ECON 100 Tutorial: Week 22

1. ECON 100 Tutorial: Week 22 www.lancaster.ac.uk/postgrad/alia10/ a.ali11@lancaster.ac.uk NEW office hours: 2:00PM to 3:00PM tuesdays LUMS C85

2. Question 1 Loanable Funds Loanable funds refers to a market that brings borrowers and savers together, determining interest rates by finding where the demand for borrowing and the supply of savings are equal. This approach shows how interest rates can be determined on an open market, without a central bank. Liquidity Preference The Keynesian liquidity preference approach to the relationship between interest rate and money balances is given by where the demand for money is in equilibrium with the supply of money set by a central bank. Loanable funds. Liquidity preference. Why two theories of interest rate determination?

3. Question 1: Loanable funds. Liquidity preference. Why two theories of interest rate determination? Steele finds these two approaches inconsistent. In his view, Keynes’ approach ignores the fact that inflation and recession can coexist. Keynes’ multiplier relates to the idea that an increase in exogenous (government) investment will increase incomes and saving, which will be reinvested. During a recession this can guide fiscal policy. A problem with the Keynesian idea of a multiplier can occur if there is inflation during a recession. Inflation will reduce the returns on savings, forcing banks to offer a higher rate of return on savings. But in a recession, interest rates will be set very low, in order for investment funds to be put into capital projects rather than simply pushed into bonds. As more projects receive investment, the expected rate of return on those investments fall (Marginal Efficiency of Capital). As a result, the rate of return a bank can offer on savings is closely related to the interest rate on bonds. The low return on savings will mean that demand for savings is very low. So stagflation can relate to low demand for bonds and low demand for savings. In this case, attempts by the government to increase investment during a recession may not lead to a multiplier.

4. Question 2 Explain the notion of the time consistency of economic policy An optimal policy computed at time t is time-inconsistent if a re-assessment at time t + n finds that a different policy is then optimal. • Individual Examples: Smoking, Pregnancy • Central Bank Examples: Interest Rate/Inflation In the face of an economic downturn, the central bank may lower the discount rate even if it previously stated it would hold discount rates steady. • If an increase in money supply (lower discount rate) is anticipated, then prices will rise causing inflation • However, an unexpected increase in money supply can lead to increased spending and GDP rise with less inflation (Think about the Federal Reserve game we played

5. Question 3 How is notion of a non-accelerating inflation rate of unemployment (NAIRU) relevant to the time consistency of economic policy? • NAIRU is the natural long-run stable rate of unemployment • If firms are able to adjust prices and production to account for inflation, policy makers cannot as easily effect unemployment by increasing money supply. • This is the same scenario as the previous slide. • This is why the central bank may “cheat” in its setting of discount rates differently than its previously stated levels – that is, to be time inconsistentand therefore be able to effect unemployment rates.

6. Question 3 How is notion of a non-accelerating inflation rate of unemployment (NAIRU) relevant to the time consistency of economic policy? Gerry’s answer: Job-seeking workers assess wage offers against their expectations of the inflation rate (ΔP/P)e in the period ahead). The original Phillips curve was made when prices were more-or-less stable (and so (ΔP/P)e ≈ 0). With zero inflation, job-seekers do not over/under estimate the purchasing power of money wage rates; so the unemployment rate rests at the equilibrium level of the ‘natural rate’. When the inflation rate is constant (non-accelerating), the case is (again) made that job-seekers do not over/under estimate the purchasing power of money wage rates; so the unemployment rate rests at the equilibrium level of the non-accelerating inflation rate of unemployment.

7. Before we look at Question 4(a) Let’s look at the Taylor Rule. What are its principal components? Taylor rule: rt = r*+ π* + w(πt – π*) + (1 – w)(yt– y*)/y* Equilibrium interest and equilibrium inflation rates: r*+ π* Weighting: w and (1-w), where 0 ≤ w≤ 1 Inflation gap: (πt – π*) Output gap: (yt– y*)/y* Note: If you look at other sources, the Taylor Rule is usually presented as: rt = r*+ π + w(πt – π*) + (1 – w)(yt– y*)/y* Whereπ is the inflation rate. Gerry presents it with π*.

8. Question 4(a) The Taylor rule equation is written as: rt = r*+ π* + w(πt – π*) + (1 – w)(yt– y*)/y* where: rtis the central bank discount rate y is the GDP πt is the inflation rate y* is the potential GDP π* is the inflation rate target w is the policy parameter How would you interpret r* the equilibrium rate of interest Gerry also mentions: Wicksell’snatural rate of interest The natural rate of interest is the rate that arises out of the equilibrium of supply and demand in the bond market.

9. Question 4(b) & (c) The Taylor rule equation is written as: rt = r*+ π* + w(πt – π*) + (1 – w)(yt– y*)/y* b) Which data series are relevant? a relevant price index (which goods/assets should be included?) More specifically, the inflation rate (CPI) and real GDP c) Which data series have to be ‘constructed? How? a relevant price index (which goods/assets should be included?) a hypothetical series for the full employment level of GDP (i.e., y* potential GDP)

10. Question 4(d) The Taylor rule equation is written as: rt = r*+ π* + w(πt – π*) + (1 – w)(yt– y*)/y* where: rtis the central bank discount rate y is the GDP πt is the inflation rate y* is the potential GDP π* is the inflation rate target w is the policy parameter Determine rtusing the parameter values: r*= 2%, π* = 2%, w= 0.5 where the inflation rate is 4.5%, Potential GDP is estimated as £1.4 trillion GDP is £1.33 trillion

11. Question 4(d) ctd. We’re given: y is the GDP = £1.23 trillion y* is the potential GDP = £1.4 trillion πt is the inflation rate = 4.5% π* is the inflation rate target = 2%, w is the policy parameter = 0.5 r* is the equilibrium interest rate = 2% First, plug in these given values into the taylor rule equation: rt = r*+ π* + w(πt – π*) + (1 – w)(yt– y*)/y* rt= 0.02+ 0.02 + 0.5(0.045– 0.02) + (1 – 0.5)(1.33 – 1.4)/1.4 Then, solve: rt = 0.02+ 0.02 + 0.5(0.045– 0.02) + (1 – 0.5)(1.33 – 1.4)/1.4 rt = 0.02+ 0.02 + 0.5(0.025) + (0.5)(– 0.07)/1.4 rt= 0.02+ 0.02 + 0.0125 – 0.025 rt= 0.0275 So, in this scenario, our central bank discount rate is 0.0275 or 2.75%.

12. Question 4 Phillips curve If the long-term stable level of unemployment (call it u*) is known, then π*is determined by the Phillips curve and y* is determined by u* Loanable Funds r* (Taylor’s equilibrium interest rate) can be determined from loanable funds theory of interest. How is the Taylor Rule related to the loanable funds theory of interest rate determination and to the Phillips curve? annual prop. real wage increase ∆w/w annual interest rate r • Loanable Funds theory Phillips Curve saving (productivity growth) r* π* loanable funds u* unemployment

13. Next Week Monday tutorials are all re-scheduled for the bank holiday: T01/01 3PM → Friday 9AM Fylde D31 T01/48 5PM → Tuesday 9AM Charles Carter A04 T01/05 6PM → Friday 1PM Fylde D31 If you have a timetable problem, contact Sarah Rossor attend a different section. Tuesday’s tutorial stays at 1 PM (Charles Carter A02)

14. Practice Past Exam QuestionsPlease Note: Solutions are not given to tutors for these questions. The solutions you see here are suggestions only – I can’t guarantee they are correct.

15. The Taylor Rule is a representation of monetary policy whereby the short-term nominal interest rate is varied systematically with respect to: (a) the trade deficit and the value of sterling (b) employment and the cost of living (c) inflation and the ‘output gap’ (d) tax revenues and the level of government borrowing 2012 Exam Q38

16. The Taylor Rule What are its principal components? Taylor rule: rt = r*+ π* + w(πt – π*) + (1 – w)(yt– y*)/y* Equilibrium interest rate and equilibrium inflation rates: r*+ π* Weighting: w and (1-w), where 0 ≤ w≤ 1 Inflation gap: (πt – π*) Output gap: (yt– y*)/y*

17. Define r as the real rate of interest and let r* be the rate consistent with long run equilibrium in the economy. Further, define π as the rate of inflation and π* as the target rate of inflation. Then r = r* + α(π – π*) is: • an LM curve • a Taylor rule • a DSGE model • incomprehensible Note: Tutors think that this question is asking about the Taylor Rule, hence answer choice B is selected. Gerry did not set this question and thinks that the question is vague and therefore incomprehensible, hence answer choice D is selected. 2010 Exam Q39

18. By the Taylor Rule, nominal interest rates are raised whenever: rt = r*+ π* + w(πt – π*) + (1 – w)(yt– y*)/y* a) inflation falls b) the output gap widens c) the output gap closes d) the inflation target is raised Note: C is correct so long as W<1 D would also be correct when w<1. On an exam, the best answer is probably C; I’d say this is because the Taylor Rule is used to control inflation and the output gap. 2011 Exam Q36

19. The Taylor Rule describes how the authorities adjust monetary policy by adjusting: (a) the exchange rate after taking account of inflation and the nominal interest rate (b) inflation after taking account of the nominal interest rate and the ‘output gap’ (c) the nominal interest rate after taking account of inflation and the ‘output gap’ (d) bond prices after taking account of inflation and the nominal interest rate

20. ‘Time-inconsistency’ exists if monetary policy implemented at time t is optimal, then re-assessed at time t + n and found to (a) require discretionary adjustments (b) be sub-optimal (c) be inconsistent with fiscal policy (d) be inconsistent with the currency exchange rate