Too big to fail' refers to the idea that certain financial institutions are so large and interconnected that their failure could cause systemic risk and thus they receive special consideration during bailouts.
26
How are bond prices affected by changes in market interest rates?
Bond prices and interest rates are inversely related. When market interest rates rise, the price of existing bonds falls, and vice versa.
27
What example illustrates the inverse relationship between bond prices and interest rates?
If a bond with a £100 face value pays a £5 coupon, its yield would be 5%. If market interest rates climb to 10%, investors would only be willing to pay £50 for that bond to receive a £5 annual coupon, matching the new rate.
28
What are gilts?
Gilts are long-term UK government bonds that pay a fixed coupon over a specified period, after which the principal is repaid.
29
What is meant by the 'spread' in the context of bank operations?
The spread is the difference between the interest banks pay on deposits and the interest they charge on loans, which constitutes a key source of bank profits.
30
What happens when banks decide to hold a higher fraction of deposits as reserves compared to the legally mandated minimum?
When banks hold a higher fraction of deposits as reserves, the money multiplier decreases, which in turn limits the overall expansion of the money supply.
31
In the simplified model of money demand, what are the two assets available?
Money (a liquid asset that serves as a medium of exchange) and bonds (an interest-bearing asset that cannot be used directly for transactions).
32
Why would someone choose to hold money instead of bonds?
Money provides liquidity—it can be accessed immediately for transactions without transaction costs and is universally accepted.
33
What is the primary benefit of holding bonds over money?
Bonds offer a financial return through interest payments, rewarding investors.
34
What factors determine the amount of money people want to hold?
The frequency of transactions and the institutional/technological factors in a given economy. Higher nominal GDP (Py) implies a greater volume of transactions and, therefore, a higher nominal demand for money.
35
How is real money demand related to real GDP and interest rates?
Real money demand (Md/P) is proportional to real GDP (y) and decreases as interest rates rise—because higher interest rates increase the opportunity cost of holding money.
36
How does the central bank influence the money supply under the traditional view of central banking?
The central bank controls the nominal supply of 'narrow money' (monetary base), which, with a stable money multiplier, determines the total (broad) money supply.
37
In a short-run macro model with fixed prices, what else can the central bank control?
With fixed prices, the central bank indirectly controls the real money supply.
38
What happens in the money market when the interest rate is driven above the equilibrium rate?
At a higher interest rate, there is excess demand for money and an excess supply of bonds. This imbalance pushes bond suppliers to offer higher yields, eventually moving the market back to equilibrium.
39
How does the central bank achieve a desired equilibrium interest rate?
The central bank sets the target interest rate and passively adjusts the money supply (by changing the monetary base) until the market returns to that interest rate.
40
Why do central banks prefer using interest rates as their policy instrument rather than setting the money supply directly?
Because of uncertainty regarding the size of the money multiplier and unpredictable variations in money demand, setting interest rates provides more precise control.
41
What are expansionary open market operations (OMOs)?
They involve the central bank buying bonds to inject cash into the banking system—lowering the interest rate to the target level and increasing credit availability.
42
What is the main target of most modern central banks?
Price stability—a low and stable inflation rate—often through an inflation-targeting regime.
43
How does monetary policy affect aggregate demand in a closed economy?
Monetary policy influences aggregate demand by affecting interest rates, which alter consumption, investment, and ultimately the value of corporate assets.
44
What is the wealth effect in monetary policy transmission?
When lower interest rates increase the present value of future earnings (such as dividends and coupon payments), boosting asset prices and household wealth, which in turn stimulates spending.
45
Besides the wealth effect, what are two other ways expansionary monetary policy works?
It makes more credit available to consumers and lowers the cost of credit, encouraging spending and investment.
46
How can the relationship between long-term and short-term interest rates affect investments?
Long-term interest rates are related to a sequence of expected short-term rates. By influencing expectations (through tools like forward guidance), governments can affect long-term investment decisions.
47
What is forward guidance in monetary policy?
Forward guidance is a central bank’s communication about its expected future short-term interest rates, aiming to influence the market’s expectations and long-term rates.
48
Why might changes in the current interest rate have little effect on long-term rates?
If market participants do not adjust their expectations or if many loans are fixed rate (e.g., mortgages), then the transmission mechanism from monetary policy to aggregate demand weakens.
49
How are long-term government bond yields determined?
They reflect the market’s expectations of future short-term interest rates plus a term premium, which compensates investors for the risk of locking in their capital for a longer duration.
50
What is the term premium?
The extra compensation investors demand for the risk of holding longer-term bonds instead of short-term ones.
51
What does the yield curve show?
The yield curve plots interest rates for government borrowing across different time horizons; it is usually upward sloping.
52
What might a downward-sloping yield curve indicate, particularly in the US?
A downward-sloping yield curve has often been a predictor of an upcoming recession.
53
How is investment demand related to interest rates?
Investment demand is inversely related to interest rates—lower rates encourage more investment projects to be viable, while higher rates restrict them.
54
What factors, besides interest rates, affect investment demand?
Expectations of future output demand and the cost of capital goods also influence investment demand.
55
What is Quantitative Easing (QE)?
QE is an unconventional monetary policy where the central bank dramatically expands the monetary base by creating cash and purchasing bonds from financial institutions.
56
Why was QE implemented following the financial crisis?
To counteract a sharp drop in the money multiplier and prevent a collapse in the broad money supply that would worsen the economic crisis.
57
How does QE aim to lower long-term interest rates?
By buying large quantities of longer-term bonds, the central bank bids up bond prices, which lowers their yields and, hence, long-term interest rates.
58
What does quantitative tightening (QT) refer to?
QT is the reverse process of QE, where the central bank reduces its balance sheet by selling bonds in exchange for cash and then withdrawing that cash from circulation.
59
What is the significance of large central bank balance sheets in the context of QE?
They represent the vast amount of money created by the central bank in exchange for assets (mostly bonds), fundamentally altering the composition of the financial system’s assets and liabilities.
60
What does the IS model represent?
The IS model represents equilibrium in the goods market—that is, when aggregate demand equals output/income—with a negatively sloped curve showing that lower interest rates are needed for higher aggregate demand (output).
61
What factors shift the IS schedule?
Shifts in the IS curve are driven by changes in government expenditure (G), taxes (T), and expectations of future income growth.
62
How do changes in interest rates affect the goods market in the IS model?
Changes in interest rates move the economy along a given IS curve. A decline in the interest rate raises aggregate demand, increasing output, while anything that alters aggregate demand is depicted as a shift in the entire IS schedule.
63
What does the MP model depict in the context of the IS-MP framework?
The MP model depicts money market equilibrium and shows how monetary policy is conducted—either by choosing an interest rate or adjusting the money supply to achieve that rate.
64
How can monetary policy be conceptualized in the MP model?
Monetary policy can be seen either as choosing a specific value of the policy instrument (such as an interest rate target) at a given moment or as setting that target as a function of the state of the economy.
65
What happens to the MP curve if the central bank adopts a more expansionary stance?
An expansionary change in monetary policy—by choosing a lower interest rate for any level of income—shifts the MP curve rightward or downward.
66
What does the MP schedule indicate about money market equilibrium?
The MP schedule shows that for every level of real income, the central bank achieves its desired interest rate. It implies the corresponding level of money demand is met by passively supplying money to maintain equilibrium.
67
How is the slope of the MP schedule interpreted?
The slope indicates how aggressively the central bank raises the interest rate as output or real income increases.
68
What is the fiscal expansion in the IS-MP model, and what does it do?
Fiscal expansion—an increase in government spending (G)—shifts the IS curve to the right, raising both the equilibrium income and the interest rate if the monetary policy stance remains unchanged.
69
What is the 'crowding out' effect in the IS-MP model?
'Crowding out' occurs when higher interest rates from fiscal expansion discourage private investment, which partially offsets the expansionary impact of increased government spending.
70
Under what conditions might fiscal policy 'crowd in' private investment?
Fiscal policy can 'crowd in' private investment if, for example, public spending (like on infrastructure) enhances private firms’ productivity and the overall investment climate.
71
How can the central bank’s monetary policy interact with fiscal expansion in the IS-MP framework?
If the central bank eases policy (shifting the MP curve right/downward) at the same time as fiscal expansion, it can help keep interest rates from rising too much, allowing fiscal and monetary expansion to work together.
72
What is the effect of fiscal contraction in the IS-MP model?
Fiscal contraction, such as a cut in G, shifts the IS curve to the left (or downward), lowering output and interest rates as the goods market equilibrium adjusts.
73
How does a change in money demand affect the IS-MP equilibrium?
When money demand changes, the central bank adjusts the money supply to maintain its target interest rate, keeping rates stable for a given level of output.
74
What is the fiscal multiplier?
The fiscal multiplier measures how much GDP changes in response to a change in government spending or taxes, depending on factors such as leakage via imports and the effect on interest rates.
75
What is Ricardian equivalence in the context of fiscal policy?
Ricardian equivalence is the theory that when governments borrow, rational consumers anticipate future tax increases to repay the debt, leading them to increase their savings and potentially offsetting fiscal stimulus.
76
During what economic conditions are fiscal multipliers usually larger?
Fiscal multipliers tend to be higher during periods of recession or economic slowdown when additional spending is more likely to translate into higher aggregate demand.
77
Why might fiscal policy be less effective under certain conditions?
Its effectiveness may be limited due to implementation lags, imperfect and revised macroeconomic data, high existing government debt, and pessimistic consumer and business expectations.
78
How do monetary and fiscal policies work together to manage aggregate demand?
They are used to minimize output gaps—when actual output deviates from potential output. Expansionary policies can stimulate demand to combat a negative output gap, while contractionary policies are used to avoid overheating and inflation.
79
What is the zero lower bound problem in monetary policy?
When short-term interest rates are close to zero, traditional monetary policy tools lose effectiveness, sometimes requiring unconventional measures like quantitative easing (QE).
80
How does the composition of final demand change with different policy combinations in the IS-MP model?
With tight fiscal policy, the government’s share in GDP falls, while expansionary monetary policy tends to stimulate private investment, altering the mix between G (government spending) and I (investment).
81
What are the welfare costs associated with recessions in the IS-MP framework?
Recessions can lead to lost jobs, increased corporate and personal bankruptcies, financial stress, and long-term damage to the economy, emphasizing the importance of aggregate demand management.
82
What does potential output (Y*) represent?
Potential output is the level the economy can produce when all resources are fully and productively employed; policies aim to align actual output with Y* to prevent negative or positive output gaps.
83
How do policy lags affect the efficacy of fiscal and monetary policies?
Both types of policy influence the economy with delays, meaning that by the time an intervention takes effect, economic conditions may have changed.
84
Why is policy coordination between monetary and fiscal authorities important?
Coordination ensures that the policies reinforce one another to stabilize output, influence the composition of demand, and avoid conflicting economic signals that could undermine stimulus efforts.
85
In the IS-MP model, how does government borrowing from the private sector affect interest rates?
Borrowing from the private sector can push up interest rates by increasing demand for available funds, while financing through central bank channels may not have the same upward pressure.
86
How does the central bank maintain its target interest rate along the MP curve?
The central bank passively adjusts the money supply to match money demand at its target interest rate, ensuring money market equilibrium for varying levels of output.
87
What impact does an expansionary monetary policy have on the MP schedule?
It shifts the MP curve rightward (or downward), meaning that for any given level of income, the central bank sets a lower interest rate, enhancing aggregate demand.
88
Summarize the combined effect of expansionary fiscal and monetary policies in the IS-MP model.
Expansionary fiscal policy shifts the IS curve to the right, raising output and interest rates, while expansionary monetary policy (a shifted MP curve) can counteract the rise in interest rates, supporting robust aggregate demand without significant crowding out.
89
What are the potential downsides if fiscal stimulus is not coordinated with monetary policy?
Uncoordinated policy could lead to rapidly rising interest rates, crowding out private investment, and inefficient stimulus effects due to higher borrowing costs.
90
Why is accurate, timely macroeconomic data important for policy in the IS-MP framework?
Because policymakers base their adjustments on current economic conditions, delays or inaccuracies can lead to inappropriate stimulus or contraction measures, potentially exacerbating economic fluctuations.
91
What role does consumer and business optimism or pessimism play in the effectiveness of fiscal policy?
Pessimism can dampen the impact of tax cuts or transfer payments if households and firms decide to save the extra funds rather than spend them, reducing the boost to aggregate demand.
92
What is the central trade-off in designing fiscal policy measures?
Governments must balance immediate stimulus (e.g., spending cuts or tax cuts to boost demand) with long-term considerations such as fiscal sustainability, investment in public capital, and the possibility of influencing consumer expectations about future taxation.
93
How can fiscal policy alter the composition of final demand, according to the IS-MP model?
By affecting the shares of government expenditure versus private investment in GDP—tight fiscal policy lowers G’s share, while expansionary monetary policy can boost the share of investment (I).
94
How does monetary policy transmission work in a world where money demand adjusts to policy actions?
The central bank sets a target interest rate, and by adjusting the monetary base, it ensures that money demand is met without altering the target rate, effectively transmitting policy to real economic activity.
95
In what way do policy adjustments and the IS-MP framework help manage output gaps?
By coordinating fiscal and monetary policy to bring actual output closer to potential output (Y*), they help avoid the adverse effects of persistent unemployment or inflationary pressures.
96
What are the basic assumptions of the classical model regarding output and prices?
The classical model assumes that output is always at its long-run equilibrium (potential output) and any deviation is quickly corrected by fully flexible prices and wages.
97
How does the classical model differ from the Keynesian view regarding how output is determined?
While the IS-MP (Keynesian) model assumes aggregate demand determines output in the short run, the classical model considers both demand and supply, where output is fixed at potential and only prices adjust.
98
Why do most central banks opt for an inflation target around 2% instead of 0%?
A modest positive inflation target prevents deflation. With zero nominal rates, even a small negative inflation (deflation) would lead to high real interest rates, further reducing aggregate demand.
99
What problem arises if a central bank targets 0% inflation and a negative shock occurs?
With nominal rates at 0%, deflation leads to high real interest rates, deepening the contraction and making it difficult for monetary policy to stimulate the economy.
100
What is the purpose of leaving a margin of error through a positive inflation target?
It provides room for the central bank to cut interest rates in response to shocks, helping to counteract a potential deflationary spiral.
101
How does the central bank set its nominal interest rates to achieve a desired real interest rate?
The central bank forecasts inflation and then adjusts nominal interest rates so that, once inflation is subtracted, the desired real interest rate is achieved.
102
What does a shift downward in the real-risk (rr) schedule indicate?
A looser monetary policy—lower interest rates for any given inflation level—is indicated by a downward or rightward shift in the rr schedule.
103
What does the aggregate demand (AD) schedule represent in this context?
It shows how changes in inflation, via central bank interest rate decisions, affect aggregate demand.
104
Under what conditions is the AD schedule relatively flat?
When the central bank’s interest-rate decisions react very strongly to inflation and when interest rates have a large effect on aggregate demand.
105
What factors can shift the AD curve?
Shifts result from changes in monetary policy (via shifts in the rr schedule) or changes in the IS schedule (e.g., fiscal expansion, tax cuts, or alterations in net exports).
106
In the long run, how is potential output determined?
Potential output depends on the economy’s factors of production—physical capital, human capital, land, energy, and technological efficiency.
107
Why is the long-run aggregate supply (AS) curve vertical?
With full flexibility of wages and prices, any increase in inflation results in proportional wage increases, leaving real wages and real output unchanged.
108
What is monetary neutrality?
Monetary neutrality means that changes in nominal variables (like the money supply) affect only nominal quantities (such as prices and inflation), not real output or employment, once wages and prices adjust.
109
How does an economy reach equilibrium output and inflation in the classical model?
Equilibrium is where the AD curve (which determines the price level) intersects the vertical AS curve at potential output.
110
How does the central bank respond if equilibrium inflation deviates from its target?
The central bank adjusts the interest rate (shifting the rr schedule) to bring inflation back to target via its influence on aggregate demand.
111
What is the impact of a positive supply shock on inflation?
A positive supply shock (e.g., productivity gains) is deflationary as it lowers costs; the central bank may lower interest rates to bring inflation back to target.
112
How does a negative supply shock affect the economy?
A negative supply shock (like a sudden increase in oil prices) raises inflation; if unchecked, it could lead to an overheated price level, though centrally, tighter policy may be applied.
113
In the context of aggregate demand, what distinguishes a supply shock from a demand shock?
Supply shocks affect the price level without altering potential output, while demand shocks shift the AD curve; in the classical framework, only the price level changes.
114
In the context of aggregate demand, what distinguishes a supply shock from a demand shock?
Supply shocks affect the price level without altering potential output, while demand shocks shift the AD curve; in the classical framework, only the price level changes in the long run.
115
What is the short-run aggregate supply (SRAS) curve, and why is it upward sloping?
The SRAS curve is upward sloping because, in the short run, prices are somewhat flexible but wages are rigid; higher-than-expected price increases raise firms' profits, leading to a positive relationship between price level and output.
116
How do firms and workers adjust when prices deviate from expectations in the short run?
In the short run, if prices rise faster than expected (with fixed nominal wages), firms increase output; over time, wage growth adjusts upward, shifting the SRAS curve upward until long-run equilibrium is restored.
117
What is the adjustment process from the short run to the long run after an AD shock?
Output and employment may change initially due to rigid wages, but falling inflation causes lower nominal wage growth over time, shifting the SRAS curve until the economy returns to potential output (real variables unaffected).
118
How does the central bank accommodate a permanent positive supply shock?
If a permanent positive supply shock lowers inflation permanently below target, the central bank may lower interest rates and the AD curve shifts right, ultimately raising output while meeting the inflation target.
119
What happens after a temporary supply shock, such as a rise in oil prices?
A temporary supply shock shifts the SRAS curve up and left, reducing output and employment. Over time, lower price levels reduce nominal wage growth, shifting SRAS back down and restoring equilibrium.
120
How might the central bank respond to a temporary supply shock to avoid a recession?
By increasing the inflation target (and thereby lowering interest rates) to shift the AD curve, though this option is generally avoided since central banks are reluctant to tolerate permanently higher inflation.
121
What is the output gap?
The output gap is the percentage deviation of actual output (Y) from potential output (Y*), with a positive gap indicating overheating and a negative gap indicating underutilization.
122
How do institutions like the OECD use the output gap?
Organizations such as the OECD estimate potential output each year to assess whether economies are operating above or below full capacity, informing policy decisions.
123
What are the primary roles of aggregate demand (AD) and aggregate supply (AS) in determining equilibrium?
In the classical (long-run) view, AD only determines the price level, while AS (vertical at potential output) determines real output and employment.
124
How do shifts in the 45-degree line help derive the AD curve in these models?
The 45-degree line helps translate the intersection of the IS curve with the rr schedule (real-risk schedule) into corresponding points for inflation and output, thereby tracing the economy’s AD curve.
125
What influences cause shifts in the AD schedule aside from monetary policy and changes in inflation?
Shifts in the IS schedule due to fiscal policy changes (like government spending or tax changes) or autonomous changes in consumption also shift the AD curve.
126
Summarize why targeting exactly 0% inflation may be problematic in practice.
Targeting 0% inflation risks deflation in adverse shocks, which can raise real interest rates when nominal rates hit the zero lower bound, thereby stifling aggregate demand and worsening economic contractions.
127
What does “flexible inflation targeting” mean in modern monetary policy?
It refers to a strategy where central banks target a modest inflation level (usually around 2%) while allowing for some fluctuations, using policy tools like the Taylor rule to adjust interest rates as economic conditions change.
128
What is the Taylor Rule?
The Taylor Rule is a guideline for setting the nominal interest rate based on deviations of actual inflation from the target and actual output from potential output. It implies that when inflation exceeds its target, the nominal rate should be raised by more than one-for-one to increase real rates and dampen inflation.
129
Who typically sets the target inflation rate in a Taylor-rule framework?
The target inflation rate is usually set by the government, even though central banks use it to adjust policy instruments.
129
According to the Taylor Rule, why might central banks increase nominal interest rates by more than the increase in inflation?
To raise the real interest rate sufficiently so that future inflationary pressures are cooled, reflecting both current conditions and future expectations.
130
What do the parameters (often noted as 'a' and 'b') in the Taylor Rule represent?
They indicate the relative weight or importance that policymakers assign to deviations of inflation and output from their equilibrium levels.
131
What equation represents the Quantity Theory of Money?
MV = PY, where M is the nominal money supply, V is the velocity of money, P is the price level, and Y is real output.
132
Why is the velocity of money (V) generally considered stable in the short run?
Because it is determined by institutional and technological factors that do not change rapidly.
133
How does the Quantity Theory of Money explain sustained inflation?
Since V is relatively stable and Y grows gradually, a sustained increase in M (money supply) leads directly to proportional increases in P (prices).
134
What is the focus of the Quantity Theory of Money in the long run?
It emphasizes that long-run inflation is primarily a monetary phenomenon, as money is neutral once prices and wages fully adjust.
135
What is the Fisher Hypothesis?
The Fisher Hypothesis states that the real interest rate is approximately equal to the nominal interest rate minus expected inflation, implying that nominal rates adjust to offset changes in inflation.
136
Write the Fisher equation.
Real Interest Rate = Nominal Interest Rate − Expected Inflation Rate.
136
What did A.W. Phillips originally find in 1958 regarding inflation and unemployment?
He identified a strong negative relationship—higher inflation was statistically associated with lower unemployment rates.
137
What is the basic idea behind the Phillips Curve?
The Phillips Curve suggests that, in the short run, there is a trade-off between inflation and unemployment as wages and prices adjust with economic cycles.
138
Why do higher inflation rates during booms tend to be associated with lower unemployment?
When demand is high, firms compete for workers, and workers can negotiate for higher wages. These higher labor costs are then passed on to consumers as higher prices.
139
How can policymakers theoretically use the Phillips Curve in decision making?
They can manipulate aggregate demand through fiscal or monetary policy to choose an acceptable point on the trade-off between inflation and unemployment in the short run.
140
What is the “natural rate” of unemployment?
It is the level of unemployment that persists when the economy is at full potential output, reflecting frictional and structural unemployment—not cyclical factors.
141
In the long run, what does the Phillips Curve look like?
It is vertical at the natural rate of unemployment, meaning there is no trade-off between inflation and unemployment once expectations adjust.
142
What happens on the short-run Phillips Curve when inflation expectations rise?
The short-run Phillips Curve shifts upward (or to the right), so that for any given rate of unemployment, inflation is higher.
143
What is stagflation?
A situation where the economy experiences both high inflation and high unemployment simultaneously, often due to a negative supply shock.
144
How can supply shocks affect the Phillips Curve?
Negative supply shocks (e.g., rising oil prices) can shift the curve upward, causing higher inflation with higher unemployment, while positive shocks can be deflationary.
145
Why is the relationship between inflation and unemployment considered weaker today?
Factors such as central bank credibility, globalization, and labor market changes (like gig work and zero-hour contracts) have moderated the traditional trade-off.
146
List some of the costs of inflation.
Inflation can distort price signals, reduce the real value of savings, lead to money illusion, and negatively affect long-term lending and borrowing by transferring wealth between borrowers and lenders.
147
Why can hyperinflation be especially damaging compared to moderate inflation?
Hyperinflation creates extreme uncertainty, severely distorts economic decision-making, undermines saving and investment, and can collapse financial intermediation entirely.
148
What do studies suggest about moderate high inflation and GDP growth?
Empirical evidence shows that moderate high inflation does not necessarily correlate with lower GDP growth, though it is generally disliked by the public.
148
Explain the short-run trade-off implied by the Phillips Curve.
In the short run, due to nominal wage rigidities, higher-than-expected inflation can temporarily reduce unemployment; however, once expectations adjust, this trade-off vanishes.
149
What happens to nominal wages when workers correctly anticipate inflation?
They adjust upward by the anticipated rate, leaving real wages—and therefore employment and output—unchanged in the long run.
149
How do inflationary expectations influence future inflation?
Future inflation is heavily influenced by current inflationary expectations; once expectations shift, businesses adjust prices and wages, nullifying temporary trade-offs.
149
Why is central bank credibility important for monetary policy?
Credible central banks are better able to anchor inflation expectations, making policy more effective and reducing the likelihood of destabilizing inflation–unemployment trade-offs.
150
Summarize the main points regarding the trade-offs between inflation and unemployment based on the Phillips Curve.
There is a short-run trade-off due to wage and price rigidities, but in the long run (after expectations adjust), no permanent trade-off exists as the economy settles at the natural rate of unemployment; policy credibility is key.
151
What is the overall significance of the Taylor Rule, Quantity Theory of Money, and Phillips Curve in modern macroeconomics?
These frameworks help explain how central banks set interest rates, how changes in the money supply influence inflation, and how short-run trade-offs between inflation and unemployment emerge and eventually dissipate as expectations adjust.
152
What is the definition of an exchange rate (S)?
It is the domestic currency price of one unit of foreign currency. For example, the bilateral exchange rate between the US and UK shows the price of dollars in terms of pounds.
153
What does an increase in the exchange rate (S) imply?
An increase in S implies a depreciation of the home currency (it costs more home currency per unit of foreign currency) and an appreciation of the foreign currency relative to the home currency.
154
How does a depreciation of the home currency affect exports and imports?
Depreciation reduces the foreign currency price of domestic exports, boosting exports, while increasing the domestic currency price of imports, making them more expensive.
155
What is the difference between bilateral and multilateral (trade-weighted) exchange rates?
A bilateral exchange rate is the exchange rate between two currencies, whereas a multilateral exchange rate is a weighted average of a currency’s exchange rates against several trading partners, with weights reflecting each country’s share of trade.
156
What is a “spot rate” in foreign exchange markets?
A spot rate is the current exchange rate at which currencies are bought and sold for immediate delivery.
157
What are forward exchange rates?
Forward exchange rates are contracts that commit two parties to exchange one currency for another at a specified future date and at a pre-determined rate.
158
Define the bid rate in the context of exchange rates.
The bid rate is the rate at which dealers are willing to buy a given currency—and conversely, sell the other currency.
159
Define the offer/ask rate in exchange rate terminology.
The offer (or ask) rate is the rate at which dealers are willing to sell a particular currency (or buy the other currency).
160
What is the bid-ask spread?
It is the difference between the bid and ask rates; it represents the transaction cost and profit margin for currency dealers.
161
How is the equilibrium exchange rate determined in the demand/supply model?
The equilibrium rate is determined by the intersection of the demand curve for foreign currency (from importers, foreign investment outflows, speculators) and the supply curve of foreign currency (from exporters, foreign investment inflows, speculators).
162
In a freely floating exchange rate system, what determines the exchange rate level?
In a free float, the exchange rate is determined exclusively by the market forces of supply and demand with no outside government or central bank intervention.
163
How can a government/central bank maintain a fixed exchange rate?
By intervening in the foreign exchange market—for example, selling foreign currency and buying domestic currency to offset market pressures and maintain the target rate.
164
What is meant by a nonconvertible (or nonconvertible) exchange rate system?
It is one where the government fixes the exchange rate and imposes legal restrictions on foreign currency transactions, often prohibiting private foreign currency holdings unless officially authorized.
165
How does a convertible fixed exchange rate system operate?
The currency is tradable, but the central bank actively intervenes in the forex market by buying or selling currencies to maintain a fixed rate, which in turn affects the domestic money supply.
166
What are “managed floats” (or “dirty floats”) in exchange rate arrangements?
These are exchange rate systems where the exchange rate is primarily determined by market forces, yet the central bank occasionally intervenes to influence its level.
167
What does the movement in foreign reserves indicate in a managed float system?
Changing levels of foreign reserves signal the extent of central bank intervention in the foreign exchange market.
168
What is meant by sterilisation of central bank interventions?
Sterilisation is the process by which a central bank counteracts the effect of foreign exchange market interventions on the money supply—typically by conducting offsetting open market operations in government securities.
169
What is the “impossible trinity” (or trilemma) in international finance?
A: It is the concept that a country cannot simultaneously maintain fixed exchange rates, allow free capital mobility, and have an independent monetary policy. Choosing any two means sacrificing the third.
170
How does an increase in central bank intervention affect the money supply when maintaining a fixed exchange rate?
Without sterilisation, interventions to maintain a fixed exchange rate change the money supply because buying or selling foreign currency affects domestic liquidity.
171
Why is it necessary for the central bank to sterilize its forex interventions in a fixed exchange rate system?
To prevent unwanted changes in the domestic money supply that could interfere with other monetary policy objectives, such as controlling inflation.
172
What factors determine the demand for foreign currency in the supply/demand model?
Demand is generated by importers needing to pay abroad, domestic investors making outgoing foreign investments, and speculators buying foreign currency.
173
What factors determine the supply of foreign currency in the supply/demand model?
Supply comes from exporters receiving foreign currency, foreign investors making incoming investments, and speculators selling foreign currency.
174
How would an appreciation of the domestic currency affect international trade?
Appreciation makes domestic exports more expensive for foreign buyers (potentially reducing exports) and imports cheaper for domestic consumers (potentially increasing imports).
174
How does the concept of “bid-ask spread” affect the quoted exchange rate?
Exchange rates are generally quoted as the midpoint between the bid and ask rates, embodying the average transaction price.
174
What is the key trade-off of the impossible trinity?
A nation must choose between having a fixed exchange rate and independent monetary policy if capital mobility is to be preserved, or give up one of these options.
175
How can a government counteract a depreciation of its currency if it wants to fix the exchange rate?
The central bank can sell its foreign currency reserves and buy domestic currency, increasing demand for the domestic currency to support its value.
176
What is the Balance of Payments?
It is an account that records all international transactions between the UK (or any country) and the rest of the world, tracking the flow of money in and out of the country.
177
What are the two main components of the Balance of Payments?
The Current Account and the Capital (or Financial) Account.
178
What kind of transactions are included in the Current Account?
The Current Account covers transactions that create no future claims in either direction. This includes the export and import of goods and services, exports and imports of labour and capital services, and unrequited transfers.
179
What are the primary components of the Capital/Financial Account?
They include direct and portfolio investment, financial derivatives, net lending by non-government agencies, and changes in foreign reserves.
180
What does a Current Account deficit mean?
A Current Account deficit indicates that a country’s imports (or payments to foreigners) exceed its exports (or receipts from abroad) and must be financed by a surplus in the Capital Account (i.e., capital inflows).
181
How is a Current Account surplus financed?
It implies that the country is exporting more capital than it is receiving; in other words, it is accumulating foreign assets, financed by a deficit on the Capital Account.
182
What is the Net International Investment Position (NIIP)?
NIIP is a country’s net foreign wealth, calculated as the difference between the foreign assets held by domestic residents and the domestic assets held by foreigners.
182
Why must the Balance of Payments always “balance” by definition?
Because every deficit recorded in the Current Account must be offset by a surplus in the Capital Account and vice versa—just as an individual's spending above income is exactly balanced by an increase in liabilities or a reduction in assets.
183
How is GDP (Y) expressed from the expenditure perspective in relation to the Current Account?
GDP is given by Y = C + I + G + (EX − IM). Since (EX − IM) represents net exports, it is equivalent to the Current Account (CA) balance in this simplified identity.
184
What is National Saving (S), and how is it calculated?
National Saving is the portion of income not spent on consumption (C) or government purchases (G). It is calculated as S = Y − C − G.
185
Express the relationship between National Saving, Investment, and the Current Account.
The identity S − I = EX − IM shows that if a country saves more than it invests, it runs a current account surplus; if it invests more than it saves, it runs a current account deficit.
186
How can National Saving be decomposed?
National Saving equals private saving (SP = Y − C − T) plus government saving (SG = T − G); hence, S = SP + SG.
187
How is the Current Account linked to savings and investment?
The Current Account balance (CA) equals private saving plus government saving minus investment: CA = SP + SG − I. A deficit implies I > (SP + SG).
188
What are “twin deficits”?
The term “twin deficits” refers to the simultaneous occurrence of a fiscal deficit (government spending exceeds revenues) and a Current Account deficit (investment exceeds national saving).
189
How might a Current Account deficit affect a country’s NIIP?
A Current Account deficit implies that the country is borrowing from abroad, which worsens (reduces) its Net International Investment Position (NIIP) over time.
190
What types of transactions in the Current Account create no future claims?
Transactions such as exports/imports of goods and services, labour and capital services, and unrequited transfers (like remittances) create no future claims.
190
In a Balance of Payments account, how are data often presented?
Data are typically presented on a net basis, showing the excess of credits over debits in each account (Current and Capital), such as in the UK Balance of Payments table.
191
How does the Curr. Account identity relate to Keynesian national income identities?
Since Y = C + I + G + (EX − IM) and National Saving S = Y − C − G, it follows that S − I = EX − IM, which means that the current account balance reflects the difference between saving and investment.
192
What is one key debate about the implications of a Current Account deficit?
There is debate over whether a Current Account deficit is inherently bad; while it may indicate external borrowing and future obligations, it can also reflect robust investment relative to saving, which might be beneficial if it finances productive investments.
193
Summarize the overall purpose of the Balance of Payments.
The Balance of Payments serves as an index of the flow between the supply and demand for the domestic currency in international transactions, providing insights into a country’s international financial position.
