Term 2 Week 8-9: Stabilisation Policy

Question 1

What do monetary and fiscal policy involve the adjustment of (2)

Answer 1

-Monetary policy involves the adjustment of i and unconventional MP
-Fiscal policy responses involve the adjustments of G and T

Question 2

How may monetary policy change for large and small economies (1,2)

Answer 2

-In large economies, the main transmission channel of IR changes goes through investments

-In small economies, the exchange rate is a very important channel, as international investors want to hold and trade financial assets from around the world
-A decrease in the policy rate -> decrease in demand for bonds -> depreciation of ER -> rising CA -> rising AD

Question 3

What is the favoured stabilisation tool + limitations (1,2)

Answer 3

-Monetary policy is the favoured stabilisation tool, as it can be changed more frequently than FP

Limitations included:
-The zero lower bound
-Countries without their own currency

Question 4

What are some unconventional monetary policy (3)

Answer 4

-Influencing expected inflation
-Quantitative easing
-Negative interest rates

Question 5

What is Quantitative easing, and what is it used for (1,4)

Answer 5

-Quantitative easing is when a central bank purchases financial assets to inject liquidity in the economy

-It is used when traditional monetary policy becomes ineffective, especially at the zero lower bound
-It is used to stimulate economic growth during recessions/deflationary periods
-It is used to lower long-term interest rates and increase liquidity
-It is used to encourage lending and investment

Question 6

How does QE work, and what are the risks posed (7, 4)

Answer 6

-The CB purchases long-term government bonds from commercial banks/financial institutions
-Purchases inject cash into the banking system, increasing the reserves of commercial banks
-As demand for bonds increases, their price rises, and their yield falls
-Government bond yields serve as a benchmark for IR across the economy
-As government bond yields decline, interest rates on borrowing also decrease, making borrowing cheaper
-With lower interest rates, banks are encouraged to lend more to businesses’ and individuals, stimulating consumption and investment
-Increased consumption and investment drive higher economic growth

Risks include:
-Inflation (excess liquidity)
-Asset bubbles (artificially low IR)
-Diminishing returns (prolonged QE reduces effectiveness)
-Exit challenges (Reversing QE is difficult without disrupting markets)

Question 7

What is an example of Quantitative easing (1,2)

Answer 7

-Quantitative easing was implemented by the Federal Reserve (US) and Bank of England (UK) following the 2008 financial crisis

-The US implemented $2.1 trillion of QE
-The UK implemented £435 billion of QE

Question 8

What are negative interest rates (2)

Answer 8

-Negative interest rates occur when the central bank sets their policy rates below 0
-Commercial banks pay interest on reserves they hold at the central bank, forcing banks to lend more money and leading to lower interest rates across the economy

Question 9

Why do central banks use negative interest rates, and what are some potential risks (4, 4)

Answer 9

Negative IR’s:
-Encourage banks to lend
-Lower borrowing costs
-Weaken the currency
-Raise inflation expectations

However, potential risks include:
-Bank profitability (Reduces banks net interest margins, making lending less profitable)
-Cash hoarding (people may hold cash rather than deposits)
-Asset bubbles (ultra-low borrowing costs fuel excessive risk taking)
-MP limitations (if banks refuse to pass on negative IR’s, the policy may not work as intended)

Question 10

What is an example of countries which used a negative interest rate (2)

Answer 10

-In 2014, the ECB cut the bank rate to -0.1%, to combat low inflation
-In 2016, the Bank of Japan cut the bank rate to -0.1%, to combat low inflation and weaken the yen

Question 11

What is government spending (2)

Answer 11

-Government spending refers to expenditures on goods and services, including government consumption and investment
-In the UK, G = 20% of GDP, this not including transfer payments as they don’t directly contribute to AD

Question 12

Why is government investment stable over time, and what does this mean (2)

Answer 12

-Unlike private investment, government investment doesn’t fluctuate with capacity utilisation or move with business confidence, and hence is stable over time
-This makes government spending a key tool for stabilising the economy

Question 13

What is T (1,1)

Answer 13

-T = tax revenues - transfers

-Tax revenues are raised from the economy, transfer payments have an indirect effect on AD through consumer spending

Question 14

What is the scope of fiscal policy (3)

Answer 14

-Income redistribution
-Resource allocation
-The provision of public goods

Question 15

What is the scope of fiscal policy as stabilisation policy, and the downside of this (2,1)

Answer 15

The scope involves:
-Discretionary fiscal policy
-Automatic stabilisers

-However, fiscal policy affects public debt, especially disretionary fiscal policy

Question 16

What is the short run multiplier (2)

Answer 16

-The short-run multiplier tells us the partial equilibrium effect of a change in government spending, holding everything else constant
-The short-run multiplier captures the immediate effect of government spending before wages, prices and policies adjust

Question 17

What is the short-run multiplier formula, and what does this tell us (2)

Answer 17

-k = 1/(1-c₁(1-t))
-Since 0 < c₁, t < 1, the multiplier is always greater than one

Question 18

What are key determinants of the full effect of government spending in general equilibrium (3,2)

Answer 18

Key determinants include:
-The economic model used
-Assumptions about monetary policy response
-The initial conditions of the economy

-This is because the general equilibrium outcome of a rise in government spending will be different depending on the way other elements of the economy are assumed to respond
-Although the short-run multiplier may be the same, the medium-run multiplier showing the full effect differs

Question 19

How can we diagramatically show how fiscal policy is used to counter a deep recession (1,3,3,1)

Answer 19

-Set up your 3 equation model diagram, with IS(A, G) at point y_e, real IR r_s, and below this the PR and PC(π^E = π^t) intersecting at y_e and π^T

-If the economy is in deep recession, a negative demand shock shifts the IS curve from A to B, to IS(A’, G)
-Due to the ZLB, fiscal policy comes to the fore as a policy instrument
-We thus end period 0 at B, with lower inflation π₀, lower output y₀, and the same interest rate, all whilst not being where the PR = PC

-We start period 1 by shifting the PC downwards, to represent the lower level of inflation
-With output and equilibrium below target, the government will increase spending to G₁ to shift the IS curve outwards to IS(A’, G₁), to get the economy back on the PR curve
-We thus end period 1 at point C, with output y₁ > y_e, inflation π₁ < π^T

-From point C on the PR, the policy maker then gradually eases the fiscal stimulus to guide the economy back to A, with output and equilibrium and inflation at target

Question 20

What is the new medium run equilibrium following fiscal policy being used to counteract a deep recession (5)

Answer 20

-In the new medium-run equilibrum, inflation is at target, and the real interest rate is at r_s, so interest-sensitive private spending will be at pre-recession level
-The new MRE, however, is characterized by higher government and lower private spending
-Autonomous private spending remains depressed at A’ (consumer confidence, business sentiment), so government spending must rise to G’ to make up the shortfall
-ΔG = G’ - G = (y_e - y₀)/k = Δy/k
-Once the negative demand shock begins to recede, the policy maker will reverse the fiscal stimulus to keep the economy at the MRE

Question 21

What is the difference between the MR and PR curve (2)

Answer 21

-MR = monetary rule = monetary policy target
-PR = policy rule = fiscal policy target

Question 22

How can we diagramatically analyse inflation bias (1,4,3,2,1)

Answer 22

-Initially, the economy starts at equilibrium output, with IS(A, G), output y_e, real interest rate r_s, and inflation π^T, the intersection between the PR curve and PC(π^E = π^T)

-Say the government introduces expansionary fiscal policy
-This shifts the PR curve to PR’, to target a higher output level y_H, whilst accepting higher inflation target π^T’
-Fiscal policy thus shifts the IS curve outwards to IS(A, G₁), reaching point B with output y_H
-Normally, the CB would counteract this, but if the government prevents monetary tightening, fiscal policy becomes dominant

-However, Point B is not an MRE, and thus the PC shifts upwards in the next period to PC(π^E = π^T’)
-The government thus partially reverses its fiscal expansion (shifts IS curve inwards) to minimize its loss function
-The economy moves to point C on PR’, however output remains above equilibrium and inflation pressures persist

-This adjustment period thus continues until the economy reaches point D, the new MRE
-After the adjustment process, output returns to y_e, but inflation rises to π₁

-This highlights the limitations of using a fiscal stimulus, unless the government is seeking a short-term gain, or is content with establishing a higher inflation target

Question 23

What is the medium run multiplier for the inflation bias (1)

Answer 23

-0, since once the economy fully recovers the change in output is 0

Question 24

What factors impact the change in y ultimately associated with the change in G (1,5)

Answer 24

-Assume there is a given size of K

Factors impacting the change in y include:
-The model
-The context
-The government objectives
-The government’s relationship with the central bank
-The behaviour of the central bank

Question 25

What does expansionary fiscal policy do with spare capacity vs at equilibrium (2)

Answer 25

-If there is spare capacity, the government can boost AD and output to improve welfare -If Y is at equilibrium, expansionary fiscal policy will lead to higher inflation and government debt, whilst output remains unchanged

Question 26

What happens if the government finances a increase in G through increases in tax (3)

Answer 26

-Assuming the interest rate is fixed, the effect of a fully tax-financed expenditure programme is the multiplier (k) = 1 -When tax is lump-sum (not dependent on income) it can be shown Δy = ΔG -The balanced budget multiplier result is interesting, not depending on the assumption that taxes are lump sum

Question 27

What does the balanced budget multiplier depend on, and when may it be useful (2,1)

Answer 27

-The balanced budget multiplier depends on an equal marginal propensity to consume for taxpayers and the providers of G/S -In this case, spending power is redistributed from taxpayers to the G/S providers (aggregate consumption remains unchanged, the only impact on y is the initial change in G) -Balanced budget expenditure may be useful if the government wants to boost AD in a recession without debt financing or monetary policy

Question 28

How does the multiplier get impacted with international context (1,3,2)

Answer 28

-It is difficult to isolate the impact of a change in G from other countries There is a larger multiplier in: -Developed countries -Closed economies -Fixed ER regimes -There is a negative multiplier in high debt countries -This is because any increase in G will lead to a much higher increase in tax, due to debt repayment

Question 29

What are automatic stabilisers (3)

Answer 29

-Automatic stabilisers offset fluctuations in economic activity without direct policy intervention -When AD is high, tax revenue increases and government benefits fall, leading to consumption smoothing -Automatic stabilisers affect the government primary budget

Question 30

What is a governments primary budget (1,2,1)

Answer 30

-Primary budget = cyclical adjusted or structural primary budget + impact of automatic stabilisers -Structural primary budget = G - T -This provides an indication of the medium term fiscal situation for a government -This is excluding interest payments on government bonds

Question 31

What is the formula for the primary budget (2)

Answer 31

-G(y_t) - T(y_t) = [G(y_e - T(y_e)] + a(y_e - y_t) -The primary budget deficit in period t = the budget deficit at equilibrium (cyclical adjusted, long term, potential output) + automatic stabilisers

Question 32

How can we formulatically see the impact of automatic stabilisers in a recession (1,6)

Answer 32

-Remember our primary budget equation G(y_t) - T(y_t) = [G(y_e - T(y_e)] + a(y_e - y_t) -During a recession, y_t and hence a(y_e - y_t) < 0 -Assume a balanced budget (G(y_e - T(y_e)) = 0, such that the actual deficit reflects automatic stabilisers -G is discretionary fiscal policy, assumed not to change -Tax will go down, and transfers will go up, so T(y_t) falls and the actual budget deficit rises -Since G(y_e - T(y_e) = 0, [G(y_t) - T(y_t)] - a(y_e - y_t) = 0 -Therefore, the change in the actual deficit will be cancelled out by the automatic stabilisers

Question 33

What happens if discretionary fiscal policy is used to stimulate the economy in a recession (2)

Answer 33

-There will be an increase in the structural deficit -This is because both G(y_e) - T(y_e) and [G(y_t) - T(y_t)] - a(y_e - y_t) will be greater than 0

Question 34

What is the discretionary fiscal impulse (1)

Answer 34

[G(y_t) - T(y_t)] - a(y_e - y_t)

Question 35

What is the government budget identity (2,2)

Answer 35

-G_t + i_tB_t-1 = T_t + ΔB_t + ΔM_t -Assume, ΔM_t = 0, so that G_t + i_tB_t-1 = T_t + ΔB_t -The LHS = government spending = government spending + interest on previous debt -RHS = government revenue = tax + extra borrowing

Question 36

What is the total deficit/surplus and the difference between this and a primary deficit (2,1)

Answer 36

-ΔB_t = (G_t - T_t) + i_tB_t-1 -The total deficit = the primary deficit + interest payment -A primary deficit is where G>T, whereas a total deficit is where G_t + i_tB_t-1 > T_t

Question 37

What is the formula for total debt (1)

Answer 37

-B_t = (1+i_t)B_t-1 + G_t - T_t

Question 38

What is the formula for the debt ratio (1,2)

Answer 38

-What is of central concern to the government is government debt relative to national income -Debt ratio = b_t = (B_t-1)/(P_ty_t) -P is the price level, and y is real national income, so Py is nominal national income

Question 39

How can we derive the budget deficit to GDP ratio (4)

Answer 39

-The budget identity (ΔB_t = (G_t - T_t) + i_tB_t-1) can be rewritten by dividing through Py -This gives us the budget deficit to GDP ratio: ΔB_t/Py = (G_t - T_t)/Py + (i_tB_t-1)/Py -This simplifies to budget deficit/GDP = d + ib -d = (G-T)/py = primary deficit to GDP ratio

Question 40

How can we determine the growth in the debt to GDP ratio (6)

Answer 40

-Start off with the definition B = bPy -Use the approximation: ΔB ≈ PyΔb + byΔP + bPΔy -Dividing both sides by Py gives (ΔB)/Py = b(ΔP/P) + b(Δy/y) + Δb -Let growth rate of prices = π, and the growth rate of output = γy -We now get Δb = d + (i - π - γy)b -Using the fisher equation r = i - π, we get Δb = d + (r - γy)b

Question 41

What is the formula for the growth in debt-to-GDP ratio (2)

Answer 41

-Δb_t+1 = d + (r - γy)b_t -The change of debt to GDP ratio = the primary deficit to GDP ratio + (real interest rate on debt payments - growth rate)(current debt to GDP ratio)

Question 42

What changes the debt-to-GDP ratio over time (3)

Answer 42

-A higher primary deficit to GDP raises the debt-to-GDP ratio -A higher real interest rate raises the debt-to-GDP ratio (effect is proportional to debt ratio at the beginning of the period) -A higher growth rate reduces the debt to GDP ratio (effect is proportional to debt-ratio at the beginning of the period

Question 43

How can we stabilise the debt-to-GDP ratio, depending on whether growth > real IR (1, 2)

Answer 43

-Rearranging the debt-to-GDP ratio (Δb_t+1 = d + (r-γy)b) , making Δb_t+1 = 0 gives us b_t = -d/(r-γy) -When γy < r, stabilising the debt-to-GDP ratio requires a primary budget surplus -When γy > r, stabilising the debt-to-GDP ratio is compatible with a primary budget deficit

Question 44

How can we draw a primary deficit if r > γy (2,3)

Answer 44

-Have b on the x axis, and Δb on the y axis -Have an upwards sloping curve, with equation Δb = 0 gives us Δb = d + (r - γy)b, with a y intercept of d and a slope of r - γy -At random point A, with a positive x and y value, the debt will continue to increase -The idea is that to repay the debt, the economy has to take on new debt, hence increasing debt -b is positive, as is r-γy, so debt continues to increase

Question 45

How can we draw a primary surplus if r > γy (2,5)

Answer 45

-Have b on the x axis, and Δb on the y axis -Have an upwards sloping curve, with equation Δb = 0 gives us Δb = d + (r - γy)b, with a y intercept of s (for surplus, below y = 0) and a slope of r - γy -Take point B, where y = 0 -In this case, the initial position of debt determines how the debt ratio changes over time -If at A > B, the debt ratio rises without limit -If at B, the debt ratio is constant but not stable -If at C < B, the debt ratio falls without limit

Question 46

How can we draw a primary deficit if r < γy (2,4)

Answer 46

-Have b on the x axis, and Δb on the y axis -Have an downwards sloping curve, with equation Δb_t+1 = d_t + (r_t - γy_t)b_t, with a y intercept of d (for deficit, above y = 0) and a slope of r - γy -Take point B, where y = 0 -At A > B, the debt ratio rises towards B -At B, the debt ratio is constant and stable -At C < B, the debt ratio falls towards B

Question 47

How can we draw a primary surplus if r < γy (2,4)

Answer 47

-Have b on the x axis, and Δb on the y axis -Have a downwards sloping curve, with equation Δb = d + (r - γy)b, with a y intercept of s (for surplus, below y = 0) and a slope of r - γy -Take point A, where y = 0 (this has a b value <0) -At A, the debt ratio is negative, constant and stable -At point B>A, the debt ratio falls towards A -At point C

Question 48

How can we illustrate the impacts of a shock on the debt dynamics (2,3)

Answer 48

-Start with b_t-1 on the x axis, Δb on the y axis -Start with a negative slope, with a primary deficit and r < γy, and start at A where b_t-1 > 0, and Δb < 0 -If there is a shock which means r > γy, the graph becomes upwards sloping, pivoting around d -We then jump to B (same x value, different y) -Now, the debt goes from decreasing towards 0 change to increasing uncontrollably

Question 49

How can we illustrate the impacts of a shock and the governments response on the debt dynamics (2,3,3)

Answer 49

-Start with b_t-1 on the x axis, Δb on the y axis -Start with a negative slope, with a primary deficit and r < γy, and start at A where b_t-1 > 0, and Δb < 0 -If there is a shock which means r > γy, the graph becomes upwards sloping, pivoting around d -We then jump to B (same x value, different y) -Now, the debt goes from decreasing towards 0 change to increasing uncontrollably -The government responds by immediately tightening fiscal policy -This thus shifts the debt ratio curve downwards, where the economy moves to point C with the same x value, and a y value of 0 -This now means the economy is in a position of constant, but unstable, debt

Question 50

How can we include the positive default risk premium into the real interest, and thus the changing debt-to-GDP ratio (3,2)

Answer 50

-r = r^RF + p -The real interest rate = the risk-free real interest rate + the positive default risk premium) -They charge higher because of the risk of loans not being paid -Δb_t+1 = d + (r^RF + p - γy)b_t -Debt dynamics are worsened by p

Question 51

What impacts the costs of the default risk premium for the government (2,2)

Answer 51

-Costs are high if r > γy -This is becayse a larger surplus is needed, thus causing painful G cuts and T rises -Rising debt may also trigger concerns of government default -Rises in the the positive default risk premium leads to increases in r, which would increase the debt burden, thus dampening investment and cutting credit off to the government

Question 52

How may there be potential feedback from the debt ratio into borrowing costs (3)

Answer 52

-There is potential feedback from the debt ratio (b) into borrowing costs (r) via increased default risk -Even if r < y, greater fiscal tightening is needed to stem the rise in the debt ratio -The risk premium may also arise due to a large b

Question 53

What is a condition for government solvency and the absence of default risk (2,1)

Answer 53

-What is a condition for government solvency and the absence of default risk is a non increasing debt ratio -Δb_t+1 = d_t + (r_t - γy)b_t ≤ 0 implies b_t ≤ -d_t/(r_t - γy) -For long run sustainability, if the long run IR > long-run growth rate (the denominator is positive), then a long run primary surplus (d<0) is needed for the debt ratio to stay constant

Question 54

When could fiscal consolidation stimulate AD (1,4)

Answer 54

-So far, we have assumed a primary surplus reduces AD and Y, as IS shifts left -But fiscal consolidation (reducing debt ratio) can stimulate AD if the economy is in a state of 'fiscal stress', an unsustainable fiscal position where p and government borrowing costs are high -Credible fiscal consolidation may boost C and I due to decreasing expectations of crisis -Although not just the size matters, but also the composition of fiscal consolidation -Lower G is more credible in signalling long-term commitment to fiscal reform

Question 55

What impacts how contractionary fiscal consolidation is (2)

Answer 55

-Consolidations are less contractionary in countries with high perceived default risk, but expansionary effects are still unusual -Consolidation will be most painful under fixed ER (eurozone) and little scope for monetary stimulus (ZLB)

Question 56

How can we ease the pain of fiscal consolidation (3)

Answer 56

The pain of consolidation can be eased by: -Accommodative monetary policy -ER depreciation -A larger reliance on spending then tax cuts

Question 57

How can we add inflation to the changing debt to GDP ratio formula (2,1,2)

Answer 57

-Δb_t+1 = d + (r - γy)b_t -Since r = i - π, Δb_t+1 = d + (i - π - γy)b_t -Inflation reduces debt, but causality goes both ways -For a given debt level, higher inflation reduces -Higher inflation may be a policy response to reduce the higher debt burden

Question 58

How can governments finance their expenditures (3,1)

Answer 58

-Creating new money -Taxation -Issuing bonds (debt) -Bonds are 'tax now or tax later', as bonds are loans that must eventually be repaid, raising future taxes

Question 59

What is Ricardian equivalence (4)

Answer 59

-Ricardian equivalence is that AD remains unchanged when a government tries to stimulate an economy by increasing debt-financed government spending -This is because forward-looking agents will anticipate having to pay higher taxes in the future, and not increase consumption (PIH) -They will instead save, rather than spend the extra disposable income, to pay for expected future tax increases used to pay off the debt -We should observe high levels of savings in countries with high levels of debt

Question 60

How can we represent ricardian equivalence through the intertemporal budget constraint (3)

Answer 60

Households: -C₁ + C₂/(1+r) = (Y₁ - T₁) + (Y₂ - T₂)/(1+r) Governments: -G₁ + G₂/(1+r_G) = T₁ + (T₂)/(1+r_G) assuming r = r_G: C₁ + C₂/(1+r) = (Y₁ - G₁) + (Y₂ - G₂)/(1+r)

Question 61

What conditions are needed for ricardian equivalence to work, and when do these assumptions not hold (3,3)

Answer 61

Conditions needed: -No credit-constrained households, able to borrow at prevailing IR (PIH) -IR and time horizon faced by households and governments are equivalent -Households behave as if they are infinitely lived (children's utility incorporated in consumption decisions) When they fail: -Credit constraints mean consumption smoothing is absent, so higher disposable income increases consumption -Government has lower IR, so households prefer debt financing (cheaper) over tax financing -Households don't always bequest to their children and act infinitely lived

Question 62

How does the RE-PIH have implications for the effectiveness of temporary tax cuts (3)

Answer 62

-A temporary tax cut requires a future tax increase, to satisfy the governments intertemporal budget constraint -Households anticipate this and save the tax cut -This means C and AD remain unchanged, the temporary tax cut is completely ineffective if RE holds, and the tax cut is assumed to be a lump-sum transfer, so ti doesn't affect incentives to work/invest

Question 63

How does the RE-PIH have implications for the effectiveness of a temporary rise in G financed by borrowing (4)

Answer 63

-A temporary increase in G in period 0 is financed by borrowing, and households recognise this leads to future tax rises to satisfy the intertemporal budget constraint -Households’ permanent income falls, leading households to reoptimize by reducing consumption in every period -However, since the tax burden is spread across all future periods, the fall in C is less than the rise in G -This means that AD increases in period 0 as the rise in G > fall in C (assuming real IR remains unchanged

Question 64

How does the RE-PIH have implications for the effectiveness of a temporary rise in G financed by higher taxes (1)

Answer 64

-Combining the first 2 results, a temporary increase in government spending financed by higher taxes (balanced budget spending boost) will have the same effect as where the spending is financed by borrowing