Question 2
13.) According to the liquidity premium theory of the term structure
a.) Because buyers of bonds may prefer binds of one maturity over another, interest rates on bonds of different maturities do not move together over time.
b.) The interest rate on long-term bonds will equal an average of short-term interest rates that people expect to occur over the life of the long-term bonds plus a term premium.
c.) because of the positive term premium, the yield curve will not be observed to be downward sloping.
d.) the interest rate for each maturity bond is determined by supply and demand for that maturity bond.
14.) According to the liquidity premium theory of the term structure, a steeply upward sloping yield curve indicates that short-term interest rates are expected to
a.) rise in the future
b.) remain unchanged in the future
c.) decline moderately in the future
d.) decline sharply in the future
15.) The preferred habitat theory of the term structure is closely related to the
a.) expectations theory of the term structure
b.) segmented markets theory of the term structure
c.) liquidity premium theory of the term structure
d.) the inverted yield curve theory of the term structure.
16.) An inverted yield curve predicts that short-term interest rates
a.) are expected to rise in the future
b.) will rise and then fall in the future
c.) will remain unchanged in the future
d.) will fall in the future.
Question 3.
Read the Economist article below "Put out" (Economist, 7/4/2009, Vol. 392, issue 8638, p 74). Summarize the article. In your summary make sure to answer the following questions, and refer to the AD/AS model presented in class: a. What is meant by an 'output gap'? b. According to the article, why is it difficult to estimate and measure the output gap and how much deflationary threat it causes? How is this related to the fact that during recessionary times, potential output also changes? c. Relating to your answer in part (b). how and why do you think NAIRU ("non- accelerating inflation rate of unemployment", or the natural rate of unemployment), thus potential output changes during recessionary times? d. How is the change in NAIRU related to the flexibility of the labor market?NAIRU's non-alignment This divergence in estimates highlights the biggest problem in relying on the output gap: it is a slippery thing to measure. How do you really gauge a firm's capacity, especially in services? How many of those not working could work? How fast is productivity growing over time? Economic shocks make the task even harder. They may render big chunks of the capital stock obsolete: many idle car factories, for example, may never reopen. Workers thrown out of a shrunken industry like finance or construction may take years to retrain for another. Some may never succeed. Although unemployed, they are not really competing for the jobs that fall vacant and are thus not putting much downward pressure on wages. That means the "non-accelerating inflation rate of unemployment", or the Nairu, may have risen. In other words, when actual output falls, it can drag potential output down with it-the main reason why Mr Williams and Mr Weidner believe that the gap is smaller than the CBO's estimates. That recessions can reduce potential output is not controversial. The question is: by how much? In its latest Economic Outlook, the OECD concludes that the collapse in business investment will cause potential output to grow more slowly in America this year and next but that it will not fall. It does think the Nairu will rise measurably in the euro area, where relatively rigid labour markets mean someone who loses a job will take much longer to find another, during which time his skills atrophy. But in the United States, whose job market is more flexible, the Nairu will barely rise. If Mr Williams and Mr Weidner are wrong and the output gap is large, then there are other explanations for why American inflation has not fallen further. The simplest is that not enough time has elapsed. Chris Varvares of Macroeconomic Advisers, a forecasting consultancy, thinks that core inflation will fall to close to zero in 2011. While it has been firm so far this year, he argues it will fall noticeably later this year as residual seasonal factors recede. Even if inflation were to fall to between zero and 1.5%, say, that would be a small drop given the CBO's estimate of the output gap. A comparable gap in 1981-83 produced a drop in core inflation of six percentage points. But in the early 1980s, inflation had fluctuated so much for so long that workers and firms quickly adapted their wage- and price-setting behaviour to the latest trends, so inflation responded more swiftly to falling demand. Since then, inflationary expectations have stabilised at around 2%, which means that inflation responds more sluggishlyto demand (as the recessions of 1990-91 and 2001 demonstrated). The OECD notes that when Finland and Canada experienced large and persistent output gaps in the 1990s, inflation fell quite far but did not become deflation, which it attributes in part to the success of central banks in anchoring expectations with inflation targets. Such expectations may rise if investors worry that central banks will print money to finance governments' rising fiscal deficits. But even if they remain well anchored, expectations alone do not explain why inflation does not respond more to economic slack. A large and persistent output gap in the 1990s eventually tipped Japan into deflation in 2000; inflation expectations also turned negative. As long as the gap persisted, deflation should have accelerated. It did not, ranging from -0.3% to -0.9% between 2000 and 2003. According to Ken Kuttner, an economist at Williams College, Japan's output gap may have been smaller than thought; workers may have resisted pay cuts; and perhaps most important, at low rates of either inflation or deflation firms may change prices less frequently, reducing the impact of output gaps. If so, this would provide a buffer to deflation in the rich world today, despite the presence of large gaps. But the thought is not entirely comforting. It also means that if inflation does fall to zero or turns slightly negative, it could be difficult to get it back up. The best cure for deflation remains prevention.Put out Uncertainty over the size of the output gap complicates the task of central banks HAVING raised the alarm on deflation, the Federal Reserve has now begun to sound the all clear. The statement it released after its policy meeting on June 24th notably omitted the warning from its three prior meetings that "inflation could persist for a time below rates that best foster economic growth and price stability". To be sure, with the economy gradually finding a bottom and the rate of decline in home prices slowing, the chances of a downward spiral of deflation and economic activity have diminished. Yet it seems premature to write off the threat as long as a large output gap persists. The output gap is the difference between actual economic output and the most the economy could produce given the capital, know-how and people available. When actual output exceeds potential, demand for products and labour bids up prices and wages, fuelling inflation. When actual output falls short, competition for scarce sales and jobs puts downward pressure on inflation. Estimating how big the output gap is, and how much of a deflationary threat it still poses, is not easy. The Congressional Budget Office (CBO) estimates that the gap topped 6% in the first quarter of this year and will average more than 7% in 2009, which would be the largest figure on record. Given that core inflation was so low when the recession began, it is not a stretch to believe that, with so much slack in the economy, it could yet turn negative. But this view has been challenged in a note by John Williams and Justin Weidner of the Federal Reserve Bank of San Francisco. Rather than follow the conventional route of deriving an inflation forecast from an estimate of potential output, they do the opposite: they infer the output gap from the behaviour of inflation. As in the euro zone, where consumer prices fell for the first time ever in the 12 months to June, and Japan, where inflation excluding perishable food was -1.1% in May, inflation in America is now negative because of a drop in fuel prices last year. But core inflation is 1.8%, within its range this decade. The authors take this as evidence that the output gap may have been only 2% in the first quarter, implying little or no threat of deflation
