ECON 3440 Lecture Notes - Lecture 5: Deflation, Liquidity Trap, Monetary Base

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18 Apr 2019

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Asset bubbles: when price of the asset (house or stock) is higher than what the stock is worth. When the bubble bursts, it takes the economy into a recession. If the recession is deep, the central bank will reduce the nominal interest rates (i) will get closer to zero and cannot go below that. This is called a liquidity trap the lower limit of i is reached and the central bank is helpless. When you are in a liquidity trap, people are indifferent between bonds and liquid assets (all assets that are a part of the money supply - m2) bonds are illiquid, but in this trap, they become indifferent. If the country is in a liquidity trap and the recession still persists, then there is a good chance that the country will fall into a deflationary spiral. When the economy is in a deflationary spiral, then the monetary policy is not effective.

Related Questions

1. Why Niall Ferguson thought that the expansionary fiscal policy (or government deficit) could produce crowding-out effect? You can explain by using the IS-LM model or you can use the logic of loanable funds theory

Answer: Ferguson believes that an increase in the government deficit could produce a crowding-out-effect. First, I will touch base on fiscal policy. Well, what is it? Basically, it adjusts the nationâs spending amount which increases the economyâs deficit to close a recessionary gap, which therefore increases the the demand for loans, meaning people want to borrow money. An increase in demand for loans leads to an increase in interest rates. Higher interest rates lead to a decrease in investment and interest-sensitive consumer spending, so both C and I decrease. Thatâs what the crowding-out-effect is, the decrease in investment due to higher interest rates.

>in Deficit = >in Demand for Loans = >in interest rates =

The government speeds up the economy by deficit spending, they crowd out consumers and investors with high interest rates. So what this means is that the government is attempting to help the economy but it is actually hurting the economy. The reason why I think Ferguson believes this is because of what he says in his debate at the New York Review of Books, that âyou canât be both a monetarist and a Keynesian simultaneouslyâat least I canât see how you can, because if the aim of the monetarist policy is to keep interest rates down, to keep liquidity high, the effect of the Keynesian policy must be to drive interest rates up.â He continues on in the interview to say that the Fed has minted out a fresh $1.75 billion in bonds and that no one is going to buy them. Driving up bonds will increase interest rates which increases mortgage rates which is why he basically doesnât agree with the Keynesian theory.

2. Why Paul Krugman thinks that Niall Ferguson was wrong and thought that government deficit could not produce a crowding-out effect? In other words, please explain Krugman's Liquidity trap .

Answer: To start I think Krugman believes that the Fiscal policy is effective. It is effective when the Liquidity-Money (LM) curve is horizontal. It creates the crowding in effect. The supply of money is constant so it creates money demanded to be interest inelastic, meaning it doesnât change. So if the government wishes to stimulate the economy, it leaves interest rates at a constant rate, and an increase in investment and saving, therefore helping the economy close the gap on a recession. There is an indifference between money and bonds so this makes fiscal policy effective. So then we get into a monetary expansion, meaning we have an increase in the money supply. Well with the liquidity trap, we get the case that the investment-savings (IS) curve is horizontal. So when the government increases the money supply, investment responds to rapidly changing interest rates, which would decrease the money demanded, making monetary policy effective. But the liquidity trap becomes apparent because interest rates cannot fall below zero percent. This is when monetary policy would become ineffective because interest rates arenât declining meaning investment wouldnât continue. Krugman in his blog basically argues this. He states âMost spectacularly, IS-LM turns out to be very useful for thinking about extreme conditions like the present, in which private demand has fallen so far that the economy remains depressed even at a zero interest rate.â He sums up his argument for the liquidity trap and explains his logic behind the investment-savings, liquidity-money curve, and that is why he disagrees with Ferguson.

3. In the discussion, other discussants such as George Soros and Robin Wells pointed out some interesting issues. Please provide at least one thing that you agree and one thing that you disagree. Discuss in details why you think so.

Answer: One thing I found interesting was George Soroâs point in the debate in the New York review of books. He states âThe other feature is that the financial system collapsed of its own weight. That contradicted the prevailing view about financial markets, namely that they tend toward equilibrium, and that equilibrium is disturbed by extraneous forces, outside shocks. Those disturbances were supposed to occur in a random fashion. Markets were seen basically as self-correcting. That paradigm has proven to be false. So we are dealing not only with the collapse of a financial system, but also with the collapse of a worldview.â He continues to mention how Obama has 2 problems he has to face and how people who are viewing this crisis the same as the previous financial crisis, are making a huge mistake. To explain he states this: âBut when you have a collapse of credit thereâs only one source of credit that is still credible, and thatâs the state: the Federal Reserve and the Treasury. Then you have actually to inject a lot more leverage and money into the economy; you have to print money as fast as you can, expand the balance sheet of the Federal Reserve, increase the national debt. And that is, in fact, what has been done, which is the right thing to do. But then once this policy is successful, you have to rein in the money supply as fast as you can.â I think Soro is agreeing with Krugman and the monetary policy of pumping money into the economy. It will raise the money supply which eventually is left for us to capitalize on supply and let our GDP. Now I find this interesting because he is also agreeing with Krugmanâs IS-LM model, and later on, we come to find out that even Ferguson had come to an agreement with Krugmanâs points, with the exception being that the United States was a powerhouse, and therefore the European Union would eventually see its downfall.

Please make comments to the answer of discussion I provided above(at least 300 words total). And you can start with "I agree with you on some points... But I disagree with you on some points".

Multiple choices

1. Banks face liquidity risk because

A) they can have difficulty meeting their depositor's demands to withdraw money.

B) they are unable to borrow from the Federal Reserve.

C) households and businesses may seek to borrow a large number of funds in a short period of time.

D) governments tend to run high budget deficits.

2. The original intention of the Fed's role as lender of last resort was to make loans to banks that were

A) not illiquid nor insolvent.

B) illiquid, but not insolvent.

C) insolvent, but not illiquid.

D) both illiquid and insolvent.

3. Why might a nation seek to maintain a pegged exchange rate?

A) It makes business planning easier for firms involved in the global economy.

B) It removes the need to intervene in the foreign exchange market.

C) It ensures that the exchange rate will remain at its equilibrium.

D) It makes their currency more attractive on the foreign exchange market.

4. Suppose a country pegs its currency. If investors start to believe the peg will collapse and the currency is going to depreciate, as the government defends the peg the interest rate will

A) Not move as interest rates must remain constant in a peg

B) Increase to maintain the peg

C) Decrease to maintain the peg

D) It depends on the inflation rate is low or high compared to the country to which the currency is pegged.

5. When the Fed extends loans to depository institutions

A) increases the level of reserves.

B) it decreases the level of reserves.

C) it reduces the total value of the assets on its balance sheet.

D) it reduces the total value of the liabilities on its balance sheet.

6. If the Fed buys securities worth $10 million, then

A) bank reserves will increase by $10 million.

B) bank reserves will decrease by $10 million.

C) currency in circulation will increase by $10 million.

D) bank holdings of securities increased by $10 million.

7. If the Fed purchases $1 million in securities from the nonbank public, the monetary base will rise by $1 million

A) if the public holds the proceeds as currency.

B) if the public deposits the proceeds as checkable deposits.

C) if the public deposits the proceeds with the Treasury in a monetary base account.

D) whether the public holds the proceeds as currency or deposits them as checkable deposits.

8. The aggregate M1 consists of

A) currency plus all deposits in financial institutions.

B) currency plus savings deposits in financial institutions.

C) currency plus checkable deposits in financial institutions.

D) currency.

9. If the Fed purchases $1 million worth of securities and the required reserve ratio is 8%, by how much will deposits increase (assuming no change in excess reserves or the public's currency holdings)?

A) rise by $1 million

B) decline by $1 million

C) rise by $8 million

D) rise by $12.5 million

10. Suppose the required reserve ratio is 8% and the Fed purchases $100 million worth of Treasury bills from Wells Fargo. Suppose Wells Fargo didn't have excess reserves, then by how much is Wells Fargo able to increase its loans?

A) $8 million

B) $92 million

C) $100 million

D) $1.25 billion

11. If banks hold no excess reserves, checkable deposits total $1.5 billion, currency totals $400 million, and the required reserve ratio is 10%, then the monetary base equals

A) $550 million.

B) $1.54 billion.

C) $1.9 billion

D) $15 billion.

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Big banks urge Ottawa to spend $20-billion in rapid stimulus

"Two of Canada's big banks want the federal government to pump $20-billion into an economic stimulus for a fast jolt to the flagging economy. Bank of Nova Scotia urged Ottawa to spend that much by mid-2017. Such a measure, the bank said, would equal 1 percent of gross domestic product and would play into its new economic forecast for GDP growth of 1.3 percent this year and 2.5 percent next. Canadian Imperial Bank of Commerce called for $20-billion in the government's first year, saying the pledges on the table just aren't enough. The Liberal government of Prime Minister Justin Trudeau has indeed promised to spend billions in infrastructure stimulus. But, beyond the recent campaign pledges, there have been no details on the final amount, the targets, and the timeline. And remember, the fiscal outlook has changed rapidly, with the Liberals now forecasting a deficit of $18-billion even without their promised spending. Canadians will get the details when Finance Minister Bill Morneau unveils his budget on March 22. While Scotiabank and CIBC are the first to have specific calls, other bank economists have said the further stimulus would be welcome, and that the government certainly has the fiscal room to accommodate it. Scotiabank painted a weak economic picture for 2016, particularly for the oil-shocked province of Alberta, and a national unemployment rate that will top 7 per cent this year and next. It projected the economy of Alberta, which had been the country's economic engine until the oil route, will contract by a further 1.9 percent this year, with a jobless rate of 7.5 percent. Our Canadian forecast incorporates our recommendation for the federal fiscal stimulus of $20-billion, equivalent to 1 per cent of GDP, implemented during the second of 2016 and the first half of 2017, said Aron Gampel, Scotiabank's deputy chief economist. "This stimulus would be over and above the deficit resulting from weaker economic conditions, estimated for fiscal 2016-17 at $18-billion by the federal government," he added. "The stimulus should be designed to: deliver a rapid economic impact; raise Canada's economic capacity and thus our longer-term growth prospects; and, facilitate adjustments in the provinces most affected by weak commodity prices. Once the Canadian economy no longer requires policy support, targeting a declining ratio of net debt-to-GDP should resume." CIBC also weighed in on the stimulus debate today, calling for $20-billion in stimulus over two years. The Liberal pledges had been for $5-billion infrastructure and a further $5-billion in other measures in their first two years in power. But CIBC World Markets doesn't think that's enough given the country's economic troubles. "Federal stimulus under that scenario would be barely more than 0.5 percent of GDP, arguably too little to do the job, particularly with some provinces applying fiscal brakes," said CIBC's Royce Mendes and Avery Shenfeld. "We see a $20-billion stimulus program with a $40-billion deficit as being more appropriate, but given the political sensitivities, the government might show something closer to $35-billion for 2016-17, while perhaps taking on some further stimulus charged to the outgoing year." Some academics believe that in this low-interest-rate environment, what we need is a strong blast of fiscal stimulus to drive employment and growth. They argue that we should reject fiscal austerity and embrace public investment. Indeed, that has been the primary economic platform for the Liberal party, and for some, the reason for them winning a majority in the last election."

(a) The IMF "It is Mostly Fiscal" appears to be what Trudeau and his economic team have bought into. Explain why further fiscal austerity could be particularly painful for the Canadian economy, and how deficit spending may lower the government debt to GDP ratio. Be sure to illustrate using the IS-LM and the AD-AS frameworks.

(b) Discuss why Canadian banks are particularly concerned that the government fiscal stimulus plan may not be enough.

(c) Discuss what are some of the problems with using expansionary monetary policy in an environment of low interest rates. That is, describe the problem of a "liquidity trap."

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ECON 3440 Lecture Notes - Lecture 5: Deflation, Liquidity Trap, Monetary Base

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