Macro Unit 8 Flashcards
(14 cards)
What is equilibrium and stability?
- an equilibrium is a situation that does not change unless an external change disturbs it
- an equilibrium is stable if a small movement away from the equilibrium is self-correcting, leading to movement back to equilibrium
- an equilibrium is unstable if, when a shock disturbs the equilibrium, there is a subsequent tendency to move even further away from the equilibrium
- a tipping point is an unstable equilibrium at the boundary between two regions. A small movement into either of the regions causes a movement further into the same region, away from equilibrium.
Use a ball on top of a hill as an example. It is an unstable equilibirum and on the tipping point because any slight movement causes the ball to roll down
What is negative and positive feedback?
-ve: feedback that counteracts movement away from equilibirum, ie pushes against the initial movement. If feedbacks are negative, equilibirum is stable.
+ve: feedback that reinforces a movement away from equilibrium. If feedbacks are positive, the equilibrium is unstable.
A ball on top of a hill is surrounded by positive feedback, as any initial movement will amplify its movement down the hill.
A ball at the bottom of a valley is surrounded by negative feedback as feedback will work against any initial movement, returning the ball to the bottom of the valley.
What is a poverty trap?
- people who have little wealth are unable to undertake actions to increase their wealth
- people with little wealth and are unable to borrow, they avoid taking risks that could benefit them if it paid off because if it didn’t pay off they wouldn’t survive
- even if those in a poverty trap get a little bit more wealth, it is unlikely to be enough to overcome the negative feedback pushing them back into poverty
- those in a poverty trap are ‘locked in’ to an equilibrium they would like to escape
- risk averse individuals have a preference for certainty, ie they wouldn’t survive rather guarantee getting £10 than a 50-50 chance of getting £20 or nothing
What is an asset price bubble and how do they occur?
- people buy assets as they expect they can sell them for a higher price in the future, this is capital gain
- some people place a high value on an asset so purchase it, which tends to raise the price of the asset, leading others to expect future price rises, motivating them to purchase the asset, and this repeats
- expectations of higher prices translate into actual higher prices, driving an asset price bubble (when the market price rises substantially and continuously fuelled by expectations of future price increases)
- this is a positive feedback process
- assets and share prices in markets are often dictated by beliefs about future value and so if a few people believe the price may go up or down, there will likely be a positive feedback process that amplifies this change
If consumers only cared about current prices, how would the housing market respond to a change in equilibrium?
We would expect a negative feedback process to restore a stable equilibrium.
- the housing market is initally in equilibrium (S=D) such that the price in this period is the same as in the next
- if price were to rise to Pa, supply>demand and there is excess supply
- some sellers realise they will not be able to sell all they would like at the going price so cut the price they are asking and price falls to Pb in the next period
- on a diagram with price in period 1+t on the y axis and price in period t on the x axis, and a 45 degree line, we find Pa on the line
- at the lower price Pb = Pt+1, the point (Pa,Pb) is below the 45 degree line
- Pb is still above the equilibrium P, so price falls again to Pc and we can find Pb on the horizontal axis on the other diagram, (Pb,Pc) is again below the 45 degree line.
- doing this for all points in this process until the price reaches P gives us a line shallower than 45 degrees, called the price dynamics curve
What is the price dynamics curve?
A graph of the relationship between the price of a good in period t and the price in period t+1. It is flatter than the 45 degrees line.
Where the PDC intersects the 45 degree line represents a market equilibrium.
PDC corresponds to a case of stable equilibrium. If a shock causes the price to move away from the equilibrium level, a process of negative feedback along the PDC restores equilibrium in the market.
Explain the price dynamics curve for housing assets when beliefs about future prices matter
We use a supply and demand diagram as before but now the demand curve depends not only on current price but also on expected future prices. If the expected future price rises, demand will be higher at each level of the current price, so the demand curve will shift outwards.
- a price shock raises the price of houses from P* to Pa. Excess supply at Pa leads to a process of dynamic adjustment back to the equilibrium price.
- but some people believe the price rise is the beginning of a period of rising prices, so the demand curve shifts outwards.
- now at Pa there is less excess supply. The process of negative feedback occurs with smaller price adjustments. As prices fall and people realise the price rise was temporary, the demand curve shifts back to where it was before and prices stabilise at P*
The price dynamics curve is still flatter than the 45 degrees line but steeper than when consumers only cared about current prices representing smaller price adjustments.
The housing market equilibrium is thus stable.
Explain what happens as a result of a large belief in future prices rises in the housing market?
- if many believe that the initial price rise signals further increases, there will be a larger shift in the demand curve, causing further price rises
- this time, when initial price rises to Pa, the demand curve shifts outwards such that there is excess demand for houses
- the price then rises above Pa to Pb in the next period. This reinforces the b eilends that prices are rising and so the demand curve shifts outwards again leading to more excess demand
- this cycle continues leading to a positive feedback process of runaway prices away from the equilibirum
- PDC passes through 45 degree line at P* but is now steeper than this line. The equilibrium is now unstable
- the positive feedback continues creating a bubble until there is a change in expectation of continuous price rises
Explain non linear PDCs
PDCs can be curved or S-shaped and hence intersect the 45 degrees line multiple times, suggesting multiple equilibirums with unchanging prices.
Ie an s shaped PDC that crosses the 45 degree line three times gives us a model of the housing market with 3 equilibrium - a stable equilibrium at a low and high price and an unstable equilibrium between the two
PDC is above the 45 degree line between the unstable equilibrium and stable high price equilibirum
Any price shock at the unstable equilibirum produces price movements in the same direction as the shock (+ve feedback), so it is a tipping point
The starting point is the equilibrium at the low price. Only a price shock large enough to take the market onto the steep part of the PDC above the 45 degree line (beyond the unstable equilibrium tipping point) will evoke a positive feedback process producing ever-larger price rises.
This process continues until the house market converges to the stable equilibrium at the high price equilibrium
Similarly a large fall in price can produce a collapse from the high price equilibrium to the low price equilibrium
Explain shifts in the PDC
The PDC tells us how the price that will occur next year depends on the price this year. The price next year depends on other things however, such as what people expect to happen to house prices in the future.
If at a high price stable equilibrium people get weary about house prices being too high and therefore expect price falls in the future, homeowners may sell their houses in pursuit of capital gain. The expected price next period is lower than the price this period, which will be a new point in a new PDC vertically below the original PDC. The entire PDC shifts down, so there is a new price for each equilibrium (stable equilibriums are now at a lower price and the unstable tipping point is at a higher price)
The downward shift of the PDC brings the market closer to the tipping point.
If confidence in the market increases again and prices are expected to rise in the future, the PDC may shift up to its original.
If people still believe the price is too high on the lower PDC, the PDC will shift vertically downward again.
This new PDC may be beneath the 45 degree line entirely apart from at the extremely low price equilibrium, and so the market converges to this low price.
Hence the bubble has popped and has resulted in a major crash.
What are the 2 factors that may disrupt an equilibrium?
- Shocks: change in this period’s price due to reasons outside the model that then affects next period’s price. This causes a movement along a PDC)
- Shifts: there is a change in beliefs about future house prices for reasons other than a change in the price itself. This causes a movement of the whole PDC.
Explain how households exploit capital gains and leverage on houses
- when house prices are expected to rise, households tend to increase their borrowing because the expected capital gain from the price increase raises the return on their investment in housing. Borrowing to invest is leverage.
- consider a households’ balance sheet. The house is an asset and the mortgage is a liability. The household’s equity in the house is the house value - mortgage (assets-liabilities). It is the proportion of the house the household owns, the rest is owned by the bank.
- the amount of debt is fixed in nominal terms but the value of the house fluctuates as house prices change. Therefore the household’s equity in the house changes too.
- if a house costs $200,000 and the household makes a down payment of 10% (20,000), it borrows $180,000 and owns $20,000. The leverage ratio is 90% (180/200)
- if the house price rises by 20% to $240,000, the return on equity the household has invested in the house is 200% (the value of the equity stake has tripled from $20,000 to $60,000. The leverage ratio falls to 75% (180/240)
- if the household anticipates further house prices rises, they can increase their leverage. The more highly leveraged a house is, the smaller the net worth/equity of the household, making households more vulnerable to price falls.
When the price of a house falls to below the mortgage, this is negative equity.
What is the financial accelerator?
- when households borrow to buy a house, this is a secured loan because of collateral. If the household fails to pay the mortgage, the lender (a bank) can take possession of the house. As such the lender is protected from the household defaulting on their loan.
- collateral plays an important role in sustaining a housing boom
- when the market value of a house rises, the household’s equity increases because the mortgage is fixed.
- the household can now borrow more from the bank by supplying this more valuable collateral
- since the household secures a larger loan, they use it to move up the housing ladder to a better property. The increased demand for houses pushes up the prices further, sustaining a bubble.
- the opposite is true if house prices fall/
The combined role of leverage and collateral in amplifying a house price boom or bust is referred to as the financial accelerator.
What are the impacts of housing crisis on the macroeconomy?
- Households have a target wealth which they try to maintain when economic circumstances change through saving and spending.
- non credit-constrained: A rise in house prices increases a household’s wealth relative to their target wealth and increasing their net worth. They will want to save less and will be able to borrow more. Consumption increases.
- credit constrained: a rise in house prices leads to higher consumption spending because the higher collateral enables more borrowing.
- falls in house prices have an amplified effect as households will be concerned with their wealth and save more if it is below target. This reduces autonomous consumption and hence reduces AD.
