midterm 2

Lucas Criterion

by Robert Lucas. A comparison between how the model predicts the economy will respond to a particular shock and how the real-world economy responds to the shock.

Impulse Responses

When monetary policy suddenly changes in actual data and model can accurately visualize the data. (i.e., changes in output, prices, interest rates)

Inflation expectations

exogenous in short run and endogenous in medium run

π

inflation

Y

output

r

real interest rate

C

consumption

I

investment

W/P

real wage

L

employment

π^e

inflation expectations

v

monetary policy shock

π*

inflation target

CS

customer sentiment

T

taxes

G

government spending

SP

animal spirits

ω

risk premium

A

technology

K

capital

μ

market power

z

reservation wage

contractionary

fixing inflation by decreasing money supply and aggregate demand

disinflationary

inflation rate is slowing down but prices are still increasing

what is change in π*? what is change in v?

persistent. transitory.

which variables affect IS curve?

CS, G, T, SP, ω

which variables affect natural level of employment/output? which curve does it shift?

A, K, z, μ have an effect and shifts SRPC and MRPC.

exogenous change in π^e or supply shock (ε) causes what kind of shift?

temporary shift in SRPC

what is monetary neutrality?

when central bank doesn't affect real economic variables in MR or LR (output, wages, employment)

what is expansionary?

increase in economic growth by increasing money supply or government spending to increase AD

what is inflationary?

increase in goods/services

most shocks have similar effects in the IS curve except which ones?

a decrease in T and increase in CS leads to higher consumption. increase in SP and decrease in ω leads to increase in I.

what variables shifts both the SRPC and MRPC?

A, K, μ, and r

most shocks have similar effects to the natural level of output except which ones?

increase in A and K are ambiguous in labor market in the SR (? for W/P and L). z decreases real wage in SR and MR

what are two shocks that only move the SRPC?

inflation expectations and supply shocks to phillips curve

what is stagflation?

when a recessions happens at the same time as an increase in inflation

how do we evaluate a macro model?

1. lucas criterion

2. test the mechanism - test mechanism on real-world economy

3. test the overall fit - joint test all assumptions and mechanisms in model. assess statistically how well models explain overall macroeconomic dynamics

what is causality in relevant terms?

the model predicts that contractionary monetary policy (high interest rates) will lower inflation and output

causality: high interest rates = lower inflation and output

what is reverse causality in relevant terms?

in practice, central bank raises interest rates when inflation and output are expected to be high.

reverse causality: high inflation and output = high interest rates

what is the identification problem?

in the real world, both causality and reverse causality exist. the identification problem is the separation between the two

what is the narrative approach?

a method of identifying monetary policy shocks by studying historical records (past data, speeches, transcripts) and looking for specific episodes where central bank explicitly took a different strategy with its policy than what it did before.

what is controlling for expectations?

a method of identifying monetary policy shocks by using historical forecasts of the central bank to capture real-time expectations of economic conditions thus identifying cases where they behaved unusually given those expecatations

how can we identify monetary policy shocks using statistical methods?

use statistical models of the economy to recreate how central banks would have normally behaved given economic dynamics overtime and thus being able to identify unusual decisions

how can we identify monetary policy shocks using market-based identification?

modern financial markets include assets that are bets on future monetary policy decisions and therefore represent what markets think the central bank will do. therefore, we can identify cases where the central bank did something different relative to market predictions.

how can we identify monetary policy shocks using natural experiments.

history has cases that are close to natural experiments: large shock unexpectedly hitting an economy

what is an impulse response function?

estimated by controlling for expectations, it is the average response of the economy to a monetary policy shock after controlling for economic conditions

how long is the short run?

2-3 years

what is the Turkish experiment?

Turkish president Erdogan was convinced that cutting interest rates would lower inflation. He fired central bank presidents until one agreed. it lead to a drastic depreciation of the Turkish Lira and significant increase in inflation

how can we identify government spending shocks?

war-related shocks: wars induce large spending increases and often unrelated to economics

narrative approach: use contemporary news reports to create measures of expected changes in govt spending

statistical methods: modeling joint determination of spending and economic activity, w/ identifying restrictions

market-based identification: stock prices of defense related companies speak to expected changes in military spending.

what is crowding out?

when increases in government spending raise interest rates and cause investment to fall

what is hysteresis?

theory that transitory and demand shocks can affect natural level of GDP due to changes in physical/human capital, R&D and technology, or exit of workers in labor force.

what is mismeasurement?

the natural level of GDP is unobservable so if the estimates seem to respond to transitory or demand shocks, it shows that the estimates are measured incorrectly.

what is the taylor principle?

when central banks raise real interest rates when inflation is above target and decrease interest rates when inflation is below target

what is divine coincidence?

stabilizing inflation is equivalent to stabilizing output at the the natural level when faced with demand shocks or shocks to the natural level of GDP

what is fiscal austerity?

rapid reductions in govt spending and increases in taxes to address large fiscal deficits

what is the fisher equation

real interest rate = nominal interest rate - expected inflation

what is animal spirits?

economics actions, like investment and consumption, aren't always based on rational calculation but are driven by confidence, optimism, and pessimism

what is the "stop-go" monetary policy?

"accidental" recessions in the 1950-60s from overly raising rates to reduce inflation and cutting them sharply during inflation

what is the Volcker Disinflation?

in the late 1970s-early 1980s, federal chair Volcker raised interest rates sharply to bring inflation down, purposefully causing a recession

what are examples fiscal austerity induced recessions (decrease in G)?

1937-38 Roosevelt recession: recovering from great depression, roosevelt administration cut spending and rose taxes to restore budget balance which lead to sharp, but short recession

greek sovereign debt crisis of 2010s: greek government implemented significant austerity package with dramatic reductions in spending and increase in taxes, which caused greek economy to go into depression where employment went up to 27%

what are examples of supply-side driven stagflations?

1974 productivity slowdown (decrease in technology): mid 1970s, growth rate of productivity declined across advanced economies, coinciding with surge in commodity prices, leading to worldwide recession and surge in inflation

2011 tokohu earthquake in japan (decrease in capital): earthquake destroyed a lot of capital (energy) which lead to increase in prices and decline in output

2022 russian invasion of ukraine (increased supply shock): invasion disrupted supplies of natural gas, oil, and agricultural commodities. energy prices heavily increase, production costs rose, and real incomes fell throughout europe

what are examples of trade and foreign financial shocks?

1990s finland: had bad recession after losing main export market following collapse of soviet union

sweden & switzerland (WWII)/cambodia & laos (vietnam war): experienced economic turmoil in main trading partners which produced slowdowns/recessions

what are examples of labor supply driven shocks?

eastern europe after 2004 EU enlargement: many central/eastern european countries joined EU, so millions moved to western europe for higher wages. decline in labor supply reduced production capacity and worsened severity of 2008-9 crisis as more people emigrated

1990s israel: due to collapse of soviet union, many people immigrated to israel, causing economic boom in GDP as labor supply expanded by decline in real wages

what are examples of pandemic business cycle?

covid: government restrictions of lockdowns shut down service sector. job losses disproportionately affected low-income and female workers who were overrepresented in service industries

stabilization policy

set of actions of govts and central banks to limit short-run fluctuations in inflation and output: achieve "dual mandate"

natural rate of interest

interest rate that clears savings market at natural level of GDp

great moderation

1980s - volatility of GDP fell substantially due to improved monetary policy (ex. better MP eliminated self-fulfilling inflation expectations)

information lag

amount of time it takes for policymakers to learn about state of economy

decision lag

amount of time it takes for policymakers to come to a decision

impact lags

amount of time it takes for policy decisions to affect economy

unobservable variables

unable to observe natural rates of output, interest, or unemployment

forecasting

since policies take time to affect economy, policymakers must predict where the economy will be when their policies kick in

quantitative uncertainty about policy

lots of uncertainty about how much different policy tools might affect economic outcomes

tradeoffs

cost-push shocks induce unavoidable tradeoffs between stabilizing inflation and output