ECON 100 Tutorial: Week 22
www.lancaster.ac.uk/postgrad/alia10/
a.ali11@lancaster.ac.uk
NEW office hours: 2:00PM to 3:00PM tuesdays LUMS C85
Question 1
Loanable funds. Liquidity preference. Why two theories of interest
rate determination?
Liquidity Preference
Loanable Funds
The Keynesian liquidity preference
approach to the relationship
between interest rate and money
balances is given by where the
demand for money is in equilibrium
with the supply of money set by a
central bank.
Loanable funds refers to a market that brings
borrowers and savers together, determining
interest rates by finding where the demand for
borrowing and the supply of savings are equal.
This approach shows how interest rates can be
determined on an open market, without a
central bank.
Question 1: Loanable funds. Liquidity preference.
Why two theories of interest rate determination?
Steele finds these two approaches inconsistent. In his view, Keynes’ approach ignores
the fact that inflation and recession can coexist.
Keynes’ multiplier relates to the idea that an increase in exogenous (government)
investment will increase incomes and saving, which will be reinvested. During a
recession this can guide fiscal policy.
A problem with the Keynesian idea of a multiplier can occur if there is inflation during
a recession.
Inflation will reduce the returns on savings, forcing banks to offer a higher rate of
return on savings. But in a recession, interest rates will be set very low, in order for
investment funds to be put into capital projects rather than simply pushed into bonds.
As more projects receive investment, the expected rate of return on those investments
fall (Marginal Efficiency of Capital). As a result, the rate of return a bank can offer on
savings is closely related to the interest rate on bonds. The low return on savings will
mean that demand for savings is very low.
So stagflation can relate to low demand for bonds and low demand for savings. In this
case, attempts by the government to increase investment during a recession may not
lead to a multiplier.
Question 2
Explain the notion of the time consistency of economic policy
An optimal policy computed at time t is time-inconsistent if a
re-assessment at time t + n finds that a different policy is then
optimal.
– Individual Examples: Smoking, Pregnancy
– Central Bank Examples: Interest Rate/Inflation
In the face of an economic downturn, the central bank may
lower the discount rate even if it previously stated it would
hold discount rates steady.
– If an increase in money supply (lower discount rate) is
anticipated, then prices will rise causing inflation
– However, an unexpected increase in money supply can lead to
increased spending and GDP rise with less inflation
(Think about the Federal Reserve game we played
Question 3
How is notion of a non-accelerating inflation rate of
unemployment (NAIRU) relevant to the time consistency of
economic policy?
• NAIRU is the natural long-run stable rate of
unemployment
• If firms are able to adjust prices and production to
account for inflation, policy makers cannot as easily
effect unemployment by increasing money supply.
– This is the same scenario as the previous slide.
• This is why the central bank may “cheat” in its setting of
discount rates differently than its previously stated levels
– that is, to be time inconsistent and therefore be able to
effect unemployment rates.
Question 3
How is notion of a non-accelerating inflation rate of unemployment
(NAIRU) relevant to the time consistency of economic policy?
Gerry’s answer:
Job-seeking workers assess wage offers against their
expectations of the inflation rate (ΔP/P)e in the period ahead).
The original Phillips curve was made when prices were moreor-less stable (and so (ΔP/P)e ≈ 0). With zero inflation, jobseekers do not over/under estimate the purchasing power of
money wage rates; so the unemployment rate rests at the
equilibrium level of the ‘natural rate’.
When the inflation rate is constant (non-accelerating), the case
is (again) made that job-seekers do not over/under estimate
the purchasing power of money wage rates; so the
unemployment rate rests at the equilibrium level of the nonaccelerating inflation rate of unemployment.
Before we look at Question 4(a)
Let’s look at the Taylor Rule.
What are its principal components?
Taylor rule:
rt = r* + π* + w(πt – π*) + (1 – w)(yt – y*)/y*
Equilibrium interest and equilibrium inflation rates:
r* + π*
Weighting:
w and (1-w), where 0 ≤ w ≤ 1
Inflation gap:
(πt – π*)
Note: If you look at other sources, the Taylor Rule is
Output gap:
usually presented as:
r = r* + π + w(π – π*) + (1 – w)(y – y*)/y*
(yt – y*)/y*
t
t
t
Where π is the inflation rate. Gerry presents it with π*.
Question 4(a)
The Taylor rule equation is written as:
rt = r* + π* + w(πt – π*) + (1 – w)(yt – y*)/y*
where:
rt is the central bank discount rate
πt is the inflation rate
π* is the inflation rate target
y is the GDP
y* is the potential GDP
w is the policy parameter
How would you interpret r*
the equilibrium rate of interest
Gerry also mentions:
Wicksell’s natural rate of interest
The natural rate of interest is the rate that arises out of the equilibrium of
supply and demand in the bond market.
Question 4(b) & (c)
The Taylor rule equation is written as:
rt = r* + π* + w(πt – π*) + (1 – w)(yt – y*)/y*
b) Which data series are relevant?
a relevant price index (which goods/assets should be included?)
More specifically, the inflation rate (CPI) and real GDP
c) Which data series have to be ‘constructed? How?
a relevant price index (which goods/assets should be included?)
a hypothetical series for the full employment level of GDP
(i.e., y* potential GDP)
Question 4(d)
The Taylor rule equation is written as:
rt = r* + π* + w(πt – π*) + (1 – w)(yt – y*)/y*
where:
rt is the central bank discount rate
πt is the inflation rate
π* is the inflation rate target
y is the GDP
y* is the potential GDP
w is the policy parameter
Determine rt using the parameter values:
r* = 2%, π* = 2%, w = 0.5
where the inflation rate is 4.5%,
Potential GDP is estimated as £1.4 trillion
GDP is £1.33 trillion
Question 4(d) ctd.
We’re given:
y is the GDP = £1.23 trillion
πt is the inflation rate = 4.5%
w is the policy parameter = 0.5
y* is the potential GDP = £1.4 trillion
π* is the inflation rate target = 2%,
r* is the equilibrium interest rate = 2%
First, plug in these given values into the taylor rule equation:
rt = r* + π* + w(πt – π*) + (1 – w)(yt – y*)/y*
rt = 0.02 + 0.02 + 0.5(0.045 – 0.02) + (1 – 0.5)(1.33 – 1.4)/1.4
Then, solve:
rt = 0.02 + 0.02 + 0.5(0.045 – 0.02) + (1 – 0.5)(1.33 – 1.4)/1.4
rt = 0.02 + 0.02 + 0.5(0.025) + (0.5)(– 0.07)/1.4
rt = 0.02 + 0.02 + 0.0125 – 0.025
rt = 0.0275
So, in this scenario, our central bank discount rate is 0.0275 or 2.75%.
Question 4
How is the Taylor Rule related to the loanable funds theory
of interest rate determination and to the Phillips curve?
Phillips curve
Loanable Funds
r* (Taylor’s equilibrium interest
rate) can be determined from
loanable funds theory of
interest.
annual
interest
rate
r
Loanable Funds
theory
saving
r*
If the long-term stable level of
unemployment (call it u*) is
known, then π* is determined by
the Phillips curve and y* is
determined by u*
annual
prop.
real wage
increase
∆w/w
Phillips Curve
(productivity growth)
π*
loanable funds
u*
unemployment
Next Week
Monday tutorials are all re-scheduled for the bank holiday:
T01/01 3PM → Friday 9AM Fylde D31
T01/48 5PM → Tuesday 9AM Charles Carter A04
T01/05 6PM → Friday 1PM Fylde D31
If you have a timetable problem, contact Sarah Ross
or attend a different section.
Tuesday’s tutorial stays at 1 PM (Charles Carter A02)
Practice Past Exam Questions
Please Note: Solutions are not given to tutors for these
questions. The solutions you see here are suggestions
only – I can’t guarantee they are correct.
The Taylor Rule is a representation of
monetary policy whereby the short-term
nominal interest rate is varied systematically
with respect to:
(a) the trade deficit and the value of sterling
(b) employment and the cost of living
(c) inflation and the ‘output gap’
(d) tax revenues and the level of government
borrowing
2012 Exam Q38
The Taylor Rule
What are its principal components?
Taylor rule:
rt = r* + π* + w(πt – π*) + (1 – w)(yt – y*)/y*
Equilibrium interest rate and equilibrium inflation rates:
r* + π*
Weighting:
w and (1-w), where 0 ≤ w ≤ 1
Inflation gap:
(πt – π*)
Output gap:
(yt – y*)/y*
Define r as the real rate of interest and
let r* be the rate consistent with long
run equilibrium in the economy.
Further, define π as the rate of inflation
and π* as the target rate of inflation.
Then r = r* + α(π – π*) is:
a)
b)
c)
d)
an LM curve
a Taylor rule
a DSGE model
incomprehensible
Note: Tutors think that this question is asking
about the Taylor Rule, hence answer choice B
is selected. Gerry did not set this question and
thinks that the question is vague and therefore
incomprehensible, hence answer choice D is
selected.
2010 Exam Q39
By the Taylor Rule, nominal interest
rates are raised whenever:
rt = r* + π* + w(πt – π*) + (1 – w)(yt – y*)/y*
a) inflation falls
b) the output gap widens
c) the output gap closes
d) the inflation target is raised
Note: C is correct so long as W<1
D would also be correct when w<1.
On an exam, the best answer is probably C; I’d
say this is because the Taylor Rule is used to
control inflation and the output gap.
2011 Exam Q36
The Taylor Rule describes how the
authorities adjust monetary policy by
adjusting:
(a) the exchange rate after taking account of
inflation and the nominal interest rate
(b) inflation after taking account of the nominal
interest rate and the ‘output gap’
(c) the nominal interest rate after taking account of
inflation and the ‘output gap’
(d) bond prices after taking account of inflation and
the nominal interest rate
‘Time-inconsistency’ exists if monetary
policy implemented at time t is optimal,
then re-assessed at time t + n and found to
(a) require discretionary adjustments
(b) be sub-optimal
(c) be inconsistent with fiscal policy
(d) be inconsistent with the currency exchange rate