Monetary Economics Final

Front 1

Through which model do we view the effects of bond-financed tax cuts on the economy

Back 1

Overlapping Generations

Front 2

What are the 4 key assumptions of the overlapping generations model when we consider the effects of bond-financed tax cuts on the real economy?

Back 2

1) Agents live for 2 periods
2) There is no fiat money
3) Agents can invest in capital or buy bonds
4) Government taxes agents in the economy

Front 3

What is the most immediate effect of bond-financed tax cuts on the economy?

Back 3

Government debt increases

Front 4

There are two cases in the bond-financed tax discussion. Broadly speaking, what defines these two periods?

Back 4

When the government debt is paid off, ie which generation is going to pay off the debt.

Front 5

In the bond-financed tax discussion, what is the first case defined by?

Back 5

The government debt is paid off by some other generation and some other date (FUTURE)

Front 6

In the bond-financed tax discussion, what happens to consumer welfare during in the first case (when the debt is paid off in the future)? Why?

Back 6

Welfare of the consumer will increase because of the tax cut he experienced. Consumption when old and young are normal goods (increase when wealth increases)

Front 7

In the bond-financed tax discussion, what happens to savings during the first case?

Back 7

Savings go up. Individuals engage in consumption smoothing, and what to consume more when yong and old. In order to consume when old, he has to save part of his tax cut. Cannot save entirety of tax cut.

Front 8

In the bond-financed tax discussion, what happens to bonds and capital in the first case?

Back 8

Bond holdings go up, capital goes down. Savings consist only of capital and bonds. Savings increase by a number less than his tax cut.

Front 9

In the bond-financed tax discussion, what happens to output in the first case?

Back 9

Output falls. This is because of the reduction in capital due to the increase in government debt. This is called the crowding out of capital because bonds are substituting for capital in personal savings.

Front 10

In the bond-financed tax discussion, what is the second case defined by?

Back 10

The government debt is paid off by the same generation in the very next period.

Front 11

In the bond-financed tax discussion, what happens to consumer welfare during in the secondcase (when the debt is paid off by the same generation)? Why?

Back 11

The consumer engages in consumption smoothing. He knows that the government will have to pay it off by raising taxes next period. So the consumers wealth does not change, so he does not change consumption decision.

Front 12

In the bond-financed tax discussion, what happens to savings in the second case?

Back 12

Savings skyrocket as the entirety of the tax cut is saved by the consumer in order to pay off the forthcoming tax increase.

Front 13

What happens to capital during the second case of the bond-financed tax discussion?

Back 13

There is no crowding out effect because it is just over 1 period. Therefore capital stays the same, as does output.

Front 14

Broadly speaking, in our bond-financed tax cut discussion, what does the second case describe?

Back 14

It describes the Ricardian Equivalence Theorem after David Ricardo. Tax cut has to be accompanied by a tax increase next period. Consumers save the entirety of the tax cut. There is no crowding out of capital.

Front 15

What does the crowding out of capital mean?

Back 15

Crowding out refers to the reduction of capital because of the increase in government debt. This is because bonds are substituting for capital in personal savings.

Front 16

What causes the crowding out of capital?

Back 16

Δs = Δk + Δb
Δb goes up by 100
Δs goes up by less than 100 (if future gens are paying)
so Δk must be negative

Front 17

When is crowding out a problem for the economy? Why?

Back 17

Crowding out is a problem when the debt is paid off by a future generation. During this time, capital falls by the increase in consumption when young. PEOPLE DIDN'T WANT TO INCREASE THEIR SAVINGS BY THE FULL AMOUNT

Front 18

When is crowding out not a problem for the economy? Why?

Back 18

Crowding out is not a problem when the debt is paid off by a current generation. During this time, people save the ENTIRETY of the tax cut. ALthough ΔB goes up, so does ΔS by the same amount. THere is thus no change change in capital.

Front 19

How does a change in capital affect real variables?

Back 19

Capital affects the marginal product of capital and the interest rate. These are the only things that affect output.

Front 20

What paper is the phrase "tighter money now can mean higher inflation eventually" from?

Back 20

It is from Sargent and Wallace's paper "Some Unpleasant Monetarist Arithmetic"

Front 21

What is the thesis of Sargent and Wallace's Paper some unpleasant Monetarist Arithmetic?

Back 21

It explains that monetary policy cannot control inflation permanently. If fiscal policy dominates monetary policy, then budget is first decided, and from that revenue is determined) then the economy cannot avoid inflation forever.

Front 22

What does Sargent say are the 2 monetarist assumptions?

Back 22

1) monetary base closely connected to its price level
2) which the monetary policy can raise seignorage.

Front 23

In the Sargent and Wallace piece, what 2 factors allows the public's demand for Bonds to constrain the government?

Back 23

1) Sets upper limit on the amount of bonds relative to the size of the economy
2) Influences the interest rate at which governments must borrow

Front 24

What distinguishes the two coordination strategies in the Wallace and Sargent Piece?

Back 24

In one, monetary policy dominates fiscal policy, and in the other, fiscal policy dominates monetary policy.

Front 25

What does it mean if monetary policy dominates fiscal policy?

Back 25

That means that the revnues generated through taxation, seignorage, and bonds are determined first, and from this figure, the government determines spending.

Front 26

What happens if monetary policy dominates fiscal policy?

Back 26

The Fiscal budget is constrained, meaning that monetary policy can control inflation.

Front 27

What does it mean if fiscal policy dominates monetary policy?

Back 27

It means that the fiscal budget is set first, and monetary policy must then adjust bonds and seignorage to finance the budget.

Front 28

What happens if fiscal policy dominates monetary policy?

Back 28

The only way for the monetary policy to keep inflation down is by keeping the rate of money supply increase down and by selling more bonds. Eventually the bond limit will be reached, requiring inflation to pay off the interest coming due. So fighting inflation with tighter money in the short term creates inflation in the long term.

Front 29

What is the crucial assumption when we say that fiscal policy dominates monetary policy?

Back 29

The real rate of interest exceeds the growth rate of the economy

Front 30

What is the governments budget constraint in time t?

Back 30

G + (r/n)bt-1 = τ + [1 - 1/zt] + bt

Front 31

What is the government's budget constraint in time period 1 given r > n and that the government runs the same deficit, g - τ every year.

Back 31

(g - τ) + (r/n)b0 = q1[1 - (1/z1)] + b1

Front 32

What conclusions can be drawn regarding bond sales if the governments budget constraint in time 1 with r > n and a constant deficit of g - τ?

Back 32

If government reduces inflation today (by decreasing z1) then it must borrow more (increase b1) to balance the budget