N40 - Consumption - Monetary Policy, Interest Rates and...

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Unformatted text preview: Monetary Policy, Interest Rates and Exchange Rates Suppose the following: - at = = —> i = , E = _ i = - what happens when Central Bank’s goal is to increase output 0 i by percentage points for next yrs 0 affect bonds 0 after the 5th yr, return to 0 financial mkts this announcement year interest rate foreign exchange 0 1 2 3 4 5 6 - at the 6th year interest rates return to original level, so 0 i0 = r0 —> exch rates return to original level - but in between, i because of expectations 0 expect interest rates to be lower 0 interest parity condition: = i* —> i = 0 each yr dom interest rates are lower, it is expected. that dom currency will ppts - over a five yr period: ppt depreciation >< yrs I ppt T in E o to to t]: E T by ppts (due to expectations) 0 t1 to t2: El by ppt (interest parity) 0 t4 to t5: El by ppt : - before the announcement: i = i* or r = r* - after the announcement: i < i* or r < r* —> ET 0 overshoots rn —> adjustment of E is called 0 application: 1970’s when going from E to E I of future interest rates I not of foreign exchange mkts - simplifications: assumptions 0 about Central Banks announcements 0 of foreign Central Banks Expectations: Consumption - earlier: Y = consumption, savings - incomplete: expectations of future wages 0 two models from the 1950’s I Fried-man’s income theory of consumption I Modigliani: theory of consumption - some terminology: o wealth: value of house minus the mortgage due 0 wealth: checking, savings, stocks, "bonds 0 wealth: PDV of expected. after-tax labor income over length of career 0 wealth: housing wealth + financial wealth o = human wealth +financial wealth 0 Ct = C( ) Example: Suppose - you are 21, with 3 more yrs of university - debt = possessions: non-human wealth - total wealth = human wealth = - 3 yrs from now: graduate, first job pays 55 - Y increases by % each year - retire at age —> start work at , work for yrs - tax rate on labor income = % - real interest = % —> sum of after tax income, V(Yf, — Tf) = 0.75(66.2)($40,000) = - how much should you save? consume? - depends on: o : 16 years after retirement = 61 + 16 = 77 ' = years remaining 0 preference: consumption each year ' $ / yrs = $ per year 0 current income while in school = 0 I "borrow 3 yrs til graduate >< $35,464 per year loan: 55 0 once working, start saving - realistically: o : gradually larger consumption over time ' deferring for retirement I not constant: 0 : future income, lifespan, retirement age, unemployment 0 loan 7E $106,392 0 constraints - all these modify consumption behavior: Ct : ( t9 ) (+) (+) - expectations of higher output in the future lead. to higher consumption today 0 thru. human wealth: I higher future increases future I higher future increases 0 thru non-human wealth: higher fiJture increases future higher future increases - how much does total wealth impact consumption? current income? 0 depends on individual 0 empirical evidence suggests: I fluctuations in affect consumption I fluctuations in affect consumption - the role of expectations 0 human wealth: o nonhuman wealth: - the impact of expectations 0 C responds less than with I vs shock o C may change even if change ...
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This note was uploaded on 12/02/2011 for the course ECON eco200 taught by Professor Wolfson during the Spring '11 term at University of Toronto- Toronto.

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N40 - Consumption - Monetary Policy, Interest Rates and...

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