Thursday, October 02, 2008

C225-Macroeconomic Policy and Financial Markets-Sample Questions 1-8

C225-Macroeconomic Policy and Financial Markets-Sample Questions 1-8
Question 1: Explain the ‘life cycle’ theory of saving and discuss its relevance for understanding aggregate saving in an economy.
From Unit 2-Saving and Finance
Keynes ideas for the Macro-economy in his theories was that savings was only a function of current income as a percentage, with a positive intercept. "Current Income"
C= A + b*Y
Consumption= Autonomous spending + Marginal Propensity to consume (b<1)* Disposable Income (after taxes).
Consumption and disposable income is highly correlated according to Figure 12.3 with US data 1980-2002.
Keynes' concept of the m.p.c. is important in understanding demand in an economy because it contributes to a multiplier effect upon an initial increase in demand.

Keynesian Cross "Rule of Thumb":
Planned Expenditure=A + b(Y) + G + I + X (in open economy)
The PE line is less step than a 45% angle in the Planned Spending, Output graph. If an autonomous increase in either A, I or G will move the PE line up by 1/MPC. "The larger is the propensity to consume, the steeper is the line PE and the greater is the multiplier."

Milton Friedman considered "Permanent Income" to consider that people look at the trend line more than the basis of single income periods for consumption patterns. One aspect is that consumers tend to shop by grocery lists. They tend to purchase the same things over periods and have the same bundle of consumption goods and not directly affected by individual income checks. Thus they tend to change spending patterns slowly over time.

Franco Modigliani considered "Life Cycle Income" as a way of predicting what the savings rates would be over the cohorts of similar age would save.

2.2.1 Definition of income
In the previous paragraph we wrote of individual consumption and saving
depending on ‘some measure of income’ denoted by y*. The powerful insights of modern theories of consumption and saving have been achieved after innovations were made in defining the appropriate concept of income. Saving in a particular period (current saving) may be related to three distinct measures of income:
• Current income: the original idea of the consumption function, developed
by Keynes in the 1930s, postulated a systematic relationship between
current consumption, current saving, and current income.
• Permanent income: a great theoretical innovation was achieved by Milton Friedman in his 1957 book A Theory of the Consumption Function where he demonstrated that a rational individual’s consumption would depend upon ‘permanent income’. A crude, highly simplified measure of an individual’s permanent income could be the trend of current income over time. When current income deviates positively from permanent income (or, let us say, deviates from trend) it is saved instead of causing an increase in consumption.
• Life cycle income: a similar important theoretical innovation was made by Franco Modigliani in the same decade as Friedman. Modigliani and his
collaborators proposed that an individual’s income follows a predictable
pattern over their life, a life cycle. Consumption depends on lifetime
income and the individual’s current saving depends on the stage of their
life cycle that they are at. In the simplest versions people save while they
are of working age and they dissave (consume their assets) in old age.

Analytically: "while consumption closely follows GDP fluctuations, it is not quite so volatile. Consumption tends to be a bit smoother than income." Which tends to support Milton Friedman's theories.
Intertemporal Budget Constraint:
The intertemporal budget constraint says that current consumption plus discounted future consumption must equal the sum of current income and future discounted income.
{Assuming no bequeathment desires by the individuals.}

The m.p.c. out of shocks to permanent income is much greater than out of temporary shocks. In the case of permanent shocks to income, the implications of the forward-looking model and the Keynesian consumption function are very similar-consumers will spend most of any increase in current income.

Saving for a rainy day and the Importance of Uncertainty.
One recent study suggests that as much as 46% of personal sector wealth is the result of higher savings aimed at insuring against future income uncertainty.
Introducing precautionary savings makes current income more important than future income.
Further, if consumers expect rising future income, then according to our "rainy day" story, savings will go negative as consumers avail themselves of the opportunity to smooth their consumption over time.
If borrowing constraints are important, it is current income rather than future income that matters.
Borrowing Constraints.
If borrowing constraints are important, it is current income rather than futrue income that matters.
The Influence of Interest Rates:
Under both Keynesian and forward-looking models, interest rates affect debtors and savers differently. In forward-looking models, the effects on savers are complicated by substitution and income effects.
Demographic Influence in the Life Cycle Model:
Because savings is likely to vary substantially over people's lives, changes in the overall demographic structure of a country are likely to have a significant impact upon its aggregate rate of saving.
The Role of Wealth and Capital Gains:
The dependence of the m.p.c. on consumers' expectations of future income, whether they perceive income increases to be temporary or permanent, the importance of uncertainty, and the variable impact of capital gains, combined with the issue of whether they have access to credit-all make the mpc a difficult number to pin down. This suggests that governments have limited ability to reliably influence consumption by shifting taxes or moving interest rates.

#2. Explain and discuss the theory that firms’ investment is determined by the cost of capital.

This basically is along the same lines as the assignment one question:
Examine the view that the cost of capital is the most important influence on the level of investment.
So I am not sure this needs anymore additional comments...
******Printout assignments*******

#3. ‘To understand what determines the level of aggregate demand this year we must understand the principle that individuals make choices between consumption now and consumption in the future.’ Explain and discuss.
Basically a two period graph with utility maximization used as the determining factor in allocation of income and savings over the two periods. I would also mention the fact of kinked interest rate lines and the fact that some consumers may be financially constrained.

#4. Central bankers can either be required to follow policy rules or can be given discretion over monetary policy. Discuss the merits of each approach.
This seems along the lines of Assignment Two question:
Comment on the fiscal rules adopted by the UK government and assess whether the UK government has met these fiscal rules in recent years.
Although this is Fiscal Rules, there could be some overlap in explaining Monetary Rules.

Norway Fiscal Rules:
Economic survey of Norway 2007: Putting public finances on a sustainable path

Unit 4|Monetary Policy and the Central Bank.

****4.1 Eran
How does that match up with the speech by Milton Friedman?
Page 439, I. What Monetary Policy Cannot Do:
(1) It cannot peg interest rates for more than very limited periods; (2) It cannot peg the rate of employment for more than very limited periods.

***Inflation Targeting-Bernanke
...such as the adoption of money growth targets in the 1970s,...
The hallmark of inflation targeting is the announcement by the government, the central bank, or some combination of the two, that in the future the central bank will strive to hold inflation at or near some numerically specified level.
"Price stability" never in practice means literally zero inflation, however, but usually something closer to a 2 percent annual rate of price change, for reasons we discuss later.
In making inflation, a goal variable, the focus of monetary policy, the inflation-targeting strategy in most cases significantly reduces the role of formal intermediate targets, such as the exchange rate or money growth. {...Page 101}
Some countries, such as Canada, came to inflation targeting after unsuccessful attempts to use a money-targeting approach.
Notably, a number of economists have proposed that central banks should target the growth rate of nominal GDP rather than inflation (Taylor). Nominal GDP growth, which can be thought of a "velocity-corrected" money growth (that is, if velocity were constant, nominal GDP growth and money growth would be equal, by definition), has the advantage that it does put some weight on output as well as prices. ...

**** Use of Explicit target (91 economies)
Because a security's price relates to the future stream of payments on it, new information that changes expectations has a powerful effect on financial markets.

"Bringing Back Regulation's Good Name"

Remarks by Governor Ben S. Bernanke At the Annual Washington Policy Conference of the National Association of Business Economists, Washington, D.C. March 25, 2003

#5. ‘Ministers of Finance are in positions of great power because fiscal policy has a major effect on aggregate demand’. Discuss.

There is a question to whether Fiscal Policy can have any effect on the economy and maybe only in negative ways. For part of this answer we need to go back to the IS-LM-BP/Mundell Fleming Model. Mundell-Fleming Model/Open Economy
Most importantly:
Floating Exchange Rates and Perfect Capital Mobility

...with perfect capital mobility and floating exchange rate, fiscal policy is ineffective at influencing output.
The result that fiscal policy is very effective at influencing output under fixed exchange rates and monetary policy is very effective under floating exchange rates with perfect capital mobility.
But also important to note:
Fiscal Expansion Under Floating Exchange Rates

BP schedule is steeper than the LM schedule, which means that capital flows are relatively insensitive to interest-rate changes, while money demand is fairly elastic with respect to the interest rate.

1. Expansionary fiscal policy shifts the IS schedule to the right.
2. Rise in domestic interest rate and domestic income.
3. Opposite effects on the BoP; expansion in real output-deterioration of CA, rise in interest rate improves capital account.
4. Capital flows are relatively immobile then CA is larger effects and thus BoP moves into deficit.
5. Deficit leads to depreciation of the exchange rate.
6. BP shifts to the right.
7. LM shifts to the left.
8. IS shifts further to the right.
9. Thus higher interest rates, higher output but a depreciation of the exchange rate.

LM schedule is steeper than BP schedule.
1. Expansionary fiscal policy shifts the IS schedule to the right.
2. Rise in interest rates (but less rise since of capital mobility is higher-BP flatter) and domestic income.
3. BoP moves into surplus since increased capital inflow more than offsets the deterioration in the CA due to increases in Income.
4. Appreciation of exchange rate moves the LM to the right.
5. IS shifts to the left.
6. Thus higher output, higher interest rate and exchange rate appreciation.

Hence a fiscal expansion can, according to the degree of international capital mobility, lead to either an exchange-rate depreciation or an exchange-rate appreciation.

Under a Classical Equilibrium Model,
1. Government spending financed from borrowing can only crowd out the same amount of investment so that:the increase in government spending has no independent effect on aggregate demand.
2. Tax cuts financed by issuing bonds results in the same: no aggregate demand increase.
3. But on the Supply-Side Effects when implementing a marginal income tax rate does effect the aggregate of labor by shifting the supply curve out, by increasing the real wage rates of after tax rates. This in turn increases (shifts to the right) the Aggregate Supply curve. Thus a reduction in marginal tax rates increases aggregate output and at lower prices.

4. Monetarist view the IS curve as relatively flat (investment demand is highly sensitive to changes in the interest rate) and the LM curve as nearly vertical (interest elasticity of money demand is small).
"In the monetarist model such crowding out occurs almost dollar for dollar with an increase in government spending. On net, aggregate demand and, hence, income is increased very little by an increase in government spending."

From Macro-economics Second Edition-Richard T. Froyen.

Ricardian Equivalence:
The theory of 'crowding out' usually posits that firms' investment expenditure declines to offset deficit financed increases in government spending. The theory of 'Ricardian equivalence argues that an increase in government spending financed by government borrowing causes an offsetting decline in households' consumption spending or, in other words, an increase in their saving rate to offset the government's dissaving. Both 'crowding out' and 'Ricardian equivalence' refer to hypotheses that a government policy leads to changes in private sector behaviour that offset it.
Basically it assumes that tax payers are able to anticipate and calculate how increased spending or reduced taxes are compensated by spending and saving behaviour changes.

But this does not "recognize the limits to and costs of information-processing and cognitive constraints that influence the expectations-formation process". Imperfect Knowledge, Inflation Expectations, and Monetary Policy" Orphanides, Williams, Federal Reserve System.
But I have not addressed the Keynesian Economics and the fiscal multiplier yet and not sure that was mentioned in the unit this question seems to be derived from.

6. Outline and discuss the role of expectations in macroeconomic policy.

Unit 6. Markets Reflect the Expected Future Today

Will Monetary Policy Become More of a Science? Frederic S. Mishkin Member Board of Governors of the Federal Reserve System September 2007

Section 6.1.1: "The American Economic Review", "The Role of Monetary Policy", Milton Friedman, Volume 58, No 1, March 1968
-as Irving Fisher pointed out decades ago. This price expectation effect is slow to develop and also slow to disappear. Fisher estimated that it took several decades for a full adjustment and more recent work is consistent with his estimates.

Reading from Text Book {Chapter 18}.
The "US government bond yield curve" shows time versus yield on a chart.
The predictive ability of the forward spread is modest.
The yield curve appears to be slightly more informative in predicting inflation than in predicting interest rates.
Evidence shows that bond prices, specifically the shape of the yield curve, do provide useful information for predicting movements in output. For example, economists have found that when the yield curve has a shallow slope (or slopes down), recession is more likely. Under the expectations theory, a downward-sloping yield curve suggest that short-term interest rates are falling, which is likely if the economy goes into a recession.
The sensitivity of bond prices to expectations of what the central bank will do in the future gives monetary policy real teeth.

"Why are TIIS Yields So High? The Case of the Missing Inflation-Risk Premium", Ben Craig
TIIS (Treasury Inflation Indexed Securities)
The difference between the TIIS yield and that of nominal Treasury securities should be a very good measure of expected inflation.
Surprisingly, the difference in yields between the two types of securities (their yield spread) for 10-year instruments is only about 1.90 percentage points for the 1997-2002 period.

6.3.4 How quickly do inflation expectations change?
In previous paragraphs we summarized an important principle of macroeconomics in these words: policy makers' cannot maintain unemployment below the natural rate unless inflation expectations continue to be different from actual inflation, and that is generally thought to be impossible because it implies that employers and employees never learn from their experience of getting expectations wrong.

******Reference to "Disagreement about Inflation Expectations"*************
The sticky-information model of Mankiw and Reis (2002) generates disagreement in expectations that is endogenous to the model and correlated with aggregate variables. In this model, costs of acquiring and processing information and of re-optimizing lead agents to update their information sets and expectations sporadically.
We follow Mankiw and Reis (2002) and assume that each period a fraction lambda of the population obtain new information about the state of the economy and recomputes optimal expectations based on this new information. Each person has the same probability of updating their information, regardless of how long it has been since the last update.
Our estimates are also consistent with the reasonable expectation that people in the general public update their information less frequently than professional economists. It is more surprising that the difference between the two is so small.
We believe we have established three facts about inflation expectations. First, not everyone has the same expectations. The amount of disagreement is substantial. Second, the amount of disagreement varies over time together with other economic aggregates. Third, sticky-information model, according to which some people form expectations based on outdated information, seems capable of explaining many features of the observed evolution of both the central tendency and the dispersion of inflation expectations over the past fifty years.
Then not all the population would be covered in any one year or even long periods of time. But I wonder if it reasonable that each individual have the same chances. I would imagine that the update of information while might be random-happen to turn on a channel or read an article-most would be idiosyncratic and have their own pattern of updates.

******Study econometric models of adaption.************
**********"Imperfect Knowledge, Inflation Expectations, and Monetary Policy"*****
How Economic News Moves Markets

Press Release How Economic News Moves Markets

What Type of Economic News Moves Markets?|Mark Thoma's Post
Imperfect Knowledge, Inflation Expectations,
and Monetary Policy
Athanasios Orphanides
Board of Governors of the Federal Reserve System
John C. Williams
Federal Reserve Bank of San Francisco
May 2002
Missing from such models, as Benjamin Friedman points out, "is a clear outline of the way in which economic agents derive the knowledge which they then use to formulate expectations." To be sure, this does not reflect a criticism of the traditional use of the concept of "rationality" as reflecting the optimal use of information in the formation of expectations, taking into account an agent's objectives and resource constraints. The difficulty is that in Muth's (1961) original formulation, rational expectations are not optimizing in that sense. Thus, the issue is not that the "rational expectations" concept reflects too much rationality but rather that it imposes too little rationality in the expectation formation process. For example, as Sims (2001) has recently pointed out, optimal information processing subject to a finite cognitive capacity may result in fundamentally different processes for the formation of expectations than those implied by rational expectations. To acknowledge this terminological tension, Simon (1978) suggested that a less misleading term for Muth's concept would be "model consistent" expectations (p.2).

John Muth From Wikipedia
Muth, John F. (1961), \Rational Expectations and the Theory of Price Movements," Econo-
metrica, 29, 315{335, July.

Simon, Herbert A. (1978), "Rationality as Process and as Product of Thought," American
Economic Review, 1{16, May.
Bounded rationality

Rational choice theory

Describing the decisions made by individuals as rational and utility maximizing may seem to be a tautological explanation of their behavior that provided very little new information. While there may be many reasons for a rational choice theory approach, two are important for the social sciences. First, assuming humans make decisions in a rational, rather than stochastic manner implies that their behavior can be modeled and thus predictions can be made about future actions. Second, the mathematical formality of rational choice theory models allows social scientists to derive results from their models that may have otherwise not been seen.

Stephen McNees: "At best, the adaptive expectations assumptions can be defended only as a 'working hypothesis' proxying for a more complex, perhaps changing expectations formulation mechanism." {Page 50}

Michael C Lovell, "Test of the Rational Expectations Hypothesis," American Economic Review, March 1966.

1Question #7: How do nominal exchange rates reflect countries' inflation rates? In your answer, please use both theoretical and empirical reasoning.

From class notes:
The real exchange rate takes account of both the nominal exchange rate and the domestic price level, therefore a change of real exchange rate reflects both changes in the nominal exchange rate and changes in price level (inflation).

Covered Interest Parity?
The nominal exchange rate is the rate at which currencies of two countries can be exchanged, whereas the real exchange rate is the ratio of what a specified amount of money will buy in one country compared with what it can buy in another.
Purchasing Power Parity (PPP), which says that identical bundles of goods should cost the same in different countries. This implies that the real exchange rate should be constant and equal to one and that changes in the nominal exchange rate are driven by inflation differences.

real exchange rate = * /
Historic data shows that fluctuations in the real exchange rate track movements in nominal exchange rate quite closely.

Law of One Price
Identical commodities should sell at the same price wherever they are sold, and the basis of the law is arbitrage.
dollar price of television in US = dollar/euro exchange rate * euro price of television in Barcelona

The law of one price fails for several real-life factors:
1. Transportation Costs
2. Border Effects-Technical Requirements (different voltage)
3. Pricing to Market-supply and demand nation factors.

Firms set prices based on local conditions and prices set by rivals. These prices tend to be sticky, but nominal exchange rates are very volatile. As a result, nominal exchange rate changes feed into real exchange rate changes and the law of one price fails to hold.

4. Not sure how it fits in here but "transaction costs" must be considered somewhere in here, due mainly to considering how efficient markets are and to what degree monopolistic competition is in various countries. Which I guess could fall into category 2 and 3 to certain degree.
The law of one price is a key part of our first theory of real exchange rate determination-Purchasing Power Parity (PPP). The law of one price refers to particular commodities. PPP applies the law of one price to ALL commodities-whether they are tradeables or not.
In other words, PPP implies that currencies depreciate if they have higher inflation that other countries and appreciate if they have lower inflation.
PPP appears to be a useful model for explaining long-run data.
It should be stated Relative PPP and not absolute PPP in above remarks.

Balassa-Samuelson effect.
Nontradeable commodities are a key reason why the law of one price does not hold. Countries with high productivity in their tradeable sector tend to have high prices for nontradeables so that rich countries are more expensive than poor countries.

Nominal and real exchange rates are both volatile and their general fluctuations show a similar pattern. Two potential explanations:
First: volatile economic fundamentals lead to a volatile real exchange rate which, in turn, produces a volatile nominal exchange rate.
Second: because prices in a country are relatively sticky, changes in the nominal exchange rate feed through into changes in the real exchange rate.

Be sure to review Optional reading (Page 14/Unit 7-"Living with Flexible Exchange Rates:...").

1Question 8:
What do you understand by the concept 'uncovered interest parity'? How relevant is the concept for analyzing countries' international capital flows, exchange rates, and macroeconomic policy?

I guess it might be best to think about CIP (covered interest parity) first.
Arbitrageurs can also make a profit with the forward exchange rates by using the Covered Interest Parity (CIP). By using the following formula:
F=((r(f)-r)*S)/(1+r)+S as F=forward, S=spot, r(f)=foreign interest rate 1 year, and r is the 1 year forward domestic interest rate.
If there is a difference between the calculated forward rates compared to the market rate then arbitrageurs will transfer monies until the rates match. “Covered interest parity is achieved as a result of arbitrage between the spot and the forward markets.”

A currency is said to be a forward premium if the forward exchange-rate quotation for that currency represents an appreciation of that currency compared to the spot quotation. Or "If F(0)>S(0), then the dollar is said to have a forward premium-the forward rate includes a dollar appreciation."
IRP (Interest Rate Parity) page 9-12 work book Unit 2.
The choice that an investor makes is to either remain in the home currency and receive the going rate OR switch to the foreign currency earn interest on the duration to time period 1 and then switch back to the home currency. Both these paths should equal the same results aside from "CIP only holds exactly if there is absolutely no risk to either the Yen or Dollar side of the transactions". That is no difference in risks from holding in different banks.
Arbitrage by investors will lead to the forward premium between two currencies being equal to the interest rate differential. High interest rate currencies are priced at a forward discount.
As money is moved from low interest rate countries to high interest rate countries the forward rate will decrease for the high interest country and interest rates will decline until the CIP holds true.
Does the CIP hold? The answer is a resounding "yes".

Uncovered Interest Parity (UIP):
As compared to returns being measured as:
Y(1+i(j)) to Y(1+i(US))F(0)/S(0)
Now the same in the country but the forward market is replaced by the Spot in the future:
Under UIP, investors rearrange their portfolio until the return on the yen account is equal to the expected return on the dollar account. In the case of UIP, we have:
expected appreciation of dollarS(0)
=Japanese interest - US interest rate

Covered and Uncovered Interest Parities

Category: Uncovered interest parity

The Exchange Risk Premium, Uncovered Interest Parity, and the Treatment of Exchange Rates in Multicountry Macroeconomic Models
UIP is correct in predicting how exchange rates respond immediately to interest rates and monetary policy, but it is wrong in forecasting the exchange rate forward. Instead, high interest rate currencies tend to appreciate.
Under UIP, when interest rates increase in the USA then the dollar immediately strengthens but then in future periods the currency should depreciate on a sliding scale-much as the J curve works.
In response to an unexpected increase in interest rates, UIP predicts that currencies should appreciate immediately so as to provide room for a larger future depreciation. Expectations of future currency strength also lead to an immediate appreciation. If overseas interest rates increase, then the currency should depreciate.

UIP says that predictable changes in the exchange rate are due to interest rate differentials but that changes in expectations will lead to substantial unpredictable fluctuations in exchange rates.

...a permanent change in monetary policy will exert a substantial impact on the current exchange rate and create volatility in the current exchange rates. Therefore, UIP implies that rational, forward-looking investors should generate a highly volatile exchange rate if changes in monetary policy are highly persistent.

Introducing Risk Averse Investors
This is an additional effort so that UIP fits the data better with loosening the assumption that investors ignore risk.
After adding the risk premium we have:
US Return = US interest rate + expected dollar appreciation
= Japanese interest rate + risk premium

Of course adding a risk premium can help explain capital flight. Risk is not just because of nationalization but also because of policies that could affect returns on assets including changes in tax laws and capital restrictions.
"Introducing risk premiums produces a more volatile exchange rate." Since expectations could be altered in even more dramatic ways.
A risk premium adds an additional source of exchange rate volatility and can potentially explain why the currencies of countries with high interest rates tend to appreciate over time.

Introducing risk premiums into UIP can help explain more of the volatility in exchange rates, but ultimately UIP fails to successfully account for short-run fluctuations in exchange rates. While it correctly predicts how exchange rates react to interest rate changes, there seem many other factors that drive exchange rates that are not reflected in UIP. Over a six-month horizon there seems little role for macroeconomics in predicting exchange rates.

Ultimately, since monetary policy affects interest rates and this in turn affects exchange rates (at least on the short term basis) then this is important consideration for any macroeconomic policy, even if over the longer period it does not hold.

*** IS-LM-BP ***
Assuming a flexible exchange rate with a high but not complete degree of capital mobility, then as the monetary officials reduce the money supply, this shifts the LM curve to the left. This in turn creates an immediate increase in the exchange rate -actually an appreciation of Currency- terms of trade is better- will shift the schedule horizontally to the left. Depending on the slope of the BP, interest rates could rise or fall but the in either case the BP will reinforce the effects of tighter monetary policy by reduced income. Thus the secondary effects could lead monetary officials to not be able to judge the exact effects of monetary policy.



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