Made by Aaron Luke
aaluke16@gmail.com
Macroeconomics Notes
Topic 1: Introduction to Economic Growth
Lecture 1
Part One: Everything about GDP
Definition of GDP: Value of all new goods and services produced within national borders in a given
time period.
Y = C + I + G + NX
Y national income C consumption
I investment
G government spending
NX net exports
Measuring long-run growth: look at annual GDP
Measuring recession: look at quarterly GDP
o (2 quarters negative growth = recession)
Real Vs. Nominal GDP: (i.e. how we can compare GDP over time)
Nominal: measured using current prices
o Changes are due to price OR quantities
Doesn’t account for inflation.
Real: measures using prices of a base year
o Changes are due to quantities ONLY
PPP Vs. Market Exchange Rates: (i.e. how we can compare GDP between different countries)
Market exchange rates: Measure with local prices. Convert local prices (usually into USD)
using market exchange rates. Compare.
o Differences are due to different prices AND different quantities
Doesn’t completely account for inflation, cost of living etc.
Purchasing Power Parity (PPP): Measures using prices of a base country.
o Differences due to different quantities ONLY
GDP Facts & Examples
1. Poor countries usually have higher PPP GDP compared to nominal (b/c low cost of living).
2. Key GDP figures I should know roughly: (World Bank 2015)
a. UK:
Nominal = $2.8 trillion (or £1.8 trillion)
b. USA: Nominal = $18 trillion
PPP: Int$18 trillion
c. China: Nominal = $11 trillion
PPP: Int$19.5 trillion
d. EU:
Nominal = $16.2 trillion
PPP: Int$19.1 trillion
Part Two: Is Growth Sustainable?
Problem 1: Running out of natural resources (weakest argument)
Solutions:
1. Substitution: find alternative resources e.g. renewable energy
Made by Aaron Luke
aaluke16@gmail.com
2. Efficiency: Using asymptotically smaller quantities of resources to produce
3. Recycling: self-explanatory
Key takeaway: These mechanisms do not require public policy market mechanisms work to
direct effort to solving bottlenecks in resources.
Problem 2: Environmental degradation & climate change (negative externalities)
1. Substitution, efficiency, and recycling still important
2. Because involves externalities, public policy is key. No automatic price mechanism b/c of
externalities.
3. Environmental Kuznet Curve for pollution: As countries develop, environment gets worse
then better b/c countries are now rich enough to clean things up (e.g. London)
Extra Info: Paris Agreement in 2015; Global effort to contain global warming (keep temperate rise within 2 Celsius); USA
pulling out from agreement. Can be an example of missing market for externalities / lack of ownership
Part Three: Is Growth Good?
Zero-growth world:
More leisure
Less materialistic, less competitive, more focus on meaningful things
Pro-growth arguments:
1. Quantity of life: GDP/capita correlates with higher life expectancy (and adult literacy, lower
infant mortality)
2. Retrograde politics: Ben Friedman argues low/no growth associated with retrograde politics
3. Hurt poor countries: Zero growth in rich world may slow growth in poor countries
4. Arbitrary: Arbitrariness of picking consumption level; leisure already an option but not
taken.
Growth Facts & Examples
1. GDP/capita has remained stagnant for most of human history; starting growing
exponentially after Industrial Revolution
2. GDP/capita today is 10X higher than in 18th century
3. Some African countries have GDP/capita lower than Britain’s 1000 years ago.
4. HDI facts: (2015)
a. Norway: 0.949;
United States: 0.920
China: 0.738 UK: 0.909
Limitations of GDP:
i. Doesn’t account for externalities
ii. Doesn’t account for underground economy
iii. Doesn’t account for household work
iv. Doesn’t perfectly account for access to health/education
v. GDP =/= consumption
vi. Includes ‘bad’ things e.g. cleaning up after environmental disaster
vii. Doesn’t account for leisure
viii. Marginal utility of consumption is likely non-linear
+Many more reasons e.g. problems with non-PP/nominal measurements, inequality etc.
Summary: GDP necessary, but not sufficient, for welfare improvement
Made by Aaron Luke
aaluke16@gmail.com
Topic 2: Economic Growth; Capital Accumulation
Lecture 2
Part One: Context to This Lecture
Focus on GDP per worker
o (strong connection between ability of average worker to produce goods/services and average GDP per
person)
Where does GDP per worker come from?
o Equipment and structures (“Tools”) i.e. capital
UK Long-run growth around 2-2.5%
Focus of this lecture is relationship between: Capital per worker GDP per worker
o Can capital accumulation alone lead to indefinite increases in living standards?
Part Two: Setting Up the Basic Solow Growth Model
Assumptions in production function: (Graph of GDP/worker vs capital/worker)
1. Increasing function
a.
Adding more capital per worker = more GDP per worker
2. Decreasing marginal productivity of capital
a.
Each added bit of capital adds less and less to GDP
Change in capital = new investment depreciation
Investment:
Act of putting into place additional new pieces of equipment and structures.
Investment is ‘endogenous’ in this model.
Investment Rate, s:
𝑠
𝐷
so Investment = s X GDP
Example investment rates: (World Bank 2015)
China: 45%
USA: 20%
UK: 17%
World: 24%
Malaysia: 25%
Depreciation:
Inevitably, capital stock ages and becomes less efficient and breaks down over time.
Depreciation is exogenous – we take it as given / cannot be influenced.
Depreciation Rate, d:
𝑑
so depreciation = d X Capital
6-7% a year is normal for d. d is usually seen as constant number
Growth happens investment exceeds depreciation. When depreciation = investment, we have
reached a Steady State. (Steady state is determined by s and d)
Made by Aaron Luke
aaluke16@gmail.com
Law of motion for capital: (must always be expressed in per worker terms change variables you get if needed)
Change in capital = new investment depreciation
In mathsy terms:
k = capital per worker
y = GDP per worker
k = sy dk
s = investment rate
d= depreciation rate
Now we divide by k…
∆𝑘
𝑘
𝑠
𝑦
𝑘
k/k = growth rate of capital per worker
𝑑
y/k = average product of capital
During transition (to steady state), growth rate keeps declining. Given the assumption of diminishing
marginal product of capital, average product of capital (y/k) will also diminish as we add more
capital.
Population Growth: Is akin to depreciation b/c as population grows, capital per worker gets diluted.
Hence why countries have fertility control policy e.g. China, India.
Conclusion: Growth through capital accumulation decreases over time and peters out eventually.
Part Three: Increase the Savings Rate
If increase s: Get an added period of growth, but it stops again (reaches a higher steady state). To
keep growing, must keep increasing share of GDP i.e. higher value of s.
GDP = C + G + I + NX
I = GDP – C – G – NX
s = 1 (C + G)/GDP NX/GDP
1 - (C+G)/GDP is National saving rate
NX/GDP is net exports as a share of GDP rate.
To get more growth…
Option 1: Increase national saving rate [i.e. decrease C and G]
Will still reach mathematical limit to savings rate [historical limit is 50% ish]
Politically costly – people may revolt if savings rate too high
Option 2: Increase imports, decrease exports [i.e. decrease NX, make it negative]
When NX is negative, we are borrowing from foreign countries
Foreign debt cannot be accumulated indefinitely.
o People will eventually stop loaning to you.
Conclusion: Therefore cannot have indefinite increases in the investment rate.
Yet barely any relationship between growth rate and capital per worker (should be downward
sloping [GDP per worker vs capital per worker should be concave as well]
Made by Aaron Luke
aaluke16@gmail.com
Part Four: Playing Around with the Model
Two countries are at the same capital-labour ratio (i.e. both are at same point of k). If one
country has a steady state that is further away (i.e. higher), it will have a faster growth rate.
o Poor countries may actually grow slower than rich countries – the absolute level of
capital per worker is not important. Rather, it’s the distance between starting point
and destination (steady state) that dictates growth rates.
A country with a higher population growth rate will have a lower steady state (population
growth is akin to depreciation).
Total output is determined by both capital and labour. If the labour force falls, total output
will fall even though capital per worker is higher now.
Relationship between GDP/worker and Capital/worker should be concave given
diminishing marginal productivity of capital
o However, assumes countries use capital with same level of efficiency (i.e. doesn’t
account for TFP differences)
Topic 3: Economic Growth; TFP & Human Capital
Lecture 3
Part One: Context to This Lecture
Example textile factory in India (Low TFP) – big mess. Has capital, but not used efficiently.
Focus of this lecture is Capital per worker + TFP = GDP per worker
Example of inefficient state: USSR
o Had lots of capital but poorly organised + did not allocate capital efficiently.
Part Two: Basics of TFP
Total Factor Productivity, TFP: Efficiency with which factors of production are used.
[Not in lectures]
Gro th in total-factor productivty (TFP) represents output growth not accounted for by the growth in inputs."
Hornstein and Krusell (1996).
TFP can be measured b the Solo residual hat s left after ou ve accounted for labour capital gro th
Graphically: Increase TFP
Entire production function shifts up (higher investment & GDP curve)
TFP growth brings a double dividend:
Increase in GDP AND increase in investment
o Investment is same proportion, but now higher absolute amount
Direct benefit: Increase GDP for given amount of capital
Indirect: Increase in investment due to increase in GDP, leading to further growth in capital
TFP growth is not subject to Diminishing Returns. It is the key to long-run growth.
Made by Aaron Luke
aaluke16@gmail.com
Part Three: Innovation
Innovation: Introducing new ways of doing more with less
Not just ‘process’ innovation, but ‘product’ innovation as well i.e. creating variety. Important
because diminishing returns from existing products.
Usually comes from two sources:
1. Research and Development, R&D:
Mostly done in firms
Takes basic research and turns it into applied things that are viable in the market
Characteristics:
Faces upfront research costs
Nonrivalry (research can be used simultaneously by different parties)
Problem:
With unrestricted entry, other firms can enter
Creator forced to sell product at marginal cost, but bears cost of research
Creator therefore incurs negative profit
Hence little innovation will occur – no profit incentive
Solutions:
Patents
o Duration is usually 20 years (Europe/USA); USA has 15-year design patents
o Gives firms market power, can charge above marginal cost to recoup research costs
o Tradeoff: Give too long, lose consumer surplus. Give too short, cannot recoup costs
Subsidies
o Allow R&D to be tax deductible for corporate taxation
o Match spending – every dollar of R&D matched by dollar of subsidy
2. Basic Research or blue sky research :
Done mostly in universities
Researches basic ideas/building blocks that usually cannot be directly marketable
o Many steps needed before can become a product
Presence of positive externalities
Heavily subsidised by government
Part Four: Imitation
For countries behind the tech frontier, imitation makes more sense than innovation (long hanging
fruit). However, imitation isn’t that simple a lot of informal & implicit/tacit knowledge required. Hard
to communicate this knowledge except with experience.
Made by Aaron Luke
aaluke16@gmail.com
Sources of International Technology Diffusion:
1.
2.
Foreign Direct Investment, FDI: Any cross-border investment that takes a form of a
plant/firm [In this context, firms in rich countries build/takeover firms/plants in developing
countries]. Generally quite effective way of increasing FDI.
a. Direct tech transfer: Build plant Plant embodies knowledge of origin firm. The
plant itself directly increases TFP (Least important mechanism)
b. Diffusion through imitation cluster: Employee of original plant learn tech, start own
plant. (e.g. textile FDI in Bangladesh from Japan)
c. Competition with inefficient local firms: Puts pressure on locals to increase efficiency
or cannot make profit. Good firms will respond and increase efficiency. Bad firms
will leave market (thus capital/labour that was trapped now gets reabsorbed into
more efficient firms)
Trade (decent evidence for this)
a. Imports
i. Get embodied technology (ideas/knowledge embodied in physical objects)
ii. Puts pressure on inefficient local firms (same analysis with FDI)
b. Exports
i. Learning by exporting (buyers teach sellers). If want to export, must raise
game. German etc. buyer will tell you how to make perfect product. They do
this because want cheaper product from developing country. Lots of evidence to support this.
ii. Market size. Imitation entails upfront costs as well. Can recover upfront cost
of becoming more efficient b/c got more scale. Scale also justifies upfront
cost of imitation
3. Education/work abroad (works to a point)
a. Worked well in Singapore, but only because they are good at getting people back
b. Other countries: people leave, loss of brightest talent.
c. Also little evidence of how much tech/knowledge actually transferred.
Should poorer countries enforce Intellectual Property Rights of rich-country firms?
Examples: HIV/AIDS patents in South Africa. Chinese firms accused of violating patents; Chinese
government accused of being complicit. Same problem historically with Japan.
Reason to violate patents
o Temptation to produce cheaply (because with patents, P>AC)
Reasons to not violate patents
o Discourages FDI (firms afraid to move into country if tech is copied blatantly)
o Adverse effect on rich-country innovation; collective effect of discouraging
innovation b/c gives firms smaller market
Especially harmful if innovation is specific to poor-countries e.g. Malaria
medication
o Rich countries don t like it (e.g. if you want trade deals…)
In practice, a lot of innovation is embodied in capital/equipment. So investment itself is a source of
TFP growth
Made by Aaron Luke
aaluke16@gmail.com
However, there are other TFP determinants besides technology….
Part Five: Managerial Quality
Big dispersion in TFP among firms within countries (particularly poor countries)
Why? Managers are heterogenous in ability
o Can make big gains from bringing up the ‘tail’ (i.e. the worst)
Causes of poor managerial quality:
1) Dynastic Management: Firms run by family members
a. In most countries (inc. rich), firms not run by shareholders, but are family-run
b. Founder usually has great talent/energy. But as leadership gets passed to children,
over time likely to get a generation that’s not fit/interested to run firm.
c. Results in talent mismatch
2) Crony capitalism: Firms run by people with political connections
a. Firm may not have to adhere to regulations
b. Can ask gov. to harass competitors e.g. send over tax/health/safety inspectors to
harass, deny import licenses
c. Also results in talent mismatch
3) State owned enterprise:
a. On average runs less efficiently b/c has other motivations besides profit
b. Or appointments by political connection
Problems that compound poor managerial quality:
High entry costs for talented outsiders (So less competitive pressure for incumbents)
a. Upfront production costs required
b. Licenses permits required etc. (red tape cost)
2) Poorly developed financial markets (to borrow and overcome upfront costs)
a. Typically as result of inefficient contract enforcement (developed country: has
system of courts etc. to ensure repayment of debt)
3) Limited scope for buyouts (hard to go to incumbent and buy them out)
1)
Venture capital: Finances initial upfront investment
Corruption & Growth:
Corruption like a tax. Saps incentives for innovation/imitation/investment if corrupt officials
target successful entrepreneurs (hits successful firms disproportionately)
Creates barriers to entry for outsiders (if insiders use corruption to buy protection/judicial
bias etc)
Deprives government of funds (embezzlement)
Suggested read: Ngozi Okonjo-Iweala (growth in Nigeria)
Made by Aaron Luke
aaluke16@gmail.com
Part Six: Human Capital
Human capital per worker: Intrinsic ability/skills to produce. Anything embodied in workers which
makes them more productive. Sourced from schooling and health (more energetic/focused, lose less
days to sickness etc.)
Benefits of Human Capital:
1) Direct effect on GDP per worker: produce more (b/c more knowledge/energy)
2) Indirect effect on investment: increases marginal product of capital (higher return on capital,
more incentive to invest because investment will have higher return)
3) Indirect effect on TFP: facilitate innovation/imitation (workers more receptive e.g. reading
manual)
Qualifier: Human capital not a panacea to growth. It is not a huuuge contribution to growth. TFP is
the true key.
Lecture 4
Part Seven: Industrial Policy
Industrial policy: The picking of particular industries to grow. Some industries need particular
attention from government (needs to be nurtured) e.g. cars, semiconductors, steel, IT.
Tools:
Tax breaks &subsidies
privileged access to currency/import channels,
suppression of labour regulations,
protection from imports.
Made by Aaron Luke
aaluke16@gmail.com
Rationale:
Externalities: For example automobile industry acts as engine for growth
Increasing returns to scale
o High upfront costs, need to guarantee return on investment OR produce over time
to get good at it via ‘learning by doing’.
Risks:
Opens up gov. to corruption/cronyism/political pressure/lobbying from vying industries
Subsidies very hard to take away – hard to reverse mistakes (those who benefit will mobilise
politically to protect privileges)
Protected industries grow complacent/inefficient
Records: Smashing success in 3 countries – Japan, Taiwan, South Korea; rest was failure. Heyday of
Industrial Policy was 60s-70s, then world moved away from it.
Made by Aaron Luke
aaluke16@gmail.com
Topic 4: Economic Fluctuations
Part One: Context
Economic fluctuations: Fluctuations in aggregate economic activity around its long-run growth path
[change in growth rate, not growth level]
Long-run economic growth in UK is around 2-2.5%. But growth fluctuates every year (shocks).
2 Kinds of shocks:
Aggregate Demand Shocks (more important/frequent; main focus)
Aggregate Supply Shocks
Expansionary (positive) shocks vs. Contractionary (negative) shocks. Use of positive/negative does not
imply value judgement – both booms and recessions are problematic.
AD Shocks: Anything that causes increase in desired C/I or G/NX
Sources of AD Shocks:
G
o
o
o
Wars (e.g. WW1/2 & Vietnam big positive shock to US economy)
Ideology changes (e.g. UK conservative’s election – Osborne’s commitment to
austerity)
Fiscal crises, gov. literally has no money (e.g. Greece)
o
o
o
Chg in taxes (e.g. Donald Trump plans to drop corporate tax to 15%)
Chg in wealth
Psychological / animal spirits (e.g. Brexit; consumers spending went up)
o
o
Changes in exchange rates (e.g. depreciation of pound is positive shock)
Foreign demand shocks (e.g. Euro area crisis)
I/C
NX
Part Two: AD Shocks under Flexible Prices vs. Sticky Prices
Flexible Prices
Micro theory would lead us to think that shocks have very little effect on quantities, but big effect
on prices/wages.
Rough Illustration: AD decreases 10%. So as a shop you expect customers want to spend 10% less.
Instead of firing workers and having your machines idle (produce less), you just cut prices by 10% to
meet new level of demand. P=MC still achieved.
More technical (from exercises): AD drops by 10%. If I don t drop prices, I have to drop quantities by 10%. This reduces MC
without reducing P equivalently (therefore not optimal, P=MC not achieved). So I have to drop price (and wages) by 10%.
P=MC is satisfied because both P and MC are dropped by 10% (MC is linear function of factor prices, so if other factor prices
and wages fall 10%, MC falls 10%). Also, the physical production required to sustain the new level of AD will be the same as
the old level
Economy ‘wants to be’ at its ‘full-employment’ level.
Made by Aaron Luke
aaluke16@gmail.com
Sticky Prices
However, there is good reason to believe prices are not flexible.
Small effects on prices, large effects on quantities.
Supply is determined by demand. Producers respond by adjusting quantities, not prices. That’s why
we have booms and shocks.
Explanations for Price Stickiness
Menu costs – costs of physical act of changing prices – not the most important
Information costs – costs of figuring out new price (e.g. hiring consultant)
Consumer reaction – inertia; collective problem of being first to change price (lose market
share to competitor, perhaps even permanently)
Wage rigidity – social norms surrounding wages.
Topic 5: Countercyclical Policy
Countercyclical policy: Policies aimed at countering the economic cycle (‘leaning against the wind’)
Fiscal Policy
o Changes in G spending (including transfers) and in taxes
o Run by Government (UK: Chancellor of the Exchequer)
Monetary Policy
o Purchases and sales of financial assets, setting of statutory interest rates
o Run by the central bank
Part One: Fiscal Policy
Terminology:
Government spending
o = G (goods and services purchased by gov) + Transfers + Interest
o G i.e. goods and services purchased by gov
o Transfers
o Interest payments on debt
Government revenues
o = mostly taxes
Deficit
o = Spending – Revenues = chg in debt
o Most govs run deficits (like UK now)
Surplus
o = Revenues – Spending = (-) chg in debt
Made by Aaron Luke
aaluke16@gmail.com
Dual Role of Fiscal Policy
1. Source of demand shocks e.g. austerity in UK
2. Tool to counter other demand shocks e.g. fiscal stimulus policies in 2007-2009
Lecture 5
Chg in spending
Chg in taxes
Impact directly on C & I
Impact indirectly on C & I
The fiscal multiplier: Change in GDP due to $1 change in the deficit.
Value of fiscal multiplier:
Greater than 0 (i.e. GDP increases when government spends more)
Usually less than 1 (crowding out – shrinks private GDP/spending i.e. C+I+NX decreases)
Possibly greater than 1 in severe recessions
*Multiplier less than 1 (crowding out) not necessarily bad – allows you to support unemployment in
response to AD shock.
Reasons behind crowding out:
Anticipation of future taxes: Increase in deficit/debt has to be repaid in future – so I think my
taxes will go up tomorrow– I better set aside money for future tax payments – therefore C
and I decline a bit
Increase in interest rates: Increase in deficit – means gov is borrowing more – interest rate
goes up
Diversion of productive capacity: Private resources reallocated to produce public resources
Limits of expansionary fiscal policy: Debtors stop lending to you when debt too high
Golden rule for fiscal policy: Run a deficit in recession, run a surplus in booms; keep budget
balanced on average. Germany is the main opponent against this – believes in always running
balanced budget. UK (Osbourne administration) says don’t run deficits ever, till now (abandoned due
to Brexit).
Part Two: Monetary Policy Basics
Done by Central Banks e.g. Fed, Bank of England, ECB, Bank of Japan
Interest: Compensation received by the lender from the borrower
Interest rates: The per-unit-value compensation
Interest rates tend to move together (due to arbitrage)
Example of arbitrage: i on gov bonds go up Demand for corporate bonds goes down
corporate bonds goes up. [corporate bonds need to raise interest rates to find lenders]
i on
Made by Aaron Luke
aaluke16@gmail.com
Policy rates: Central bank controls certain rates directly:
Rates on commercial banks’ deposits with central bank (reserves)
Rates on commercial banks’ borrowing from the central bank (discount window rate, repo rate)
Changing policy rates affects all other rates in the economy e.g. Interest rates on commercial bank
borrowing from central bank goes down financing for commercial banks becomes cheaper
commercial banks require lower interest rates to lend.
Interest Rates and Investment (same parallel with consumers)
Cash poor firms: interest rate is cost of borrowing; high i deters borrowing to invest
Cash rich firms: interest rate is opportunity cost of investment project; if i is high, might as
well lend money rather than use it to invest.
Part Three: Monetary Policy; The ELB
Effective Lower Bound (ELB): The point below which conventional monetary policy is ineffective
Until recently, ELB was thought to be 0 (i.e. the Zero Lower Bound, ZLB)
ELB reflects the cost of storing cash
o Negative interest rates should give incentive to borrow and hoard infinite cash,
pushing up interest rate to 0% again [b/c creditor pays borrower]
o But this does not happen – hoarding cash costs money (security, storage costs,
insurance etc.)
o Therefore people still willing to rely on electronic deposits (ELB < 0%)
Estimated that negative interest rates are still feasible at -0.5%
Examples of Central Bank Policy Rates:
Switzerland (Jan 2015): -0.75%
Japan (Jan 2016): -0.10%
UK (Aug 2016): 0.25%
*ECB (March 2016): 0%
Sweden (Feb 2016): -0.5%
USA (March 2017): 1.00%
[Extra info] *Deposit facility rate (interest banks receive for deposits with central bank overnight) is -0.4%. main refinancing operations
(MRO; cost for banks to borrow from central bank for one week, most important rate) is 0%. Marginal lending facility rate (cost of
borrowing from central bank overnight) is 0.4%
Getting around the ELB: (i.e. how to make monetary policy effective at low/negative interest rates)
Option 1: Abolish paper currency
Without cash, must hold deposits and face the negative interest rate
Problems:
o Poor rely depend on paper currency, may not have current accounts
o Some legitimate transactions hard to conduct w/out paper e.g. Yard sale
o [not in lectures] Individuals may turn to alternative currencies (Bank of Canada, 2016 paper)
Option 2: Abolish high denominations of currency
Overcomes most shortcomings of complete abolition of paper currency
Still effective: small denominations increase storage cost, resulting in lower ELB
Made by Aaron Luke
aaluke16@gmail.com
Part Three: Monetary Policy; QE & The Yield Curve
Quantitative Easing:
Long term bonds usually have positive interest rates even when short-term ones are at zero
or negative. This ‘spread’ is a risk premium:
o Compensate lenders for locking-in money for long time
o Borrowers don’t mind locking in a fixed interest rate even if it’s slightly higher
These long-term interest rates are very important – involves big purchases like cars, houses
& most businesses concerned primarily with long-term rates
Central Banks may switch to buying long-term bonds in attempt to lower long-term interest
rates [Bypasses relationship with commercial banks – go straight to financial market]
Mechanism for QE:
1. Central Bank starts buying long-term assets (using newly created electronic money)
2. Therefore demand for long-term assets increases
3. This pushes down interest rates specifically on long-term assets
4. Long-term interest rates are most important for investment decisions
5. So low long-term rates can help foster growth/recovery
QE Facts/Examples:
USA – stopped in 2014, accumulated $4.5 trillion in assets on balance sheets
UK – created £375 billion between 2009 and 2012; Bought another £60 billion in gov bonds and £10 in
corporate bonds to support Brexit in August 2016
ECB – Reduced monthly purchases to $60 billion in Dec 2016; $4.2 trillion on balance sheet
Yield curve (Interest rate against Maturity)
Shape:
Usually upward sloping (i.e. long-term bonds have higher interest rate than short-term ones)
Reasons for upward sloping: [Not sure if examinable, was discussed in my class]
Expectations Hypothesis: Overall returns on a long-term bond and an equivalent sequence of
short-term bonds should ultimately be the same (if not, investors would opt for the higher return
option). So long-term bonds have a higher interest rate, given interest on short term bonds can be
compounded over that same duration.
Liquidity Premium Theory: Long term bond has higher interest rate to compensate for risk of
locking in money for so long
Segmented Market Hypothesis: Assumes markets for long-term and short-term are separate. So
both markets have different demands. Demand for short-term bonds is higher given investors prefer
liquidity. Higher demand implies lower interest rates compared to long-term.
Why it might be downward sloping: Bad economic climate (I expect CB to lower short-term rates
soon to boost economy, therefore I’m willing to accept lower long-term rates to lock-in a decent
return)
Made by Aaron Luke
aaluke16@gmail.com
Movement:
Short-term and long-term rates move together (but long-term will be higher)
Action
Movement
Central Bank increases policy
rate
Short-term rates expected to
increase in future
Curve becomes shallower (‘flatter’) Short-term rates increase, but long-
Inflation expected to increase
in future
Curve becomes steeper If I think inflation will erode my purchasing power in the
term rates are less responsive to the policy rate, so the curve becomes flatter.
Curve becomes steeper If I think short-term rates will increase in future, I want
better compensation for my long-term bond now.
future, I want better compensation for my long-term bond. Also, I expect CB may
increase short-term rates in future to combat inflation.
Curve becomes shallower Central bank buys long term bonds, increasing their
**Quantitative Easing**
demand and decreasing their interest rate (intuition: if so many people want my bond,
why should I pay a high interest rate for it…?)
Lecture 6
Other ways QE may help:
Boost stock markets (b/c bond returns go down, holders of stocks feel richer as stocks
increase in price)
Make room for loans on commercial banks’ balance sheets (fewer bonds to buy)
Depreciate the exchange rate (b/c supply of currency increases e.g. euro)
Psychological boost to investors and consumers (seen to be doing something)
Does QE work? Who knows – only one data point (for now)
Part Four: Monetary Policy; Helicopter Money [from exercises]
Helicopter money: Central Banks prints money and gives it directly to individuals
Part of that money gets spent on goods/services
o Has an effect similar to fiscal stimulus [direct impact on AD]
Part of that money gets saved
o From this, some gets saved in form of cash
o Some gets saved in form of interest-bearing assets
Hence increase in demand for interest-bearing assets
Thus interest rates get lowered
o Has an affect similar to monetary policy as well
Comparison to QE
o HC has less impact on interest rates (only part of it gets saved vs. QE)
o But may be more powerful than QE when interest rates low and unresponsive
Money given to poor will have bigger impact on economic activity
o Poor have higher marginal propensity to consume (MPC)
Made by Aaron Luke
aaluke16@gmail.com
Topic 6: Inflation
From short-run to long-run: Prices not sticky forever. Economy gravitates back towards its
‘natural’ level of output
Booms are bad as well: when prices become unstuck, inflation occurs
Risk of expansionary monetary policy: may swing too far and generate inflation, or not
enough, then recovery takes too long
Inflation: The percentage increase in the level of prices
Part One: Measuring Inflation
Measure 1: GDP Deflator
𝐺𝐷𝑃 𝐷𝑒𝑓𝑙𝑎𝑡𝑜𝑟
100 𝑋
𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃
𝑅𝑒𝑎𝑙 𝐺𝐷𝑃
i.e when nominal GDP grows faster than real GDP, the difference is inflation.
Measure 2: Consumer price index
Measure changes in price of fixed bundle of consumer goods.
CPI vs Deflator:
Deflator: Change in price of average item produced domestically
CPI: Change in price of the average item consumer by households
CPI is mainly consumer-focused
Prices of capital goods
o Included in deflator (if produced domestically)
o Excluded from CPI
Price of imported consumer goods (deflator is entirely about domestic goods)
o Included in CPI, excluded from deflator
Basket of goods
o CPI is fixed; deflator changes every year
UK inflation tends to gravitate towards 2% inflation. Recently flirted with deflation.
Example Inflation Rates:
Venezuela: 808% (2016)
USA: 2.4% (March 2017)
UK: 2.3% (April 2017)
Part Two: Problems/Benefits of Inflation
Problems:
1. Relative price distortions
We don’t care about absolute prices -- relative prices convey information on scarcity and wants –
crucial so that producers/consumers respond efficiently.
Made by Aaron Luke
aaluke16@gmail.com
Firms change prices infrequently (sticky prices) -- different firms change prices at different times,
leading to relative price distortions – causes microeconomic inefficiencies in the allocation of
resources.
Therefore inflation renders price changes as merely ‘noisy signals’.
2. Mistakes and misperceptions of relative prices
Consumers/firms mistake nominal price changes for relative price changes e.g. may feel purchasing
power is falling when it is not; see that broccoli is 30% higher but don’t realise their wage is also
higher. Consumers react differently to different price changes (monetary illusion).
Inflation is costly because it leads consumers to misallocate resources.
Also has direct negative psychological effect (consumers feel poorer).
3. Increased uncertainty
Higher inflation rate means more variability and unpredictability. Higher rate means inflation tends
to turn out different from expectations more often and differences tend to be larger (but not
systematically positive/negative).
Higher uncertainty – makes risk-averse people worst off.
Complicates financial planning. Harder to estimate correct inflation rate for use in contracts etc.
One benefit:
Improve functioning of labour markets:
Nominal wages rarely get cut (downward rigidity), thus may make recessions worse.
Inflation allows real wage to fall without nominal wage cuts (product the firm sells becomes higher
priced relative to wages they pay out) – so moderate inflation may improve the functioning of labour
markets.
So mild inflation around 2% is not a bad thing.
Part Three: Tackling Inflation & Hyperinflation
Bringing inflation down:
Once inflation starts, people start forming expectations around it
o Contracts/annual price & wage changes formed around expectation of inflation rate
o Inflation rate starts getting ‘baked in’
To get inflation down, must engineer recession with sharp increase in rates
o that’s why CB very careful with inflation inching up
Inflation targets: to anchor expectations – have explicit medium-run target
Bank of England: 2%
ECB: less than but close to 2% (problematic: Draghi thinks this means close to 2%, Germany thinks it means 0%)
Made by Aaron Luke
aaluke16@gmail.com
Hyperinflation: Inflation rate above 50%.
Caused by excessive currency creation.
Stems from fiscal problems
o Governments unable to raise taxes or sell bonds to cover deficit spending
o So covers it via printing money (revenue raised from printing money: seigniorage)
Examples of hyperinflation:
Zimbabwe recently, Germany after WW1, Hungary after WW2
Lecture 7
Ending hyperinflation
Two-pronged strategy:
1. Fiscal reform
Without adjustment on fiscal side, root cause of hyperinflation will continue to exist. Requires gov to
do things like raise taxes, cut spending, sell public assets to reduce dependence on seigniorage.
2. Decouple monetary policy from fiscal by providing nominal anchor.
Ppl expecting high inflation – ‘baked in’ expectations – Ppl don’t believe inflation will come down
Promise a fixed rate of money supply growth
o People don’t actually get to observe this
only find out later if money supply truly under control
o History of CB breaking promises to control money supply growth
o Therefore this solution typically lacks credibility
Set an inflation target
o Better because observable (can see target)
But inflation is delayed consequence (see results quarters later….)
So not sure if CB is sticking with it right now, still suspicious
o Also gov may lie about inflation rate (e.g. Venezuela, Argentina)
Peg currency to a more stable currency (fixed exchange rate)
o Exchange rate responds to changes in relative supply of currency
Print too much money – currency depreciates
Print too little money – currency appreciates
Exchange rate very responsive to money supply
o Even if official exchange rate not true, black market rate will pop up
o Hence, good way of ‘tying’ the govs hands
Establishing central bank independence may help
o Gov cannot ask CB to just print money
Made by Aaron Luke
aaluke16@gmail.com
Case study 1: Argentina s convertibility plan
In 1991, by Economy Minister Domingo Cavallo
Fiscal reform:
Attack on tax evasion
o Named and shamed evaders
o Individuals could turn in their sales receipts for lottery tickets
B/c business evaded sales taxes, hard to track without receipts
Incentivised people to ask for sales receipts
Monetary reform:
Pegged peso to dollar
Pretty much replaced central bank with a machine
o Machine would print peso if USD came in (one-for-one convertibility)
o Guarantee: “I stand ready to exchange the peso for dollar at any time”
o Peso cannot lose value – every peso backed by a USD
Case Study : Brazil s Plano Real [not in lectures/classes; extra notes]
Brazil experienced high inflation in 1994 Government introduced a virtual currency called the URV
(unit of real value) all prices were to be quoted in URVs, but payments were to be made in cruzeiros
(the inflating currency) URV was pegged to USD and every day gov. would update value of cruzeiros
to URVs on July 1st 1994 Gov introduced new currency called the Real to replace the cruzeiro; had
same value as URV new currency was followed by contractionary fiscal/monetary policy inflation
eliminated URV functioned as nominal anchor; countered psychological inertia of inflation
Part Four: Deflation
Deflation is negative inflation
Problems:
Same problems as inflation
o Relative prices are also distorted
o Mistakes/misperceptions in relative prices also happen
However, deflation has its own unique problems
o Causes consumers to delay purchases
Would rather wait to purchase when prices lower in future
o Causes increase in debt burdens
Nominal wages / prices (for businesses) falling
But debt is fixed
Deflation has a self-perpetuating / vicious cycle element
o Prices fall – consumers delay purchases – prices fall more – repeat
o Debt burden increase – people go bankrupt – recession worsens – debt burden
increases – repeat
Made by Aaron Luke
aaluke16@gmail.com
Part Five: Discussion on Supply Shocks
Supply shocks are simple: Something happened on firm side that made it more expensive/cheaper
for them to operate.
Sources of Supply shocks:
Accelerations or decelerations in technical change
o Say, TFP/tech change growth is on average 2%
o Maybe TFP grows more/less than the 2%
Changes in cost of raw materials e.g. oil
o Important input – firms cut on production
Why most shocks are demand shocks, not supply shocks:
1. Prices tend to be procyclical
a. In demand shock, p and q move in same direction (procyclical)
b. In supply shock, p and q move in opposite directions (countercyclical)
2. In most recessions/downturns, growth rate is negative (not just slowed down)
a. While reasonable to believe TFP growth can slow down, unlikely for it to be negative
b. Negative TFP growth implies society on average became dumber/forgot how to do
things [reasonable for individual firms, but not overall economy]
c. Therefore rules out supply shocks sourced from TFP downturns
Made by Aaron Luke
aaluke16@gmail.com
Topic 7: Unemployment
Part One: Basics + Terminology
Employed, E = working at a paid job
Unemployed, U = not employed but looking for a job (serious about getting job)
Labour force, L = employed + unemployed persons (everyone who wants to work)
𝑼
Rate of unemployment, 𝑳 = percentage of labour force that is unemployed
Components of unemployment:
1. Natural rate of unemployment
a. The unemployment rate when economy is neither in recession or boom
2. Cyclic component
a. Difference between actual and natural rate (influenced by fluctuations)
Unemployment Facts and Examples:
Average unemployment rates (1970 2011):
Japan
Germany
: 3%
: 8%
Spain
UK
: 14%ish
: 7%
Greece : 11%
USA
: 6%
Latest unemployment rates (Around Feb to April 2017):
Japan
Germany
: 2.8%
: 4%
Spain
UK
: 18%
: 4.7%
Greece : 23%
USA
: 4.5%
Part Two: Matching Theory (Pissarides)
Separations
o Dismissals, redundancies, firm closures
o Quits
Search
o Of workers for firms
o Of firms for workers (vacancies)
Matches
o Search and matching process takes time and effort
s = rate of job separation rate
Fraction of employed workers that become separated from their jobs in a given period
f = rate of job finding
Fraction of unemployed workers that find jobs in a given period
Made by Aaron Luke
aaluke16@gmail.com
New unemployed = s X E
New employed = f X U
At natural rate: f X U = s X E (flows in equal flows out)
𝑠𝑋 𝐿
𝑠𝑋𝐿
In Boom: f X U > s X E
𝑠𝑋𝐸 𝑓𝑋𝑈
𝑈
𝑓 𝑋 𝑈 ; replaced E from U + E = L
𝑠 𝑓 𝑋 𝑈; bring s X U to right, factorise
𝑼
𝑳
𝒔
𝒔
𝒇
Lecture 8
Part Three: Policies and Institutions Influence on Natural Rate
1. Unemployment insurance (UI)
Pays part of a worker’s former wages for a limited time after the worker loses their job
Advantages:
Reduces hardship of unemployment
Better matches between jobs and workers (more time to search, won’t just take first job)
o Greater productivity, higher incomes, good for society, less wasted skills
[Not in lectures] Functions as an automatic stabiliser to cushion AD drops (Blinder 2006)
Disadvantages:
Increases search length + unemployment, because reduces opp cost of being unemployed
o Studies: longer a worker is eligible for UI, longer the average spell of unemployment
o Gov’s problem: choosing level and duration of UI so to find right balance between
costs and benefits
UI Net Replacement Rates Ho much of the person s former income is covered b UI
Portugal: 90%
Spain: 60%
Germany: 60%
Italy: 55%
(European Commission 2013 paper)
UK: 10%
2. Active Labor Market policies
Government policies to help workers in search process / increase employability of workers.
Gov employment agencies
o Disseminate info about job openings to help matching
Conditional unemployment benefits
o Make UI dependent on job search effort (incentive)
Public job training programs
o Help displaced workers from declining industries get skills needed for growing industries
Made by Aaron Luke
aaluke16@gmail.com
[Not in lectures] Other active policies include Direct Job Creation (creates temporary nonmarket jobs e.g. France’s Job’s for
Young People), Supported Employment (subsidies for individuals with reduced working capacity), Job-Search Assistance
(covers employment agencies, but also subsidies to help workers relocate), and subsidies for hiring workers.
3. Employment Protection Legislation
Policies that make it difficult and costly to fire workers.
Analogy: Does forbidding divorce results in more/less unmarried people? Hard to tell – no flows
from married to unmarried, BUT fewer flows from unmarried to married. Low s, but low f.
USA: Fire at will (i.e. divorce easy)
Other countries – policies to make firing more costly (i.e. divorce hard)
o High mandatory severance pay
o Strict conditions for severance e.g. grave firm distress (e.g. firm may go bankrupt
otherwise). grave misconduct from employee
As such, lots of litigation (unlawful dismissal)
o Implication is ambiguous. Reduces s but also reduces f.
Most economists believe latter effect is somewhat stronger (Some evidence, but
not robust, that this legislation leads to high natural unemployment e.g. Italy,
Spain)
OECD EPL Index (0 = Least Restrictions, 6 = Most Restrictive; P = Permanent, T = Temp. jobs):
Spain: 2.4 P, 3.2 T
UK: 1.6 P, 0.5 T
Italy: 2.9 P, 2.7 T
USA: 1.2 P, 0.3 T
Japan: 2.1 P, 1.3 T
Malaysia: 1.9 P, 0.3 T
EPL interacts with other institutions…
4. Wage setting process
Most wages not set on spot market
o Instead, central wage setting: reps from employers / employees / maybe
government sit down to discuss wages
o e.g. Singapore’s Tripartism (Trade Union, NTUC; Employer Federation, SNEF;
Ministry of Manpower, MOM)
Country comparison
o USA: little centrality.
o South European: high centrality
Disproportionate weight on interests of employed workers (insiders)
o May result in wages too high to encourage job creation (f low)
o To detriment of unemployed (outsiders)
Central wage setting amplifies EPL: Know you’re not going to be fired – have incentive to push for
higher wages (b/c unlikely you will be fired, also unlikely you will become an ‘outsider’) -- Creates
insider-outsider situation
Made by Aaron Luke
aaluke16@gmail.com
5. Dual Labour Markets
Category of jobs where EPL does not apply (Temporary Jobs). But to prevent employers using ONLY
temporary jobs, apply a time limit e.g. Italy 6 months then must hire permanently.
Permanent Jobs with EPL
o Very expensive
Temporary Jobs without EPL
o Cheap but…
After few months must hire permanently or fire
No firm incentives to invest in workers, no worker incentives to invest in
firm
Result
o Middle aged workers secure in permanent jobs
o Young workers unemployed, punctuated by brief spells in temp jobs
Current attempts at reform
o Unified contract with gradually increasing EP (Watch Spain and Italy)
6. Payroll taxes
Taxes gov levies on payroll (easiest to charge, important source of revenue)
Increases cost of labour
Fewer vacancies created, so potentially lower f
Example Payroll Tax Rates (W
Spain: 6% W, 31% E
worker’s contribution as
Italy: 9% W, 32% E
of salary, E Employer’s contribution as
Germany: 20% W, 20% E
of payroll):
USA: 5.5% W, 10% E
7. Minimum Wage
Conventional views:
o Minimum wage leads to decline in labour demand therefore few vacancies, lower f
o If minimum wage > marginal productivity of workers, firms won’t hire them
Unconventional views:
o If firm is monopsonist, they will artificially reduce demand for labour to squeeze
wages (Alan Manning)
Therefore, minimum wage may not actually increase unemployment (or
lower f)
o Higher minimum wage may decrease quits (lower s) (Brochu and Green, 2011)
Workers less keen on quitting
Layoffs may decrease. Replacements more expensive (coupled with search
costs/risk)
Made by Aaron Luke
aaluke16@gmail.com
Topic 8: The Financial System and Macroeconomy
Part One: Basics
Financial sytem: The set of institutions that allows savers to transfer funds to borrowers (i.e.
facilitates flow of funds)
Economies with good financial systems have
High investment rate
o More funds available for investors
Higher efficiency
o Agents with lower productivity options can transfer assets to those with highproductivity ones
Components of Financial System
Financial Markets
o Through which HH/firms directly provide funds to firms/gov
i) Bond market (corporate/gov bonds)
ii) Stock market
iii) Etc
Financial intermediaries
o Through which households/firms indirectly provide funds to firms/HH/gov
i) Banks
ii) Insurance companies
Why have Intermediaries?
Asymmetric Information:
Need for screening (Adverse selection): investors who know their projects are less
likely to succeed are more eager to finance the projects with other people’s funds
Need for monitoring (Moral Hazard): entrepreneurs investing other people’s money
are not as careful as with their own funds. Bank may restrict how loan proceeds are
spent.
Maturity Transformation: Bank issues short-term debt (Deposits from savers) and transforms it into
a long-term asset (loans)
If banks/intermediaries didn t exist?
Big firms like Apple or the government will probably be fine
But small firms + startups + households will suffer (too small for everyone to individually screen)
Made by Aaron Luke
aaluke16@gmail.com
Part Two: Bank’s Balance Sheet
Assets
Liabilities and Owner s Equity
Loans (very Illiquid)
Deposits (Very liquid)
Securities e.g. bonds (Somewhat liquid)
Debt e.g. bonds issued by bank, direct loans
from other banks (Not so liquid)
Reserves e.g. money in vaults, money in ATMS, primarily
reserves with Central Bank (Very liquid)
Capital (Owner’s Equity) difference between assets
and liabilities, mostly owners of shares.
Where bank capital comes from:
Share issuance
o Dilutes ownership – shareholders don’t like this
Reinvested retained earnings/asset appreciation
How banks make money:
Borrow cheap (e.g deposits) and lend dear (e.g. bank loans).
Issue bonds: cheap because safe
Leverage:
The use of borrowed money (at cheap rates) to supplement existing funds for purposes of
lending/buying assets.
More leverage = more profits.
But leverage is a vulnerability
Insolvency:
Assets less < liabilities. Usually bank shuts down. Bankruptcy = cannot repay creditors.
Risk of insolvency is intrinsic to leverage
More capital = more cushion to cover losses.
o If everything is equity, you can never go insolvent.
Leverage ratio =
(rough measure)
Part Three: Origins of Financial Crises
Step 1: Excessive Optimism / (Irrational) Exuberance
Intermediaries use leverage to make increasingly aggressive loans to firms/HH
HH/intermediaries invest heavily in stock market
HH borrow to buy larger/more expensive houses
HH/intermediaries/firms become heavily indebted
EVERYONE Levering up.
Made by Aaron Luke
aaluke16@gmail.com
Step 2: Asset price bubbles
Frequent feature of run-up to crisis is speculative asset-price bubble.
o Not buying for intrinsic worth/dividend of asset,
o Rather, buy to sell at higher price later.
o Prices going up in way that’s hard to justify by fundamentals
Examples of asset price bubbles:
o Stock market bubble (e.g. NASDAQ in late 1990s)
o Housing price bubble (e.g. mid-2000s)
Onset of crisis coincides with bursting of bubble.
o People start to doubt
o Try to sell, but can’t find buyers – settle for lower price (price starts dropping)
o Neighbours see this, start selling as well
Lecture 9
Step Three: Insolvencies at Financial Institutions
Insolvencies:
Crisis begins with large losses on asset side of balance sheet
o Loans defaulted
o Value of securities decline because bubble burst
Large losses + high leverage = insolvencies
Problem in 2007:
1. House prices fall
2. Homeowners default on mortgage
a. Mortgages: loans where house acts as collateral.
b. Why bother when your mortgage is worth more than the house?
3. Bank takes over the house
4. But house prices have fallen, so balance sheet loss (house price < value of loan)
Contagion:
1. Insolvencies spread to other banks
a. Direct mechanism: Losses to other banks who may have lent to them
b. Indirect mechanism: Reduced confidence in other banks (“How exposed are they?
How similar are lending practices?”)
2. Withdrawals Risk of illiquidity (Even if solvent, may become illiquid)
a. e.g. Northern Rock, Bear Stearns, Lehman Brothers
Fire sales:
When insolvent banks get liquidated, assets get sold +
Solvent banks also must sell to stave off illiquidity =
Therefore steep price declines.
o Collectively make situation worse because securities decline in value
Made by Aaron Luke
aaluke16@gmail.com
Moving into the real economy….
Step Four: Credit Crunch
1. Firms relying on insolvent banks cannot borrow
o Relationship to bank lost = lose access to credit.
o Remember banks take time to screen etc.
2. Solvent banks try to turn as much loans into reserves
o Repaid loans + any cash injections kept as reserves
Hence firms and HH find it harder to get funding
More people default (new round)
Recession
AD falls, Unemployment rises
Vicious cycle that reduces profits, asset values and incomes with more defaults/bankruptcies.
Asset price bust
Insolvencies Falling confidence Credit crunch
More insolvencies + asset price bust
Recession
Part Four: Immediate Policy Response
1. Conventional counter-cyclical policy.
2. Lending of last resort
Central bank makes direct loans to these banks (even gov may make loans) Solves issue of illiquidity.
Examples: US Treasury lends $10 billion in preferred stock to Goldman Sachs
3. Nationalisation
Can’t lend to an insolvent firm – or else will still be insolvent. So Gov injects capital, takes ownership
of company – Gov makes up difference in assets and liabilities. Gov owns whole bank because they
are the entire capital share.
Weaker form of nationalisation is recapitalisation form firms close to insolvency. Gov takes partial
control.
Examples:
AIG ($180b to US Gov)
RBS (£42b for 73% stake)
Northern Rock (£1.2b + £26.7b in loans)
Lloyd’s (£20.3b for 43% stake – taxpayers repaid in full)
4. Subsidies to lending.
Give top-up on interest + guarantees on loans. (e.g. UK lend-to-buy scheme subsidised mortgage
loans; however most economist thought ineffective because raised housing prices)
Made by Aaron Luke
aaluke16@gmail.com
Topic 9: Financial Reform
Financial reform is a cross country issue – requires international cooperation.
Part One: Diagnosis of the Crisis
Diagnosis 1: Over-optimism
Believe assets/boom will continue indefinitely
Overconfidence in financial system resilience + financial innovation (MBS, CDO)
Diagnosis 2: Role of Credit Rating Agencies
Big Three agencies: Moody’s, Standard and Poor’s, Fitch
Gave very high ratings to securities that lost considerable value in market
o e.g. CDOs rated Triple-A, but raw material was only BBB [not in lectures]
Diagnosis 3: Bad Incentives for Originators
Old model: originate and hold
o Screening and monitoring present
o Bank would make mortgage and hold mortgage
o Directly liable for default
New model: originate and distribute
o Laxer screening and no monitoring
o Someone else on the hook
Diagnosis 4: Bad Incentive for Management
Structure of compensation: asymmetric risks i.e. fully participate on upside, but sheltered on
downside
o Fixed pay + bonus contingent on profits you bring in
o Bonus cannot be negative.
o If bet goes wrong – shareholders, creditors lose but not CEO. Therefore take
excessive risk
Diagnosis 5: Bad incentives for bank creditors
Creditors need to do HW, ask for higher interest rate if find risky behaviour
However, reckless or safe, both types can borrow at same interest rate
o Because Implicit bailout guarantee (Too Big To Fail)
o Cheap bank funding encourages high leverage
o More I lever up, the more big become, the more important to gov that I don’t fail
Diagnosis 6: Cultural Change
Culture of greed rather than service (kind of people banks attract)
Short-termism: quarterly report and evaluations
o Look at competitors cashing in on bubble, pressured to focus on short-term returns
rather than long-term risks
Imperative to grow: Imperial CEOs
Made by Aaron Luke
aaluke16@gmail.com
o Consequence of TBTF – Guarantees safety – CEOs want to grow big
Complexity of banking operations
o Top management loses control and cannot stamp out risk-taking.
Too Big to Fail causes two distortions:
1. Creditors exert less pressure/monitoring on banks which are TBTF
2. TBTF banks can borrow at cheaper interest rates
Idea: Bail-Ins i.e. bond holders forced to take losses when gov. recapitalises the bank e.g. €10b
bail-in of Cyprus (Possible problem: Makes gov. reluctant to intervene and recapitalise banks)
Part Two: Regulations and Supervisions
Regulation: Rules financial institutions must follow.
Supervisions: Implementation of rules.
1. Micro vs macro prudential
Traditionally only micro (supervise individual banks).
Macroprudential: if one is dangerous that’s fine. If others are, not fine
o e.g. if one bank is doing mortgages that’s cool because others aren’t affected if they
fire sale, or putting stop on full loans
Examples of Macro-prudential policies [Mentioned, but not explained, in exercises]:
Caps on loan-to-value ratios
o If I borrow 90k to buy a 100k house, my LTV ratio is 90%.
o High LTV ratio is riskier – less of the asset price is covered by borrower’s equity
Countercyclical capital requirements (In Bassel III)
o When economy is growing, more capital required and vice versa
o Builds cushion during good times, allows lots of lending in bad times when its
needed most
Time-varying reserve requirements
Liquidity cover ratio
o Whether firms have highly-liquid assets to meet short-term obligations
Structure of Bank of England:
MPC (Monetary Policy Committee): Set interest rates
FPC (Financial Policy Committee): Protects whole financial system (macro pru)
PRA (Prudential Regulation Authority): Monitors soundness of individual banks
2. Protection of deposits
Two kinds of banking operations
o Commercial banking = deposit taking, makes loans etc
o Investment banking = borrows, riskier investments in securities (in house trading)
More important to avoid failure of commercial side
o Depositors more vulnerable
Made by Aaron Luke
aaluke16@gmail.com
o Greater pressure for bailouts (more widespread effect)
Solution: separation of commercial and investment banking
o Volcker Rule (USA)
o Ring-fencing (UK)
Lecture 10
3. Capital requirements (most important)
Minimum buffers that financial institutions must have. Most controversial / hard to pass regulation.
Examples metrics:
Leverage ratio: compares equity to total assets.
Capital ratio: compares equity to ‘risk-adjusted’ assets
o
[safe assets Don t need so much capital, but if risky assets must hold more]
To what extent should we raise capital requirements?
Trade-off
o Pro: Makes banks safer so less fail due to crisis.
o Con: [bank lobby] Increased cost of funding hence less lending in normal times.
IF Capital amount fixed + ceiling on leverage in place (i.e. capital requirements)
o Balance sheet constrained, cannot borrow more
o So indeed there will be limit on lending
BUT, if get more capital?
o More lending sourced not just from borrowing, but from capital.
o Don’t rely exclusively on borrowing – can still lend
Argument from banks: Equity more expensive than debt. Need to guarantee return akin to
other equity (7-8% return). It matters how we finance the marginal loans we make.
Why is bank equity expensive compared to debt?
Firm owners have incentive to raise new equity when firm is overvalued. New equity
providers know this and ask for bigger share of pie
o Counterarguments:
If so, then use retained earnings to grow capital!
Less relevant if all banks are made to raise equity by regulators (new equity
not due to overvaluation but regulation)
Debt is cheaper because of implicit bailout guarantee (and tax advantages)
o But then equity is privately more expensive, but not socially more expensive
Difference between equity and debt financing large privately, but small socially
o
Lending supported by implicit bailout guarantees should not happen [Risk taken on
by taxpayers] Maybe those additional loans aren’t worth the social cost.
4. Compensation reform
a. Level of compensation
Logically, should not impact risk-taking (but perhaps matters in other areas e.g. impact on inequality)
Made by Aaron Luke
aaluke16@gmail.com
b. Structure of compensation
May impact risk-taking if it makes CEOs compelled to participate in asset-price bubbles
Proposal: Clawback
Status Quo: Do well this year, get big bonus (short-termism)
Clawback: We monitor your decisions from past, have right to come back and take your
bonus away
o Should incentivise better long-term decisions
5. Responsibility reform
Heads of financial institution made responsible for all wrong-doing
o More focused on rigging and frauds rather than risk-taking
Made by Aaron Luke
aaluke16@gmail.com
Topic 10: Intro to Euro Crisis
Part One: Interest Rate Spreads
Interest rate spreads: Difference in interest rates between countries. Differences due to risk
premiums [more risky = higher interest rate incurred]. Eurozone benchmark rate is Germany’s.
Focus on spreads between gov. bonds
1. Before introduction of the Euro: High spreads between countries (pre-1999)
a. Each currency had own currency (e.g. Italian Lira)
b. Unlikely country will default because can print currency to pay debt.
c. BUT risk was currency depreciation.
i. Return for foreign investors is interest rate + change in exchange rate.
ii. Lira Drachma etc. more depreciation prone than German Mark
iii. Therefore Italy, Greece have higher interest rates
2. Euro introduced: No exchange rate risk! (1999 2008ish)
a. Italy, Greece now using Euro – less risk of depreciation
b. Therefore spreads started converging
3. Onset of Euro crisis: Spreads get high again (post-2008)
a. Euro took away risk of depreciation
b. But re-introduced risk of defaults (cannot print currency to pay off debts)
Cause of High Spreads 1: Worsening of fiscal outlook
In 2008-2009, countries enacted fiscal stimulus and expensive bank rescues, leading to larger
government debts.
Severe crisis meant GDP fell (recession). This coupled with higher spending means debt/GDP ratio
went up, spooking investors.
Made worse by concerns of further problems in banking. If banks weak – maybe need to recapitalise
or bail them out, which will worsen fiscal situation for governments.
Enough reason for higher spreads? Probably not. Need another reason
Cause of High Spreads 2: Changed attitudes to sovereign debt
Before crisis investors counted on implicit bailout guarantee from EU. Default of Lehman Brothers in
USA + general contentiousness of bailouts may have led to reconsideration. (“Maybe Germany
would let Greece go down?”) Political climate hostile to bailouts
Thus, investors demand higher interest rates from countries like Greece/Italy
Made by Aaron Luke
aaluke16@gmail.com
Part Two: Consequences of High Interest Rate Spreads
1. Gov risk of insolvency (not enough liquidity to pay back debts). Forced to cut spending and
increase taxes Austerity
2. High interest rates on benchmark gov bonds spread to rest of economy (Interest rates move
together) Credit Crunch
Austerity + credit crunch = Recession. Origin of recession is in sovereign debt crisis.
Greek GDP around 25% lower in 2015 compared to 2007.
Interest rates on 10-year Greek bonds peaked at 27%ish in 2011-2012ish
Greek Unemployment now at 23.5%, Debt is at 185% of GDP now (OECD)
Italy still 9% below 2007 GDP levels
3. Vicious cycle occurs
a. Recession weakens economy – lowers tax revenues – further forces austerity
b. Recession weakens banks – increasing implicit gov liabilities – forcing further austerity
Increasing number of observers who believe fiscal multiplier is larger than 1 in eurozone periphery.
Therefore less G increase in debt/GDP ratios, even though gov. is shoring up spending
Part Three: Response from the EU; ‘Bailouts’
Loans to most desperate/urgent cases.
Greece first to get bailout
o Debt coming due, but unable to raise funds from private market.
o 2010: €110b first bailout
o 2012: €130b second bailout + 50% reduction in bond maturities (private investors)
Greece to reduce debt/GDP ratio to 120% by 2020
o 2015: Greece become first country to default on IMF loan (missed a €1.6b payment)
o 2015: Third bailout for €86 in 2018 approved
o 2017: IMF warns Greek debt unsustainable. EU creditors agree to more lenient
budget targets, Greek PM Tsipras agrees to tax/pension reforms
Other bailouts:
o Portugal: May 2011 €78
o Ireland: November 2010 €85 (exited EU bailout programme in 2013 after successful reforms)
Disbursements spread over time and conditional on austerity/reform targets
Made by Aaron Luke
aaluke16@gmail.com
Why Germany is Concerned with Periphery Countries / the German Dilemma
Periphery Countries = Portugal, Italy, Ireland Greece, Spain
If leave Periphery countries alone alone:
Greece (or others) defaults German banks lose money invested in periphery-country assets
o German banks not healthy – coming out of financial crisis
o Form of indirectly bailing out own banks (if not, may have to directly bailout in future)
May cause contagion – same with Lehman situation in USA
o Ppl terrified run on banks.
o When people see Germany as similar to Greece, Germany nicer to Greece.
o When not, tougher on Greece.
o In Greece’s incentive to make contagion look likely
Possible Eurozone breakup
o Creates a precedent
If assist Periphery countries:
Bailing out creates moral hazard
Condoning tax evasion, corruption, lack of reform (unsavoury cultural/institutional
problems)
May solve current crisis, but perhaps sow seed of future crisis
Solution: Bailouts with tough conditionality
Balancing Burdens [Exercise]:
Solution to Sovereign Debt Crisis requires a balancing act between three parties:
1. Debtor-country tax payers: Shoulders increased taxes/less G spending
2. Creditors: Gov may fail to pay debt / impose haircut on creditors
3. Creditor-country tax payers: Stronger-countries may provide loans to crisis country, imposes
risk/loss to taxpayers there
Part Four: ECB Response + Other Banking Issues
2010 2012: Occasional secondary-market purchases of gov bonds (to contain spreads)
Mario Draghi becomes ECB Governor in Nov. 2011. Draghi more hands on
2012:
Cheap loans to banks (provide liquidity)
Whatever it takes speech (Summer 2012) spreads fall down afterwards
Commitment to buy newly-issued government debt if necessary (essentially printing money)
Made by Aaron Luke
aaluke16@gmail.com
2014: QE starts
2015: QE, negative rates.
2016: QE, negative rates, free long-term loans to banks
There’s a school of thought in Germany that hates Draghi, claims ECB policy too expansionary.
Recent increase in inflation makes it harder to support economy (2% in February, 1.5% in March
2017)
Benefits of ECB Intervention:
Purchased large amount of Gov. bonds, reducing interest rates on these bonds
o Govs can borrow at cheaper rates
o Lower rates transmit to other sectors – less credit crunch
o Euro is kept relatively low
Provided cheap loans to banks
o Less liquidity pressure on banks/decreased risk of bank failure
o Banks can use loans to buy gov bonds, driving down interest rates further
o Banks use loans to lend to firms/households
New banking crisis
Problem: Diabolical loop
o Gov bonds lose value because of implicit liability from banks.
Fear of financial strain of bailing out banks
o Bank sheets lose value because losses on Gov bond valuations
Solution: Banking Union
o Break the nexus between Gov and domestic banks
Responsibility for individual banks not in hands of gov, but centralised
o Achieved: Unique banking regulator for Europe (ECB)
o To do: Joint deposit insurance scheme
EU-wide guarantee on deposits, not contingent on health of individual
governments
__________________________________________________________________________________
Disclosure
I claim no liability for inaccuracy/incompleteness in these notes. Just know that if you mess up because of it, I
probably will too.
These notes won’t do you much good in understanding the material – at best it’ll help you outline and keep
track of it. Caselli is bae. Listen to his lectures. I recommend x1.8, or x1.9 if you’re feeling feisty.
Special thanks to Edward Kwan for helping fill in some gaps in Topics 1 & 2.
Peace out, and remember that LSE doesn’t mark on a relative scale (from my knowledge), so share the love.
Much love,
Aaron