Fiscal Policy

Fiscal policy
- automatic stabilizer: tax revenue, unemployment benefit
- discretionary policy

tax revenue is endogenous, sensitive to the state of economy than spending

fiscal policy is planned with horizon larger than monetary policy

fiscal consolidation may increase AD, eg. expansionry fiscal contraction
- people expect lower debt, lower taxes in future
- spending cut, wage cut -> labor cost down, Investment up , profit up
- structure reform complement fiscal contraction

Interaction of fiscal and monetary policy

use stackelberg game to model the interaction of policy makers

C- cooperation , Pareto efficient equilibrium 

OM -monetary leadership, OF -fiscal leadership

Government Budget Deficit

deficitt = rBt-1 + Gt -Tt
where r: real interest rate
    Bt-1: government debt at the end of year t-1

let deficitt = Bt - Bt-1
therefore:
Bt - Bt-1 = = rBt-1 + Gt -Tt
Bt = (1+r)Bt-1 + (Gt -Tt)

-if government spending is unchanged, a decrease in taxes today will have to be offset by an increase in taxes in the future.
-the longer the government waits to increase taxes, the higher the real interest rate, and higher the increase in future taxes

Debt to GDP Ratio

Bt/Yt = (1+r)Bt-1/Yt + (Gt -Tt)/Yt
after mathematics munipulation:
Bt/Yt - Bt-1/Yt-1 = (r-g)Bt-1/Yt-1 + (Gt -Tt)/Yt
where g: GDP growth rate

How countries reduced their debt ratios
- run budget surplus, (Gt -Tt) < 0
- have low real interest rate and high GDP growth, (r - g) > 0, real interest low can be low or even negative when inflation is high.
- a large part of the decrease in debt ratios was achieved by paying bond holders a negative real interest rate on the bonds

Balanced Budget

- It means Gt = Tt
If economy is good, T up -> G up -> cause overheating

If economy is not good, T down -> G down -> econ could not recover

Therefore, balanced budget is not practical

Ricardian Equivalence

David Ricardo developed a theory about government spending and private spending. When government stimulate demand bu debt financed spending, the people will save money to pat for future tax increases (to be used to pay off the debt).
- So overall demand is unchanged

Cyclically Adjusted Deficits

It is used to indicate whether tax/revenue system is going to create deficit at Yn (output at natural full employment). If it is negative at Yn, deficit is *not* going to go down.
- We never know exact Yn, and Yn changes, so Cyclically Adjusted Deficits is not useful

Money Finance
1. Debt Monetization
Fiscal dominance of monetary policy: Central bank must do what the government tells it to do. Government issues bonds and forces CB to buy. The central bank then pays the government with the money it creates, and the government uses that money to finance its deficit. This process is called debt monetization.

2. Seignorage
The amount of good and services that government can obtain by printing money. The revenue from money creation is called seignorage.

seignorage = ΔH/P = ΔH/H * H/P
seignorage/ Y =  (ΔH/H * H/P ) / Y

If government uses seinorage to finance budget deficit of 10% of GDP, seignorage/ Y = 10%, so ΔH/H = 10% and (H/P)/Y = 1,  the growth rate of nominal money must be 10%.

Unconventional Monetary Policy

Quantitative Easing
QE is Large Scale Asset Purchase (LSAP). The Fed buying a set quantity of bonds from private financial institutions
The goal :
to facilitate bank lending and increase money supply
to increase broad money supply even without further bank lending

to lower interest rates for types of risky financial assets
- enlarge the balance sheet of the Fed

misconceptions about QE
- QE gives banks free money
the money is not free because while banks earns interest on the newly created reserves, it also need to pay interest on the newly created deposit

As seen in figure above, pension fund sells gov bond, get cash, buy more risky assets (portfolio rebalancing), support asset prices because of search of yields.

- QE leads to high quantity of M2
customer can use the money to repay loan, and reduce money supply
( customer borrow cheaply, to repay expensive loan)

Monetary Finance
or helicopter money as coined by Milton Friedman
running fiscal deficit, not financed by debt, but by increase in monetary base
such as CB directly credits gov current account, free of interest
- enlarge the balance sheet of CB

Negative Interest Rates
CB charge banks that hold reserve at CB
bank cannot transfer negative rates to deposits, for fear of losing customers
new loans are priced at lower rates
banks net interest income falls
the profit margin between lending and deposit rates is squeezed
banks unwilling to lend -> less bank income -> bank shares fall

the existence of paper currency makes it difficult for CB to take policy rate below zero

Negative Interest Rates policy could be contractionary, as it is a reduction of money supply

Forward Guidance
Management of expectations
let business estimate how long low interest rates may be around
a way of converting low ST interest rates into lower LT interest rates
time inconsistency can be a problem of forward guidance

Financial Crisis
initial phase (credit boom and bust, asset price boom and bust)
->banking crisis->debt deflation
debt deflation: debt become bigger in real terms during deflation

initial phase (credit boom and bust, severe fiscal imbalances)
->currency crisis->financial crisis

wholesale deposits: a deposit at a bank made by institutional investors, such as mutual bank, pension, large business, another bank. It involves large amount of money, and usually short term

** if banks use whole funds as a source of funds, and make long term loan. If wholesale funding dries up, banks could have liquidity problem.

Yield Curve
term spread = 10 yr yield - 2 yr yield  (slope of the yield curve)
stock market is poor indicator of recessions
(the link between stock prices and GDP growth is weak)
yield curve is better indicator of recessions

Breakeven inflation
the rate that make you indifferent between TIPS and nominal bond, if CPI inflation averages to that level over the years
eg. 10 yr breakeven rate = 10 yr nominal treasure yield - 10 yr TIPS yield

if CPI inflation > breakeven inflation, buys TIPS

The Money Supply Process

Players in the money supply process
- Central Bank
- Commercial Bank
- Depositors: individuals and institutions

Monetary Base = Currency + Reserves
(MB: aka High powered money)

Reserves = RR + excess reserves

Reserves are bank's deposit with CB, plus currency in bank's vault

Monetary Base Changes
To change MB, CB uses OMO, or lending to banks
- to increase MB, buy gov bond
- to decrease MB, sell gov bond

Example: Open market purchase from a bank
CB
Asset                         Liabilities
Securities +100m     Reserves +100m
Commercial Bank
Asset                          L
Securities -100m       no change
Reserves  +100m

Example: Open market sales to a bank
CB
Asset                         L
Securities -100m     Reserves  -100m
Commercial Bank
Asset                          L
Securities +100m       no change
Reserves  -100m

Example: CB lends to bank
CB
Asset                         L
Loans +100m           Reserves  +100m
Commercial Bank
Asset                         L
Reserves +100m       Loans + 100m

MB = MBn + BR
BR: borrowed reserves by banks, cannot controlled by CB
MBn: non borrowed monetary base

Money Creation
CB control MB, but not the overall money supply
commercial banks are creators of deposit money

Bank A
Asset                   L
Reserves +100   checkable deposit +100
(after bank A makes a loan to bank B)
Bank A
Asset                  L
Reserves +100   checkable deposit +100
newloan  +90     newdeposit   +90
(after borrower withdraws cash)
Bank A
Asset                 L
Reserves +10    checkable deposit +100
newloan  +90  
Bank B
Asset                 L
Reserves +90    checkable deposit +90

R = rr x D     ; rr : required reserve ratio, D : deposit, R : reserve
M = m x MB   ; m : money multiplier
M = C + D
MB = C + R = C + rrD + ER
m = (C + D) / (C + rrD + ER)

Definition of Money
narrow money
M0: notes and coins in circulation
MB: M0 + reserves
M1: M0 + checkable deposits + traveler cheques
broad money
M2: M1 + savings deposit, time deposits,

Central Bank and Monetary Policy

The Monetary Policy Objectives
Price stability - control inflation
Economic stability - push for sustainable economic growth
Financial stability - efficient payments system

Inflation is bad because:
erode purchasing power
cause uncertainty in economy
reduce country's competitiveness - goods and services become expensive
worse income inequality - the rich can always keep their financial assets in stock market, real estate, foreign assets
other economic costs -  rent seeking behavior, inflation make credit cheap

FX intervention is costly
control depreciation - not enough FX reserve
control appreciation - negative carry, FX valuation loss
- negative carry:  the difference of interest payment on foreign assets and interest payment on domestic gov bonds
- FX valuation loss: the valuation of FX assets reduce when FX depreciate against domestic currency

FX sterilization: to offset the effect of FX intervention. For example, CB sells domestic currency, and buys foreign currency to support its currency. To mop up excess liquidity in the market , do so by selling gov bonds,

Monetary Policy Tools
Reserve requirement (RR):
for liquidity management and monetary control
increase the cost of operation on banks, distort market system if the reserve does not pay interest (it is a tax on banks)

Open Market Operations (OMO):
- repo, reverse repo

1 day bilateral repo rate: policy rate
7 day, 14 day repo rate, auction

- outright purchase/sale of gov bands
- foreign exchange swap

Discount window and discount rate
- discount window also known as standing facility
lending facility , deposit facility
CB lending rate : policy rate + 0.5%
CB borrowing rate : policy rate - 0.5%

iU (CB lending rate ), iL (CB borrowing rate)
iU - iL : interest rate corridor
important to have corridor, CB wants to influence the market rate around the policy rate

- discount rate is usually set at fed fund rate + 100bp. The purpose is the Fed prefers banks to borrow from each other in the federal funds market, so that they can monitor each other's credit risk.

corridor too wide: more volatility in market rate
corridor too narrow: too little penalty for commercial bank when they come to lend/borrow

standing facility and OMO are market based , RR is not market based. If banks don't transmit well, use RR

Monetary Policy Regime
1. exchange rate targeting:
-CB must have sufficient reserves
-CB and gov must be ready to use capital controls

2. monetary targeting:
-target the supply of money in economy

3. inflation targeting:
-public announcement of medium term inflation target,
-easy to understand
-reduces time inconsistency problem
-stresses transparency and accountability
-take time to have effect ( 6 - 8 quarters)
-too much rigidity, eg. inflation nutter

Monetary Policy and Financial Stability
Time inconsistency problem: CB deviate from a policy after it was announced, destroys CB's creditability
Nominal anchor: money supply or inflation rate

** use nominal anchor because the public can observe nominal variable, such as price increase

** second round effect: if wage goes up, price goes, up, wages goes up, wage-price spiral. If CB can anchor inflation expectations, the second round effect is minimal

**if monetary policy is credible enough to anchor inflation expectation, the inflation overall will be  maintained.

Clean vs lean debate:
Lean
besides price stability risk, CB respond to other risk, such as asset bubble risk
because cost of cleaning up is too high
Clean
It is impossible to lean against credit bubbles using monetary policy
difficult to identify asset price bubbles
only clean up after bubble burst

Two types of asset price bubbles:
- credit driven bubble
bank extends BS to investors, debt overhang problem
- "irrational exuberance" bubble
overly optimistic view of the investors

interest rate is a blunt tool, affecting other economic variables
and raising interest rate may not be effective in restraining bubbles

macroprudential policy can be used to reign in asset price bubbles, policy tools such as LTV, leverage ratio, and the below:
countercyclical buffer: good times banks hold more reserves
liquidity ratio: the ratio of liquid assets to total net cash outflows, that banks need to have

It is dangerous to associate easing/tightening of monetary policy with a fall/rise in ST nominal rates. It is important to look at other assets prices as well.
Case study:
In Japan, in the two lost decades, although the nominal rate is low, deflation means real rate remained high. The high real interest rate is reflected in the lower asset prices of real estate and stock valuation.

Monetary Policy and Transmission Channels
Interest rate: real interest rate affects consumers and business, LT interest rate has major impact on spending
Credit supply:
- bank lending channel: policy rate affects banks marginal cost of funds, increase in cost of funds make banks reduce loan
- balance sheets channel: interest rate affects firms balance sheet, firms can borrow more when their balance sheet improves
Asset prices: stock price up, financial wealth up, consumption rises
Exchange rate: FX changes lead to changes in relative prices of domestic and foreign goods and services
Expectations: anchor expectations

Money and Inflation
Nominal Rigidity
- known as price stickiness or wage stickiness
- lags in the adjustment of prices and wages to changes in demand
- so money affects real variables in the short run, and prices in the long run

there are no explicit relationship between money aggregates and inflation but correlation exists

International Financial Systems

Balance of Payments
The BoP accounts record all transactions between residents of a country and residents of all foreign nations.

It is composed of
- current account
- capital and finance account
- official reserve account
- statistical discrepancy : net errors and omission

Current Account
- export/import of goods and services
- net income: interest earned on foreign assets, interest paid on foreign debt
- Unilateral transfers: workers remittances from abroad, official grants

Capital and Finance Account
- capital transfer: debt forgiveness, transfer of ownership of fixed assets (it is in capital account and the amount is small)
- direct investment: greenfield investments, FDI
- portfolio investment:  debt and equity securities
- other investments: deposits and loans
- financial derivatives

CA + KA = Δ reserve

Under a flexible exchange rate regime
CA + KA = 0

BoP is a double entry system of accounts

CA: Surplus + / Deficit -
  export + / import -
KA: Net borrowing + / Net lending -
  increase in financial assets -   ; because money going out
  increase in financial liabilities +

Example: import oil
import - ; increase in financial assets +

Example: company export
export + ; increase in financial assets -

Example: borrowing from abroad
 increase in financial liabilities +
 increase in financial assets -

BoP effect on exchange rate
export ↑ -> CA surplus ↑ -> FX rate ↑

KA surplus ↑ -> demand for local currency ↑ -> FX rate ↑

reduce appreciating pressure on local currency, sell local currency, buy USD
-> reserve ↑

Interpretation of CA
- Trade balance: CA deficits reflect living beyond one's mean
- Difference in national savings and investment
Y = C + I + X - M ; ignore G
Y - C - I = X - M
S - I = X - M
it reflects high investment and low savings rate

- Timing of trade
CA deficit means choose to consume now by borrowing from abroad
CA surplus means choose to consume later by lending to abroad

consumption smoothing
- borrow from future income, and spend today

Role of International Reserves
- reduces currency speculation
- precautionary purpose, as insurance cover to smooth temporary stops in capital flows

FX Intervention
Unsterilized FX intervention
- domestic currency is sold to purchase foreign assets -> increase in international reserves - > increase in money supply -> domestic currency depreciation
Sterilized FX intervention
To counter the effect of FX intervention above, CB sells gov bond, reduces the money supply

Reserves adequacy
Traditional measures:
- Trade based : reserves to monthly import , 3-4 months
- Debt based : reserves to ST external debt ,  > 100%
- Money based : reserves to M2 ; 5-10% if flexible exchange rate
 (flexible exchange rate act as automatic stabilizer)

Drawbacks of Traditional measures
- reserves to months of imports, neglect international financial linkages
- reserves to ST external debt, neglect other liabilities (stock holdings, bond holdings)
- reserves to broad money, neglect external drain on reserves

Having reserves means intervening in FX market?

New approaches:
- BoP stress testing: scenarios looking at all BoP items
- insurance model : cost benefits of holding reserves, eg. negative carry, valuation loss
- balance sheet analysis

**BoP is flow concept, need to look at stock holdings

Case study: China's FX reserves
China's exports are larger than its imports, it is running a positive trade balance. Foreign currency flows into China via trade flows and investment flows. The more foreign currency is floating in its economy, the lower the price of that currency relative to domestic currency will be. This will have appreciation pressure on domestic currency.  To offset, the CB will sell domestic currency and buys up the foreign currency. The intervention will build up the FX reserves.

Capital Controls
- produces misallocation and corruption
- not effective in the long run (people will find a way to circumvent the restrictions)
- delay reform, money flow out because domestic investment opportunity maybe not attractive
- better to strengthen econ fundamentals, and improve bank regulation

Labor Economics (Part 2)

Demand for Labor

Principles
Labor demand = derived demand (product demand comes first, labor demand comes second)

government influences:
- min wages
- welfare laws
- retirement , pension regulation
- safety protection laws
- immigration control
increase the cost of hiring labor

profit maximization
2 preconditions
- price are influenced by the market ( profit max is done thru output decision)
- most decisions are marginal (incremental)

max profit = incrementally optimise output
- if income of one additional input unit > expense of unit => add more input
- if income of one additional input unit < expense of unit => reduce input

2 input factors: labor , capital

marginal product
  MPL = dQ/dL ( holding capital constant)
  MPK = dQ/dK ( holding labor constant)

marginal revenue
  MR = P in competitive mkt

marginal revenue product
  MRPL = MPL * MR     =>     MRPL = MPL * P

marginal expense of labor
  MEL = w  ( forms are wage takers in competitive mkt)

Employee Value Proposition
- what ppl can get out of the company
- why ppl would want to work there

Labor demand in the SR
(capital is fixed, only labor can be adjusted)
assume declining MPL, diminishing marginal returns

from profit max to labor demand, MRPL = MEL
MPL*P = w ; in dollar term
MPL = w/P ; in physical quantity

at E2, MPL < (w/p)0, make a loss, reduce employees
at E1, MPL > (w/p)0, make a profit, increase employees

not making judgement about individual, labor are interchangeable

criticism (to the marginal productivity theory of demand)
- firms don not really understand MPL, firm guess the value added of a worker
- adding labor without increasing capital does not work
 (not entirely true: holiday coverage. shift breaks)

Labor demand in the LR
LR: other input factors can be varied and affect the demand for labor
Two equations must be fulfilled:
MPL = W/P   ;   MPK = C/P

so   W/MPL = C/MPK
- marginal cost of producing an extra unit, using capital , same as marginal cost of producing an extra unit, using labor
- to maximise profit, firm must adjust the labor and capital inputs, so that MC of an extra unit is equal, whether using L or K

(to be continued...)

Labor Economics (Part 1)

Labor Market

It is a special market, the conditions under which services are rented can be as important as the price. it means for labor market, non pecuniary factors are important, such as :
- work environment
- personality of manager
- perception of fair treatment
- flexibility of working house

Nonetheless, it is still a market
- institutions such as employment agencies facilitate contact between buyers and sellers of labor resources
- info about price and quality is exchanged
- formal and informal contracts exists, regulating time and compensation

Positive economic model
- theory of behavior whereby people respond positively to benefits and negatively to costs
Scarcity - we have to make trade offs
Rationality - utility max
(correct vs incorrect)

Normative economic model
- based on some underlying values, what ought to exist
min wage, immigration, welfare program
(good vs bad)

culture is a system of values and norms
values are abstract ideas about what a group believes to be good, right, desirable
norms are social rules and guidelines that prescribe appropriate behavior in situations

two types of transactions
- voluntary , mutually beneficial
- mandatory, based on policy or law, even though one or more parties might lose out, eg. tax

five types of market failure
- ignorance
- transaction barriers
- externalities
- public goods, free rider problem
- price distortion, eg. min wage
gov intervention can correct market failures, such as intervene to promote socially beneficial transactions

Efficiency vs equity
- What is efficient is not necessarily equity. Normative econ stress efficiency, because it can be analysed scientifically. For equity, seek guidance from political systems, not market.

Labor Market Overview

A market with buyers and sellers

Labor force and employment

unemployment rate = number of ppl unemployment /number of ppl in labor force

Wage, earnings, compensation and income

wage rate * unit of time = earnings
earnings + employment benefits (in-kind or deferred) = total compensation
- payment in kind: employer provided health care or insurance
- deferred: social security
total compensation + unearned income (interest, dividend) = income

How it works

two effects
- scale effect: wage ↑, price ↑, product demand ↓ -> employment ↓
- substitution effect: wage ↑, capital intensive production ↑  -> emp ↓
(substitute labor and machine, product market stays the same)

other effects
- demand for product ↑ -> hire more labor

higher demand at any price -> demand for labor ↑

- supply of capital, when capital price ↓

a. scale effect dominates
- more machine -> hire more workers to run the machine -> higher labor demand

b, substitute effect dominates
- same product demands -> substitute labor with machines

Thus, no clear prediction from econ theory

Supply of Labor
- market supply

if salary in other professions remain the same, more people want to become lawyers if lawyer's wages rise

if wage of insurance up, supply of paralegals comes down

- supply to firms

individual firms are wage takers - pay market wage

Wage determination
market clearing wage

w1 -> demand ↑  S ↓
w2 -> demand ↓  S ↑
market clearing wage - wage which supply = demand. at We, everyone is satisfied

The market clearing wage becomes going wage in the market.

disturbing the equilibrium
- demand shift

eg. if there is new regulation, more lawyers need

- supply shift

workers decrease, market wage goes up

barriers to adjustment
- workers: skill change, cost of moving
- employers: search and training cost, firing cost, wage cost
- non market forces: law constraining individual
  customs, culture

barrier of adjustment is the reason of unemployment

Discussion
market adjust more quickly for rising wages, because forces keep wages above market
market adjust slowly to decreasing wages, because labor union may protest
- the above market wages implies S of labor greater than D of labor, there will be unemployment

Applications of the theory

company overpay with above mkt wages
- if lower wages (lower than We), less ppl want to work

at individual level, economic rent is the amount where one's wage exceeds one's reservation wage
- reservation wage is the wage below which worker would not want to work

for L0 workers, they receive economic rent of W2 - W0

- employer do not know the reservation wage , so they pay more
- hard to know the fair wage