Financial sector: Demand for financial assets/commodities.
Supply shortages (cost-push) can cause inflation also:
Product chain hold-ups.
Cartel decisions, e.g. OPEC.
Not always straightforward to tell the difference…
Chapter 13: Monetary Policy. The rise of the Central Banker…
A Central Bank’s Balance Sheet
Instruments and Targets
Monetary Policy and the LM Curve
IS Curve: Interest rate and income combinations s.t. goods mkt in equilibrium.
Need LM curve: Interest rate and income combinations s.t. money mkt in equilibrium.
Recall: \[
MV = PY.
\]
In equilibrium \(M=M^s=M^d\) and rearranging: \[
\frac{M^d}{P} = \frac{Y}{V}.
\]
Demand for real balances depends on income and velocity.
Velocity depends on interest rate: Opportunity cost of holding money.
If Income Increases, Interest Rate Increases
The LM Curve
Central Bank Influences LM Curve Via \(M^s\)
Increase \(M^s\) Shifts LM Curve
The IS-LM Model: Equilibrium in Good and Money Markets
Different Targets
Possible Targets
Money supply.
Interest rates.
Exchange rate.
Inflation rate.
Which Money Supply?
And What About Velocity?
Inflation Targetting
Explicit target (gold, exchange rate, etc) binding— leads to constraints.
Inflation targetting: Central Bank targets particular rate at particular time.
Tool used is interest rate (not money supply). Set by Central Bank.
Sets rate via manipulation of inter-bank lending. Open market operations.
Target range usually quite broad, Central Bank has lots of discretion.
Usually see increased transparency alongside inflation targetting.
Targetting Money Supply Causes Volatility
Targetting Interests Rates Less So…
The Transmission Mechanism: Policy to Real Economy
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The Taylor Rule
Taylor rule (John B Taylor) simplified version of Central Bank behaviour.
Interest rates should be set as function of inflation and output gap: \[
r_t = r_0 + \lambda (y_t-\overline{y}) + \alpha(\pi_t- \pi^*_t),
\] where \(\overline{y}\) is trend output, and \(\pi^*_t\) is inflation target.
Taylor suggested \(\lambda=0.5\) and \(\alpha=1.5\).
Quantitative Easing: When Negative Rates Required
The Impact of QE
Chapter 14: Fiscal Policy and the Role of Government
It Hasn’t Always Been This Way…
Different Governments Have Different Priorities
Rationale for Intervention
Invisible hand and efficient markets hypothesis:
Market ensures resources go to their most productive use. Pareto efficiency.
But efficiency relies on conditions holding:
Perfect competition, perfect information, low cost of mistaken choice.
Private costs and benefits equal social costs and benefits.
Justifications for government:
Traditionally: Public good provision.
Social insurance provision.
Paternalism: People can’t look after themselves.
But how big…?
Taxation Funds the Machine…
But Taxes Distort…
Cost of Taxes is Square of Taxes
More Taxes, More Distortion
The Laffer Curve
But No Relationship Between Govt Size and Growth…?
Other Sources of Finance for Govt Spending
The UK Debt Situation
Global Phenomenon of Large Budget Deficits
The Debt League Table
The Optimal Budget Deficit
Deficit financing investments can be profitable.
Deficit financing ensures taxation is smoother:
Instead of tax hikes to pay for wars or greater benefits, deficits used.
Sustainable? Borrowing against future income, borrowing in own currency.
The Argument for Tax Smoothing
Concluding
Today:
Chapter 12: Money and Prices.
Chapter 13: Monetary Policy.
Chapter 14: Fiscal Policy.
For week 10 classes: The Budget— what should we expect?
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