Macro Term 2 Flashcards
(18 cards)
Generic Intertemporal Utility Function
U = U(c1) + Beta.u(c2)
Power utility function
If you want to get of power 1/x…
Power by x
If you want to get of power x…
Power by 1/x
What is the Ricardian Equivalence theorem?
If Gov spending stays the same, then a decrease in T1 will require more debt/borrowing to pay for the government spending.
More debt will require a higher T2 next year to pay it off.
Understanding this, if T1 goes down, although consumers will get more disposable income…they know in the next period, T2 will go up.
So they will save any extra diposable income to pay off next year’s tax, keeping CONSUMPTION CONSTANT.
Why might Ricardian Equivalence not hold?
- Governments & households have different planning horizons - e.g. consumers may die before having to pay the next period’s tax, so when tax goes down now, consumers may spend more now knowing they won’t have to pay next year’s tax
- Intragenerational redistribution
- Distortionary taxes (e.g. VAT) could distort prices and therefore affect consumption
- Credit constraints (e.g. if someone cannot borrow as much as they want to on their credit > when tax goes down, more disposable income, they may increase consumption)
What influences the natural rate of employment?
B - tech up, MPL up, hire more workers because they’re more productive
mp - price mark up, higher prices, output goes down because of reduced demand, fewer workers needed, less employment, unemployment up
mw - wage mark up, higher wages, less employment because workers more expensive, unemployment up
b - benefits, higher b, firms have to pay workers more to get them off benefits, so costs firms more to hire, unemployment up
Policy Ineffectiveness Proposition
If private agents know the Central Bank’s monetary rule line and have access to the same information as the Central Bank, the Central Bank cannot systematically affect output.
We can see this in the equations: h and b are the only two parameters the CB can set, but neither output nor inflation depend on h and b. Therefore the CB’s policy cannot affect output or inflation, only unexpected economic shocks can.
Overall, this implies a very limited role for the Central Bank.
Does PIP hold in real life?
Research by Ball shows that the sacrifice ratio:
= Cumulative Output Loss divided by change in inflation
Is equal to 1.4%. But if PIP were true, then it would be just 0% because the CB would have no affect at all on the economy. This is evidence against PIP.
One reason PIP does not apply to real life is staggered wages. Suppose there are just two trade unions in the economy, who bargain for fixed wages but in alternating years. The fixed wages means private agents act like agents with adaptive expectations, despite being rational. The CB can therefore be effective because it can make decisions ahead of private agents and affect the economy.
Finally, it may be the case that the CB has more up-to-date expectations than private agents, e.g. because it is directly collecting the data itself. [Do the derivation] As we can see, the CB can now affect output and inflation gap because both depend on h and b, the CB’s parameters.
Wordy half-life question:
It has been found that a model described by the equations above creates persistence in output that is much higher than what has been found in the data.
How has such finding been obtained?
Discuss why the persistence is higher.
Discuss how the model could be improved.
How has such finding been obtained?
Using microeconomic data, alpha and gamma have been estimated.
Substituting in alpha and gamma into the half-life equation, we find an estimate of 3 years. In other words, it takes 3 years for the economy to return half-way back to equilibrium after a shock.
However, the real data shows half-life to be much shorter. So our model generates too much persistence.
Discuss why the persistence is higher:
This is perhaps because we have incorrectly assumed naive expectations in our model and real life expectations our closer to rational.
Discuss how the model could be improved:
We could change our equation for inflation expectations to reflect more rational or adaptive expectations.
WTF is half-life?
How long it takes to get halfway back to equilibrium after a shock.
To get all the way back it takes infinitely many periods, but we can measure halfway back using the half-life.
h>0
If h < 0, this means that higher inflation leads to a decrease in real interest rates which causes a increase in consumption and a increase in investment which leads to higher inflation and eventually leads to a hyper inflation. therefore must be h>0.
1970’s high inflation rate
In the pre -volcker era up until 1979, the economy experienced a very high inflation rate.some of this was because of oil shocks, but clarida (2000) found that policy had a role, too…because pre-1979, h was estimated to be below 0.
If h < 0, this means that higher inflation leads to a decrease in real interest rates which causes a increase in consumption and a increase in investment which leads to higher inflation and eventually leads to a hyper inflation. This explains the high inflation rate.
sigma > 1
we require sigma > 1 because sigma is the elasticity of firms demand. if sigma is constant and always less than or equal to one then demand is always inelastic, so a firm would increase revenues and profits by increasing price and reducing output to an optimal output of 0. the economy would collapse. so we require sigma, if constant to be greater than 1.
natrual rate of emplyment is …
1-U bar
slope h and b
Rotation
h (+)
b(-)
Shift
h (-)
b (+)
h tells us what priority the CB give inflation gap. if h increases, the central bank focuses more on inflation gap. so inflation increased, r would increase a lot to control it, so output would decrease a lot so the slope becomes flatter.
b tells us what priority the CB give output gap. if b increases, the CB focuses more on output gap and relatively less about the inflation gap. so, if inflation increased, r would increase only a little to control it, so output would decrease only a little, so the slope becomes steeper.
have deflations usually been costly?
looking at the data from Balls research on the sacrifice ratio = cumalitive output loss divided by the change in inflation, we see that the disinflation leads to 1.4% cumlative output loss, which is a significant cost to society.
how does bargained wage depend on e?
e is the real wage elasticity of firm’s labour demand. if e increases, firms are more resposive to changes in wages, and will therefore bargain for lower wages, decreasing wi
