A central bank, reserve bank, or monetary authority is the institution that manages the currency, money supply, interest rates of a state or formal monetary union, oversees their commercial banking system. In contrast to a commercial bank, a central bank possesses a monopoly on increasing the monetary base in the state, generally controls the printing/coining of the national currency, which serves as the state's legal tender. A central bank acts as a lender of last resort to the banking sector during times of financial crisis. Most central banks have supervisory and regulatory powers to ensure the solvency of member institutions, to prevent bank runs, to discourage reckless or fraudulent behavior by member banks. Central banks in most developed nations are institutionally independent from political interference. Still, limited control by the executive and legislative bodies exists. Functions of a central bank may include: implementing monetary policies. Setting the official interest rate – used to manage both inflation and the country's exchange rate – and ensuring that this rate takes effect via a variety of policy mechanisms controlling the nation's entire money supply the Government's banker and the bankers' bank managing the country's foreign exchange and gold reserves and the Government bonds regulating and supervising the banking industry Central banks implement a country's chosen monetary policy.
At the most basic level, monetary policy involves establishing what form of currency the country may have, whether a fiat currency, gold-backed currency, currency board or a currency union. When a country has its own national currency, this involves the issue of some form of standardized currency, a form of promissory note: a promise to exchange the note for "money" under certain circumstances; this was a promise to exchange the money for precious metals in some fixed amount. Now, when many currencies are fiat money, the "promise to pay" consists of the promise to accept that currency to pay for taxes. A central bank may use another country's currency either directly in a currency union, or indirectly on a currency board. In the latter case, exemplified by the Bulgarian National Bank, Hong Kong and Latvia, the local currency is backed at a fixed rate by the central bank's holdings of a foreign currency. Similar to commercial banks, central banks incur liabilities. Central banks create money by issuing interest-free currency notes and selling them to the public in exchange for interest-bearing assets such as government bonds.
When a central bank wishes to purchase more bonds than their respective national governments make available, they may purchase private bonds or assets denominated in foreign currencies. The European Central Bank remits its interest income to the central banks of the member countries of the European Union; the US Federal Reserve remits all its profits to the U. S. Treasury; this income, derived from the power to issue currency, is referred to as seigniorage, belongs to the national government. The state-sanctioned power to create currency is called the Right of Issuance. Throughout history there have been disagreements over this power, since whoever controls the creation of currency controls the seigniorage income; the expression "monetary policy" may refer more narrowly to the interest-rate targets and other active measures undertaken by the monetary authority. Frictional unemployment is the time period between jobs when a worker is searching for, or transitioning from one job to another. Unemployment beyond frictional unemployment is classified as unintended unemployment.
For example, structural unemployment is a form of unemployment resulting from a mismatch between demand in the labour market and the skills and locations of the workers seeking employment. Macroeconomic policy aims to reduce unintended unemployment. Keynes labeled any jobs that would be created by a rise in wage-goods as involuntary unemployment: Men are involuntarily unemployed if, in the event of a small rise in the price of wage-goods to the money-wage, both the aggregate supply of labour willing to work for the current money-wage and the aggregate demand for it at that wage would be greater than the existing volume of employment.—John Maynard Keynes, The General Theory of Employment and Money p11 Inflation is defined either as the devaluation of a currency or equivalently the rise of prices relative to a currency. Since inflation lowers real wages, Keynesians view inflation as the solution to involuntary unemployment. However, "unanticipated" inflation leads to lender losses as the real interest rate will be lower than expected.
Thus, Keynesian monetary policy aims for a steady rate of inflation. A publication from the Austrian School, The Case Against the Fed, argues that the efforts of the central banks to control inflation have been counterproductive. Economic growth can be enhanced by investment such as more or better machinery. A low interest rate implies that firms can borrow money to invest in their capital stock and pay less interest for it. Lowering the interest is therefore considered to encourage economic growth and is used to alleviate times of low economic growth. On the other hand, raising the interest rate is used in times of high economic growth as a contra-cyclical device to keep the economy from overheating and avoid market bubbles. Further goals of monetary policy are stability of interest rates, of the financial market, of the foreign exchange market. Goals cannot be separated fr
Real business-cycle theory
Real business-cycle theory is a class of new classical macroeconomics models in which business-cycle fluctuations to a large extent can be accounted for by real shocks. Unlike other leading theories of the business cycle, RBC theory sees business cycle fluctuations as the efficient response to exogenous changes in the real economic environment; that is, the level of national output maximizes expected utility, governments should therefore concentrate on long-run structural policy changes and not intervene through discretionary fiscal or monetary policy designed to smooth out economic short-term fluctuations. According to RBC theory, business cycles are therefore "real" in that they do not represent a failure of markets to clear but rather reflect the most efficient possible operation of the economy, given the structure of the economy. Real business cycle theory categorically rejects Keynesian economics and the real effectiveness of monetary policy as promoted by monetarism and New Keynesian economics, which are the pillars of mainstream macroeconomic policy.
RBC theory is associated with freshwater economics. If we were to take snapshots of an economy at different points in time, no two photos would look alike; this occurs for two reasons: Many advanced economies exhibit sustained growth over time. That is, snapshots taken many years apart will most depict higher levels of economic activity in the period. There exist random fluctuations around this growth trend, thus given two snapshots in time, predicting the latter with the earlier is nearly impossible. A common way to observe such behavior is by looking at a time series of an economy's output, more gross national product; this is just the value of the services produced by a country's businesses and workers. Figure 1 shows the time series of real GNP for the United States from 1954–2005. While we see continuous growth of output, it is not a steady increase. There are times of times of slower growth. Figure 2 extracts a smoother growth trend. A common method to obtain this trend is the Hodrick–Prescott filter.
The basic idea is to find a balance between the extent to which general growth trend follows the cyclical movement and how smooth it is. The HP filter identifies the longer term fluctuations as part of the growth trend while classifying the more jumpy fluctuations as part of the cyclical component. Observe the difference between this growth component and the jerkier data. Economists refer to these cyclical movements about the trend as business cycles. Figure 3 explicitly captures such deviations. Note the horizontal axis at 0. A point on this line indicates at that year, there is no deviation from the trend. All other points above and below the line imply deviations. By using log real GNP the distance between any point and the 0 line equals the percentage deviation from the long run growth trend. Note that the Y-axis uses small values; this indicates that the deviations in real GNP are small comparatively, might be attributable to measurement errors rather than real deviations. We call large positive deviations peaks.
We call large negative deviations troughs. A series of positive deviations leading to peaks are booms and a series of negative deviations leading to troughs are recessions. At a glance, the deviations just look like a string of waves bunched together—nothing about it appears consistent. To explain causes of such fluctuations may appear rather difficult given these irregularities. However, if we consider other macroeconomic variables, we will observe patterns in these irregularities. For example, consider Figure 4 which depicts fluctuations in output and consumption spending, i.e. what people buy and use at any given period. Observe how the peaks and troughs align at the same places and how the upturns and downturns coincide. We might predict. For example, hours worked productivity, how effective firms use such capital or labor, amount of capital saved to help future endeavors, capital stock, value of machines and other equipment that help firms produce their goods. While Figure 5 shows a similar story for investment, the relationship with capital in Figure 6 departs from the story.
We need a way to pin down a better story. By eyeballing the data, we can infer several regularities, sometimes called stylized facts. One is persistence. For example, if we take any point in the series above the trend, the probability the next period is still above the trend is high. However, this persistence wears out over time; that is, economic activity in the short run is quite predictable but due to the irregular long-term nature of fluctuations, forecasting in the long run is much more difficult if not impossible. Another regularity is cyclical variability. Column A of Table 1 lists a measure of this with standard deviations; the magnitude of fluctuations in output and hours worked. Consumption and productivity are much smoother than output while investment fluctuates much more than output; the capital stock is the least volatile of the indicators. Yet another regularity is the co-movement between the other macroeconomic variables. Figures 4 – 6 illustrated such relationship. We can measure this in more detail using correlations as listed in column B of Table 1.
Procyclical variables have positive correlations since
A financial crisis is any of a broad variety of situations in which some financial assets lose a large part of their nominal value. In the 19th and early 20th centuries, many financial crises were associated with banking panics, many recessions coincided with these panics. Other situations that are called financial crises include stock market crashes and the bursting of other financial bubbles, currency crises, sovereign defaults. Financial crises directly result in a loss of paper wealth but do not result in significant changes in the real economy. Many economists have offered theories about how financial crises develop and how they could be prevented. There is no consensus and financial crises continue to occur from time to time; when a bank suffers a sudden rush of withdrawals by depositors, this is called a bank run. Since banks lend out most of the cash they receive in deposits, it is difficult for them to pay back all deposits if these are demanded, so a run renders the bank insolvent, causing customers to lose their deposits, to the extent that they are not covered by deposit insurance.
An event in which bank runs are widespread is called a systemic banking banking panic. Examples of bank runs include the run on the Bank of the United States in 1931 and the run on Northern Rock in 2007. Banking crises occur after periods of risky lending and resulting loan defaults. A currency crisis called a devaluation crisis, is considered as part of a financial crisis. Kaminsky et al. for instance, define currency crises as occurring when a weighted average of monthly percentage depreciations in the exchange rate and monthly percentage declines in exchange reserves exceeds its mean by more than three standard deviations. Frankel and Rose define a currency crisis as a nominal depreciation of a currency of at least 25% but it is defined as at least a 10% increase in the rate of depreciation. In general, a currency crisis can be defined as a situation when the participants in an exchange market come to recognize that a pegged exchange rate is about to fail, causing speculation against the peg that hastens the failure and forces a devaluation.
A speculative bubble exists in the event of sustained overpricing of some class of assets. One factor that contributes to a bubble is the presence of buyers who purchase an asset based on the expectation that they can resell it at a higher price, rather than calculating the income it will generate in the future. If there is a bubble, there is a risk of a crash in asset prices: market participants will go on buying only as long as they expect others to buy, when many decide to sell the price will fall. However, it is difficult to predict whether an asset's price equals its fundamental value, so it is hard to detect bubbles reliably; some economists insist that bubbles never or never occur. Well-known examples of bubbles and crashes in stock prices and other asset prices include the 17th century Dutch tulip mania, the 18th century South Sea Bubble, the Wall Street Crash of 1929, the Japanese property bubble of the 1980s, the crash of the dot-com bubble in 2000–2001, the now-deflating United States housing bubble.
The 2000s sparked a real estate bubble where housing prices were increasing as an asset good. When a country that maintains a fixed exchange rate is forced to devalue its currency due to accruing an unsustainable current account deficit, this is called a currency crisis or balance of payments crisis; when a country fails to pay back its sovereign debt, this is called a sovereign default. While devaluation and default could both be voluntary decisions of the government, they are perceived to be the involuntary results of a change in investor sentiment that leads to a sudden stop in capital inflows or a sudden increase in capital flight. Several currencies that formed part of the European Exchange Rate Mechanism suffered crises in 1992–93 and were forced to devalue or withdraw from the mechanism. Another round of currency crises took place in Asia in 1997–98. Many Latin American countries defaulted on their debt in the early 1980s; the 1998 Russian financial crisis resulted in a devaluation of the ruble and default on Russian government bonds.
Negative GDP growth lasting two or more quarters is called a recession. An prolonged or severe recession may be called a depression, while a long period of slow but not negative growth is sometimes called economic stagnation; some economists argue. One important example is the Great Depression, preceded in many countries by bank runs and stock market crashes; the subprime mortgage crisis and the bursting of other real estate bubbles around the world led to recession in the U. S. and a number of other countries in late 2008 and 2009. Some economists argue that financial crises are caused by recessions instead of the other way around, that where a financial crisis is the initial shock that sets off a recession, other factors may be more important in prolonging the recession. In particular, Milton Friedman and Anna Schwartz argued that the initial economic decline associated with the crash of 1929 and the bank panics of the 1930s would not have turned into a prolonged depression if it had not been reinforced by monetary policy mistakes on the part of the Federal Reserve, a position supported by Ben Bernanke.
It is observed that successful investment requires each investor in a financial market to guess what other investors will do. George Soros has called th
Overlapping generations model
The overlapping generations model is one of the dominating frameworks of analysis in the study of macroeconomic dynamics and economic growth. In contrast, to the Ramsey–Cass–Koopmans neoclassical growth model in which individuals are infinitely-lived, in the OLG model individuals live a finite length of time, long enough to overlap with at least one period of another agent's life; the OLG model is the natural framework for the study of: the life-cycle behavior, the implications of the allocation of resources across the generations, such as Social Security, on the income per capita in the long-run, the determinates of economic growth in the course of human history, the factors that triggered the fertility transition. The construction of the OLG model was inspired by Irving Fisher's monograph The Theory of Interest, it was first formulated in 1947, in the context of a pure-exchange economy, by Maurice Allais, more rigorously by Paul Samuelson in 1958. In 1965, Peter Diamond incorporated an aggregate neoclassical production into the model.
This OLG model with production was further augmented with the development of the two-sector OLG model by Oded Galor, the introduction of OLG models with endogenous fertility. Books devoted to the use of the OLG model include Azariadis' Intertemporal Macroeconomics and de la Croix and Michel's Theory of Economic Growth; the most basic OLG model has the following characteristics: Individuals live for two periods. In the second period of life, they are referred to as the Old. A number of individuals are born in every period. N t t denotes the number of individuals born in period t. N t t − 1 denotes the number of old people in period t. Since the economy begins in period 1, in period 1 there is a group of people who are old, they are referred to as the initial old. The number of them can be denoted as N 0; the size of the initial old generation is normalized to 1: N 0 0 = 1. People do not die early, so N t t = N t + 1 t. Population grows at a constant rate n: N t t = t In the "pure exchange economy" version of the model, there is only one physical good and it cannot endure for more than one period.
Each individual receives a fixed endowment of this good at birth. This endowment is denoted as y. In the "production economy" version of the model, the physical good can be either consumed or invested to build physical capital. Output is produced from labor and physical capital; each household is endowed with one unit of time, inelastically supply on the labor market. Preferences over consumption streams are given by u = U + β U, where β is the rate of time preference; the pure-exchange OLG model was augmented with the introduction of an aggregate neoclassical production by Peter Diamond. In contrast, to Ramsey–Cass–Koopmans neoclassical growth model in which individuals are infinitely-lived and the economy is characterized by a unique steady-state equilibrium, as was established by Oded Galor and Harl Ryder, the OLG economy may be characterized by multiple steady-state equilibria, initial conditions may therefore affect the long-run evolution of the long-run level of income per capita. Since initial conditions in the OLG model may affect economic growth in long-run, the model was useful for the exploration of the convergence hypothesis.
The economy has the following characteristics: Two generations are alive at any point in time, the young and old. The size of the young generation in period t is given by Nt = N0 Et. Households earn Y1, t income, they earn no income in the second period of their life They consume part of their first period income and save the rest to finance their consumption when old. At the end of period t, the assets of the young are the source of the capital used for aggregate production in period t+1. So Kt+1 = Nt,a1,t where a1,t is the assets per young household after their consumption in period 1. In addition to this there is no depreciation; the old in period t own the entire capital stock and consume it so dissaving by the old in period t is given by Nt-1,a1,t-1 = Kt. Labor and capital markets are competitive and the aggregate production technology is CRS, Y = F; the one-sector OLG model was further augmented with the introduction of a two-sector OLG model by Oded Galor. The two-sector model provides a framework of analysis for the study of the sectoral adjustments to aggregate shocks and implications of international trade for the dynamics of comparative advantage.
In contrast to the Uzawa two-sector neoclassical growth model, the two-sector OLG model may be characterized by multiple steady-s
History of macroeconomic thought
Macroeconomic theory has its origins in the study of business cycles and monetary theory. In general, early theorists believed monetary factors could not affect real factors such as real output. John Maynard Keynes attacked some of these "classical" theories and produced a general theory that described the whole economy in terms of aggregates rather than individual, microeconomic parts. Attempting to explain unemployment and recessions, he noticed the tendency for people and businesses to hoard cash and avoid investment during a recession, he argued that this invalidated the assumptions of classical economists who thought that markets always clear, leaving no surplus of goods and no willing labor left idle. The generation of economists that followed Keynes synthesized his theory with neoclassical microeconomics to form the neoclassical synthesis. Although Keynesian theory omitted an explanation of price levels and inflation Keynesians adopted the Phillips curve to model price-level changes; some Keynesians opposed the synthesis method of combining Keynes's theory with an equilibrium system and advocated disequilibrium models instead.
Monetarists, led by Milton Friedman, adopted some Keynesian ideas, such as the importance of the demand for money, but argued that Keynesians ignored the role of money supply in inflation. Robert Lucas and other new classical macroeconomists criticized Keynesian models that did not work under rational expectations. Lucas argued that Keynesian empirical models would not be as stable as models based on microeconomic foundations; the new classical school culminated in real business cycle theory. Like early classical economic models, RBC models assumed that markets clear and that business cycles are driven by changes in technology and supply, not demand. New Keynesians tried to address many of the criticisms leveled by Lucas and other new classical economists against Neo-Keynesians. New Keynesians adopted rational expectations and built models with microfoundations of sticky prices that suggested recessions could still be explained by demand factors because rigidities stop prices from falling to a market-clearing level, leaving a surplus of goods and labor.
The new neoclassical synthesis combined elements of both new classical and new Keynesian macroeconomics into a consensus. Other economists avoided the new classical and new Keynesian debate on short-term dynamics and developed the new growth theories of long-run economic growth; the Great Recession led to a retrospective on the state of the field and some popular attention turned toward heterodox economics. Macroeconomics descends from two areas of research: monetary theory. Monetary theory dates back to the 16th century and the work of Martín de Azpilcueta, while business cycle analysis dates from the mid 19th. Beginning with William Stanley Jevons and Clément Juglar in the 1860s, economists attempted to explain the cycles of frequent, violent shifts in economic activity. A key milestone in this endeavor was the foundation of the U. S. National Bureau of Economic Research by Wesley Mitchell in 1920; this marked the beginning of a boom in atheoretical, statistical models of economic fluctuation that led to the discovery of regular economic patterns like the Kuznets wave.
Other economists focused more on theory in their business cycle analysis. Most business cycle theories focused on a single factor, such as monetary policy or the impact of weather on the agricultural economies of the time. Although business cycle theory was well established by the 1920s, work by theorists such as Dennis Robertson and Ralph Hawtrey had little impact on public policy, their partial equilibrium theories could not capture general equilibrium, where markets interact with each other. Research in these areas used microeconomic methods to explain employment, price level, interest rates; the relationship between price level and output was explained by the quantity theory of money. Quantity theory viewed the entire economy through Say's law, which stated that whatever is supplied to the market will be sold—in short, that markets always clear. In this view, money can not impact the real factors in an economy like output levels; this was consistent with the classical dichotomy view that real aspects of the economy and nominal factors, such as price levels and money supply, can be considered independent from one another.
For example, adding more money to an economy would be expected only to raise prices, not to create more goods. The quantity theory of money dominated macroeconomic theory until the 1930s. Two versions were influential, one developed by Irving Fisher in works that included his 1911 The Purchasing Power of Money and another by Cambridge economists over the course of the early 20th century. Fisher's version of the quantity theory can be expressed by holding money velocity and real income constant and allowing money supply and the price level to vary in the equation of exchange: M ⋅ V = P ⋅ Q Most classical theories, including Fisher's, held that velocity was stable and independent of economic activity. Cambridge economists, such as John Maynard Keynes, began to challenge this assumption, they developed the Cambridge cash-balance theory, which looked at money demand and how it impacted the economy. The Cambridge theory did not assume that money
Econometrics is the application of statistical methods to economic data in order to give empirical content to economic relationships. More it is "the quantitative analysis of actual economic phenomena based on the concurrent development of theory and observation, related by appropriate methods of inference". An introductory economics textbook describes econometrics as allowing economists "to sift through mountains of data to extract simple relationships"; the first known use of the term "econometrics" was by Polish economist Paweł Ciompa in 1910. Jan Tinbergen is considered by many to be one of the founding fathers of econometrics. Ragnar Frisch is credited with coining the term in the sense. A basic tool for econometrics is the multiple linear regression model. Econometric theory uses statistical theory and mathematical statistics to evaluate and develop econometric methods. Econometricians try to find estimators that have desirable statistical properties including unbiasedness and consistency.
Applied econometrics uses theoretical econometrics and real-world data for assessing economic theories, developing econometric models, analysing economic history, forecasting. A basic tool for econometrics is the multiple linear regression model. In modern econometrics, other statistical tools are used, but linear regression is still the most used starting point for an analysis. Estimating a linear regression on two variables can be visualised as fitting a line through data points representing paired values of the independent and dependent variables. For example, consider Okun's law, which relates GDP growth to the unemployment rate; this relationship is represented in a linear regression where the change in unemployment rate is a function of an intercept, a given value of GDP growth multiplied by a slope coefficient β 1 and an error term, ε: Δ Unemployment = β 0 + β 1 Growth + ε. The unknown parameters β β 1 can be estimated. Here β 1 is estimated to be −1.77 and β 0 is estimated to be 0.83.
This means that if GDP growth increased by one percentage point, the unemployment rate would be predicted to drop by 1.77 points. The model could be tested for statistical significance as to whether an increase in growth is associated with a decrease in the unemployment, as hypothesized. If the estimate of β 1 were not different from 0, the test would fail to find evidence that changes in the growth rate and unemployment rate were related; the variance in a prediction of the dependent variable as a function of the independent variable is given in polynomial least squares. Econometric theory uses statistical theory and mathematical statistics to evaluate and develop econometric methods. Econometricians try to find estimators that have desirable statistical properties including unbiasedness and consistency. An estimator is unbiased. Ordinary least squares is used for estimation since it provides the BLUE or "best linear unbiased estimator" given the Gauss-Markov assumptions; when these assumptions are violated or other statistical properties are desired, other estimation techniques such as maximum likelihood estimation, generalized method of moments, or generalized least squares are used.
Estimators that incorporate prior beliefs are advocated by those who favour Bayesian statistics over traditional, classical or "frequentist" approaches. Applied econometrics uses theoretical econometrics and real-world data for assessing economic theories, developing econometric models, analysing economic history, forecasting. Econometrics may use standard statistical models to study economic questions, but most they are with observational data, rather than in controlled experiments. In this, the design of observational studies in econometrics is similar to the design of studies in other observational disciplines, such as astronomy, epidemiology and political science. Analysis of data from an observational study is guided by the study protocol, although exploratory data analysis may be useful for generating new hypotheses. Economics analyses systems of equations and inequalities, such as supply and demand hypothesized to be in equilibrium; the field of econometrics has developed methods for identification and estimation of simultaneous-equation models.
These methods are analogous to methods used in other areas of science, such as the field of system identification in systems analysis and control theory. Such methods may allow researchers to estimate models and investigate their empirical consequences, without directly manipulating the system. One of the fundamental statistical methods used by econometricians is regression analysis. Regression methods are important i
Demand-pull inflation is asserted to arise when aggregate demand in an economy outpaces aggregate supply. It involves inflation rising as real gross domestic product rises and unemployment falls, as the economy moves along the Phillips curve; this is described as "too much money spent chasing too few goods." More it should be described as involving "too much money chasing too few goods," since only money, spent on goods and services can cause inflation. This would not be expected to happen, unless the economy is at a full employment level, it is the opposite of cost-push inflation. In Keynesian theory, increased employment results in increased aggregate demand, which leads to further hiring by firms to increase output. Due to capacity constraints, this increase in output will become so small that the price of the good will rise. At first, unemployment will go down; this increase in demand means more workers are needed, AD will be shifted from AD2 to AD3, but this time much less is produced than in the previous shift, but the price level has risen from P2 to P3, a much higher increase in price than in the previous shift.
This increase in price is called inflation. Demand-pull inflation is in contrast with cost-push inflation, when price and wage increases are being transmitted from one sector to another. However, these can be considered as different aspects of an overall inflationary process: demand-pull inflation explains how price inflation starts, cost-push inflation demonstrates why inflation once begun is so difficult to stop. There is a quick increase in consumption and investment along with confident firms. There is a sudden increase in exports due to huge under-valuation of the currency. There is a lot of government spending; the expectation that inflation will rise leads to a rise in inflation. Workers and firms will increase their prices to'catch up' to inflation. There is excessive monetary growth, when there is too much money in the system chasing too few goods. The'price' of a good will thus increase. There is a rise in population. Built-in inflation Cost-push inflation Theory 1 - Demand-pull inflation - is inflation demanding?, Bank of Biz/ed