Week 22 - Stabilising the economy Pt2 Flashcards
(89 cards)
1
Q
What is the Zero Lower Bound (ZLB)?
A
A level close to zero below which central banks cannot further reduce short-term interest rates.
2
Q
Why can’t interest rates go far below zero?
A
Because people are unlikely to pay someone to lend them money.
3
Q
What tools can the Fed use when interest rates are at the Zero Lower Bound?
A
Quantitative Easing (QE), Forward Guidance, and Negative Rates on Excess Reserves.
4
Q
What happens to agents’ preferences at the Zero Lower Bound?
A
They become indifferent between holding money and bonds, leading to a liquidity trap.
5
Q
What is a liquidity trap?
A
A situation where people and businesses hold onto money instead of spending or investing, despite low interest rates.
6
Q
What is the economic consequence of a liquidity trap?
A
Even with ample liquidity, demand remains low, and the economy can be stuck in a low- or no-growth phase.
7
Q
How does the Zero Lower Bound affect traditional monetary policy?
A
It limits the effectiveness of tools like the federal funds rate or the discount rate in stimulating the economy.
8
Q
What is Quantitative Easing (QE)?
A
A policy where the Fed buys financial assets to lower their yields and inject liquidity into the economy.
9
Q
How does QE stimulate the economy?
A
By purchasing long-term assets, raising their prices, and lowering long-term interest rates, which encourages borrowing and investing
10
Q
What are the economic goals of QE?
A
To stimulate economic activity and create jobs.
11
Q
When did the Fed significantly use QE?
A
Since 2008 and during the Covid-19 crisis, purchasing trillions of dollars worth of assets.
12
Q
What is Forward Guidance?
A
A tool where the Fed signals its future policy intentions to influence market expectations and behaviour.
13
Q
What is the purpose of Forward Guidance?
A
To shape market expectations and encourage economic activity in anticipation of future Fed actions.
14
Q
What is Interest on Reserves?
A
A policy where the Fed pays interest on reserves held by banks, encouraging them to hold money at the Fed.
15
Q
Why might the Fed pay interest on reserves even when interest rates are zero?
A
To give banks a reason to keep their money at the Fed rather than lending it out.
16
Q
What components of planned aggregate expenditure are affected by the real interest rate (r)?
A
Household saving and consumption, and firm investment.
17
Q
How do higher real interest rates affect household behaviour?
A
They encourage more saving at higher interest rates and higher savings means less consumption.
18
Q
How do higher real interest rates affect firm investment?
A
They discourage investment because borrowing becomes more expensive.
Investments are made if the cost of borrowing is less than the return on the investment
19
Q
When will firms choose to invest?
A
When the expected return on investment exceeds the cost of borrowing.
20
Q
What is the overall effect on planned expenditure when the real interest rate increases?
A
Both consumption and planned investment decrease.
21
Q
Interest in the Keynesian Model – An
Example
Components of aggregate spending are
C = 640 + 0.8 (Y – T) – 400r
IˆP = 250 – 600 r
G = 300
NX = 20
T = 250
1. If the real interest rate (r) increases from 4% to 5%, how much does consumption change?
2. If the real interest rate increases from 4% to 5%, how much does planned investment change?
3. How much does total planned spending decrease with a 1 percentage point increase in r (before the multiplier)?
A
- It decreases by 400 x 0.1 = 4
- It decreases by 600 x 0.01 = 6
- By 10 units (4 from consumption + 6 from investment)
22
Q
What is the formula for Planned Aggregate Expenditure (PAE)?
A
PAE = C + IˆP + G + NX
23
Q
Planned Aggregate Expenditure Example
C = 640 + 0.8 (Y – T) – 400r
IˆP = 250 – 600 r
G = 300
NX = 20
T = 250
A
PAE = 640 + 0.8(Y - 250) - 400r + 250 - 600r + 300 + 20
PAE = 1,010 – 1,000r + 0.8Y
In this example, planned aggregate expenditure depends on both the real interest rate and the level of output
Equilibrium output can only be found once we know the value of r
24
Q
What does this PAE equation show?
A
That planned aggregate expenditure depends on both the real interest rate (r) and the level of output (Y).
25
Why can't equilibrium output be determined from the PAE equation alone?
Because it also depends on the value of the real interest rate (r), which must be known to solve for equilibrium.
26
Planned Aggregate Expenditure
PAE = 1,010 – 1,000r + 0.8Y
Suppose the real interest rate is 5%, or 0.05
Planned aggregate expenditure becomes
PAE = 1,010 – 1,000 (0.05) + 0.8Y
PAE = 960 + 0.8Y
Short-run equilibrium output is PAE = Y
Y = 960 + 0.8Y
0.2Y = 960
Y = $4,800
The graphical solution is the same as before
The real interest rate, r, is 5%
Short-run equilibrium output is $4,800
Potential output is $5,000
Recessionary gap is $200
Multiplier is 5
Monetary policy can be used to increase PAE
The first change in spending required is 200/5 = 40
1,000 (change in r) = 40
Change in r = 40/1,000 = 0.04
The Fed should decrease the real interest rate to 1%
27
What happens to planned aggregate expenditure (PAE) when the Fed reduces the real interest rate (r)?
The expenditure line shifts upward.
28
What is the purpose of reducing the real interest rate during a recession?
To stimulate spending and close the recessionary gap.
29
What happens to output when r is reduced to 1%?
The expenditure line shifts upward, increasing output toward full employment (closing the gap).
30
How does the central bank influence interest rates using the money supply?
By increasing or decreasing the money supply, which affects the equilibrium interest rate based on money demand.
31
What happens when the Fed increases the money supply?
The supply curve for money shifts right, lowering the interest rate.
32
What determines how much the interest rate falls when the money supply increases?
The responsiveness (elasticity) of money demand to interest rate changes.
33
What happens if money demand is highly responsive (elastic) to interest rate changes?
A shift in the money supply results in a small change in interest rates.
34
What happens if money demand is not very responsive (inelastic)?
A shift in the money supply causes a larger change in interest rates, making monetary policy more powerful.
35
What limits the effectiveness of monetary policy at the zero lower bound?
Interest rates can't fall much further, even if the money supply increases, due to the liquidity trap.
36
What is a recessionary gap in monetary policy?
occurs when the economy's actual output (real GDP) is below its potential output, meaning the economy is not operating at full employment.
37
What is an expansionary gap in monetary policy?
occurs when the actual output (real GDP) is higher than the potential output (what the economy could produce with full employment).
38
What are the monetary policy effects when the central bank lowers interest rates (r decreases)?
C ↑: Consumption increases (cheaper to borrow, saving less attractive).
IP ↑: Investment spending increases (loans are cheaper).
PAE ↑: Planned Aggregate Expenditure rises due to higher C and IP.
Y ↑: Output/GDP increases via the multiplier effect (higher spending leads to even more income and spending).
Used to close a recessionary gap (actual output < potential output).
39
What are the monetary policy effects when the central bank increases interest rates (r increases)?
When the Central Bank Raises Interest Rates (r ↑)
C ↓: Consumption decreases (borrowing is more expensive).
IP ↓: Investment spending falls.
PAE ↓: Planned spending falls.
Y ↓: Output falls via the multiplier.
Used to close an expansionary gap (actual output > potential output).
40
What was the Fed’s main interest rate policy in response to Covid-19?
It cut the short-term nominal interest rate to roughly zero.
41
What were the Fed's key goals during the Covid-19 pandemic?
Maintain planned aggregate expenditure (PAE), support lending, prevent bankruptcies of fundamentally sound businesses, and stabilise financial markets.
42
Why did the Fed aim to preserve PAE during Covid-19?
To ensure the economy and financial system were positioned to recover after lockdowns ended.
43
What is Quantitative Easing (QE) as used during Covid-19?
The Fed committed to purchasing at least $500 billion in Treasury securities and $200 billion in agency mortgage-backed securities.
44
What is the purpose of QE during a crisis like Covid-19?
To inject liquidity, lower long-term interest rates, and support borrowing and investment.
45
What is Forward Guidance in the context of Covid-19?
A commitment to keep interest rates near zero until the economy is on track to reach maximum employment and price stability.
46
Why is forward guidance important in a crisis?
It shapes market expectations and encourages spending and investment by reducing uncertainty about future policy.
47
What is one option for monetary policy during the recovery period?
Continue some or all of the policies from the lockdown period.
48
What stronger action can the Fed take to raise expected inflation?
Why can’t the nominal interest rate (i) go much lower?
Take stronger steps to raise expected inflation, since r=i−π and i can’t fall much below zero.
Because of the zero lower bound—rates close to zero can’t drop significantly below it.
49
Is there a direct link between monetary policy and inflation?
No, the connection is indirect.
50
How does monetary policy eventually affect inflation?
Lowering r shifts the PAE line up; if this causes Y>Y* for a sustained period, inflation will eventually rise.
51
What must happen for inflation to rise significantly due to monetary policy?
The Fed must pursue expansionary policy long enough to keep output well above potential output (Y*)
52
Do people currently expect high inflation due to monetary policy?
No, because current expectations don’t anticipate prolonged output above Y*
53
The Feds' response to 9/11
* Economy began slowing in late 2000
* Terrorist attack led to contraction in travel, financial, and other industries
* The federal funds rate is the interest rate banks charge each other for overnight loans
– This interest rate is the one the Fed targets when changing the money supply
* In late 2000, the fed funds rate was 6.5%
– January 2001, the Fed cut the rate to 6.0%
– More rate cuts followed
– July 2001, the rate was less than 4%
* After the 9/11 attacks
– Fed immediately worked to restore normal operation of the financial markets and institutions
– The Fed temporarily lowered the rate to 1.25% in the week following the attack
* In the aftermath, the Fed grew concerned that consumers would decrease spending
– Interest rate was 2.0% in November 2001
* 4.5 percentage points lower than a year before
* Combination of tax cuts and aggressive monetary policy helped keep the 2001 recession shallow and short
54
What causes an expansionary gap?
Planned spending exceeds normal output levels at current prices.
55
What is a short-run result of an expansionary gap?
Unplanned decreases in inventories.
56
What happens if an expansionary gap persists?
Prices begin to rise, leading to inflation.
57
What does the Fed do to fight inflation caused by an expansionary gap (to close expansionary gap)?
Raises interest rates.
58
What is the effect of higher interest rates on consumption and investment?
Both consumption and planned investment decrease.
59
How does a decrease in consumption and investment affect planned aggregate expenditure (PAE)?
PAE decreases.
60
What is the ultimate goal of the Fed raising interest rates during inflation?
To reduce equilibrium output and close the expansionary gap.
61
Monetary Policy for an Expansionary Gap
PAE = 1,010 – 1,000r + 0.8Y
* The real interest rate, r, is 5%
– Short-run equilibrium output is $4,800
* Potential output is $4,600
– Expansionary gap is $200
* Multiplier is 5
Monetary policy can be used to decrease PAE
– The first change in spending required is 200/5 = 40
1,000 (change in r) = 40
Change in r = 40/1,000 = 0.04
* The Fed should decrease the real interest rate to 9%
62
Interest Rates Increased in 2004 and
2006
* With slow recovery beginning in November 2001, the Fed continued to decrease interest rates until it reached
1.0% in June 2003
* Real GDP growth was nearly 6% in the 2nd half, 2003
– Growth was nearly 4% in 2004
– Unemployment was 5.6% in June 2004
* Inflation increased in 2004, mainly due to oil prices
– Fed began tightening in June 2004
– Fed funds rate increased from 1.0% to 1.25%
– Continued gradually raising the fed funds rate
– June 2006, the rate was 5.25%
63
What does an increase in the real interest rate (r) do to the expenditure line?
It shifts the expenditure line downward.
64
What economic gap is the Fed trying to close by raising r?
The expansionary gap.
65
How does raising r help close the expansionary gap?
It lowers consumption and planned investment, reducing PAE and equilibrium output.
66
What happened to the S&P 500 between January 1995 and March 2000?
It increased by 233%.
67
How did rising stock prices affect the economy in the 1990s?
They buoyed consumption and supported economic growth.
68
What criticism did the Fed face after the 1990s stock market boom and crash?
That it should have acted sooner to prevent excessive speculation and moderate the crash.
69
What was Fed Chair Alan Greenspan’s response to the criticism?
Separating speculation from real growth is difficult.
The Fed could not have timed its intervention in the stock market accurately.
70
Why is it hard for the Fed to intervene in asset markets like stocks?
Because it’s difficult to distinguish healthy growth from speculative bubbles in real time.
71
Monetary Policy and the Stock Market
* The Fed has limited ability to manage the stock market
– Fed does not know the "right" prices
* Information available to the Fed is publicly available
– Monetary policy is not well suited to addressing an asset bubble (a speculative increase in asset prices
over their underlying market value)
* Fed can raise interest rates and slow the economy
* Could result in a recession and rising
unemployment
* The debate over the Fed's role in asset prices got attention after the mortgage meltdown of 2007 – 2008
72
What does a policy reaction function describe?
How a policymaker's actions depend on the state of the economy.
73
What is the Taylor Rule formula for setting the real interest rate (r)?
r = 0.01 + (0.5)(Y-Y* / Y*) + 0.5π
r is the real interest rate set by the Fed
Y – Y* is the current output gap (the difference between actual output and potential output)
(Y – Y*)/ Y* is the output gap relative to potential output
π is the inflation rate expressed as a decimal
74
What does the Fed’s policy reaction function graph show?
The relationship between the inflation rate π and the real interest rate r set by the Fed.
75
What does a positively sloped Fed policy reaction function imply?
The Fed raises real interest rates in response to rising inflation.
76
Why does the Fed increase real interest rates when inflation rises?
To cool down the economy and keep inflation under control.
77
The Role of Monetary Policy before and
during the Great Recession
* Some have argued that the Fed's low interest rate monetary policy in
the early 2000s contributed to the housing bubble, which in turn was
a trigger of the crisis.
* Most evidence suggests otherwise:
* International comparisons: For example, the United Kingdom had a
house price boom during the 2000s despite tighter monetary policy
than the United States.
* Size of the bubble: Changes in mortgage rates during the boom
years seemed far too small to account for the magnitude of house price increases.
* Timing of the bubble: House prices began to pick up (late 1990s)
before monetary policy began easing and rose sharply after monetary policy began tightening (2004).
* Economists continue to debate this issue
78
Policy Response to the Financial
Crisis: Overview
* Lessons from the Great Depression
– In a financial panic, the central bank needs to lend freely to halt runs and restore market functioning.
– Highly accommodative monetary policy helps support economic recovery and employment.
– Heeding those lessons, the Federal Reserve and the federal government took vigorous actions to stem the
financial panic, support key financial markets and institutions, and limit the contraction in output and
employment.
– Similar actions were taken by foreign central banks and governments.
79
Global Response
* On October 10, 2008, G-7 countries agreed to work together to stabilise the global financial system. They agreed to:
– prevent the failure of systemically important financial institutions
– ensure financial institutions' access to funding and capital
– restore depositor confidence
– work to normalise credit markets
* The international policy response averted the collapse of the global financial system.
– After the announcement, the interest rates banks paid to borrow short-term funds dropped dramatically
80
What is the Discount Window?
A facility through which the Federal Reserve lends money to banks.
81
How did the Fed change the Discount Window during the crisis?
It extended loan maturities and reduced the interest rate.
82
What were the Fed’s auction actions during the crisis?
It held regular auctions of Discount Window funds to encourage broad participation.
83
Why did the Fed create new liquidity programs?
To provide liquidity to financial institutions and markets facing runs or other illiquidity problems.
84
What was required for all Fed crisis loans?
They had to be secured by adequate collateral.
85
What were the main goals of these Fed liquidity actions?
Enhance financial system stability
Promote credit availability to households and businesses
Support economic recovery
86
What traditional central bank role did these actions reflect?
The lender-of-last-resort function.
87
Consequences of the Crisis for
Spending, Output, and Employment
* Spending and output contracted sharply in response to reduced credit flows, skyrocketing borrowing costs, and plummeting asset values.
– GDP fell a total of more than 5 percent from its peak to its trough.
– Manufacturing output declined nearly 20 percent, and new home construction plummeted 80 percent.
– More than 8-1/2 million people lost their jobs.
– Unemployment rose to 10 percent.
* Threat of a second Great Depression was very real.
88
Comparison to the Great Depression
* In terms of economic consequences, the Great Depression was considerably more severe than the Great Recession.
* The forceful policy response to the recent financial crisis and recession likely averted much worse outcomes.
* Financial Risks to the Fed were minimal:
– Lending was mostly short-term and backed by collateral; thousands of loans were made, none defaulted.
– Although the objective of these programs was stabilisation, not profit, taxpayers came out ahead.
89
Monetary Policy during and after the
Great Recession
* Conventional monetary policy involves management of a target short-term interest rate (the federal funds rate).
Because longer-term rates tend to fall when the Fed lowers the short-term rate, and because lower longer-term rates tend to encourage purchases of long-lasting consumer goods, houses, and capital goods, cutting the federal funds rate helps stimulate the economy.
* To support the recovery, the Fed reduced the federal funds
rate from 5¼ percent in September 2007 to nearly zero in December 2008, where it
has remained until 2018.
* Covid-19 prompted the Fed to cut interest rates back to zero.
* Rates likely to increase in light of current rising inflationary pressures.
