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Flashcards in Tutorium 5 Deck (12):
1

Definition: Quantitative Easing

The central bank targets longer-term interest rates, bc. short term interest have hit the zero lower bound.

Possibilities:
• Buy long-term securities to increase their price (or decrease their yields) —> banks sell them —> new money for loans
• Promise to keep the short-term rate low for an extended period
—> more trust in the financial system —> consumption

2

How to test the effectiveness of quantitative easing

• Identify key components related to QE
• Compare the yields (and volume) of bonds before the announcement (of the Central bank) and after the ann.
—> the lower the yield drops, the more effective the policy

3

future short-term interest rates —> long-term interest rates

long-term interest rate depends on:
• current short-term rate
• future expected short-term rate

—> central bank can announce that it will keep short-term rates low in the future, to influence current long-term rates

4

True?
Quantitative easing can lower interest rates, bc. it lowers the probability of companies to default

If QE is exp. to be successfull in stimulating economy
—> fewer companies go bankrupt and companies will have to pay less to borrow
—> yield on corporate bonds goes down (especially for riskier companies) and the premium of CDS goes down

5

inflation expectations —> interest rates

quantitative easing successfull —> higher demand
—> higher prices —> higher exp. inflation
—> decreases real interest rate
(bc. real = nominal - exp. inflation)

6

tax cuts —> economy

Stimulate the economy:
• hh. have more disposable income —> consumption
• firms expect higher profits —> invest more

—> aggregate demand goes up

Decreasing economy:
• gov‘t has to borrow to finance tax cuts
—> higher demand for credits —> interest rates up
—> crowds out investment
• hh. and firms expect taxes to increase in the future
—> encourages saving money today

—> overall effect is ambigous

7

Reasons for the gov‘t to cut taxes

• gov‘t has a budget surplus / lower gov‘t spending
• please the rich
• reduce the size of the gov‘t (political reason)
• stimulate the economy in a recession

8

Why is it misleading to look at the change of the economy after a tax cut?

• tax cuts may be correlated with other factors that affect the economy as well

e.g. gov‘t cuts taxes in a recession
—> the factor that led the economy into the recession still affects the economy

—> only looking at the change of the economy after a tax cut would underestimate the pure effect of the tax cut

9

How to:
Measure the influence of a tax cut to the economy

• identify tax cuts, that are implemented independent from the current economic conditions —> exogenous tax cuts

e.g. by studying policy speeches or reports, in which the tax cuts were announced
—> study the economy after these „exogenous“ tax cuts

10

Romer and Romer:
How big is the effect of a tax increase of 1% on GDP?

Decreases the GDP by up to 3%

11

Which components of aggregate demand are most sensitive to tax changes?

Investment and durable goods (durable = haltbar)

12

How do tax changes influence the equilibrium?
Are changes positive or negative?

the overall effect is very limited.
gov‘t borrows money to cut taxes —> interest rate increases

—> but: in reality, investment actually increases after tax cut
—> the stimulating effect of the tax cut is bigger, than the crowding out effect, but the effect is very small (or ambigous)