What is a recession?

A significant decline in economic activity spread across the economy, lasting more than a few
months, normally visible in real GDP, real income, employment, industrial production, and
wholesale-retail sales. A recession is typically different from a slowdown, when for instance GDP
growth is not negative, but still is lower than the long run trend. CEPR define recession in EURO
area as a significant decline in economic activity in 2 or more consecutive quarters of negative
growth in GDP, employment and any other measures of aggregate productivity for Euro area as
a whole. For example, great recession for 4 quarters of negative GDP growth last 2 quarters of
2008 and 2 quarters in 2009.

When is procyclical and countercyclical variable?

Economic indicators are classified according whether or not they generally move in the same
direction as the main positive measure of business cycle, such as GDP, Production, Employment.
Procyclical: they move roughly in the same direction as business cycles for example retail sales
Countercyclical: they move roughly in the opposite direction as business cycles, for example
unemployment rates
Acyclical: they have no regular relationship to business cycles, for example population and
agriculture

What is the random walk?

A class of economists argues that Business cycles are ultimately irregular. There are ups and
downs, but the pattern is misleading. This pattern is called a random walk of a drunk man: the
direction of each step has same likelihood and best average prediction for man’s location
after the next step is where he is standing now.
Random walk has important property: there is tendency for process to return to particular level
or trend linn once displaced.
Log of productivity follows a random walk with drift
Random walk:
Yt=Yt-1 + €t
Y1=Y0 + e1
Y2=Y0 + e1 + e2
.
.
Yn= Y0 + e1 + …+ en

Random walk with drift

Yt=d + Yt-1 + et
Y1 = d + Y0 +e1
Y2 = d + d + Y0 + e1 + e2
.
.
Yn = nd + Y0 + e1 +…+ en

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What is potential output? Discuss different manners to estimate the potential output!

Potential output is abstract and idealized concept. it answers the question how much output
(GDP) would be produced if its inputs (labor and capital) were fully employed in an
optimal way,give a state of technology. Potential output is an abstract concept, since it is not
directly observable. It is
basically conceivable as the output an economy would produce when running at full
capacity, i.e. at full employment and no idle productive capacity.

Potential output may be operationally estimated by assuming a production function Yp = F(

AL,K)

CU=
While there is no trouble with the index of industrial production, which is readily available in the
data, that is not equally true for the index of industrial capacity. It is basically computed via
surveys, in which professionals and managers are asked whether they think their firm to be
running at full capacity or not and, if the latter is the case, to determine the amount of idle
capacity.
1. Then, to compute potential output, consider a standard production function Y = F(AL;K),
and let LF be the whole labour force. Then, potential output is given: Yp = F( A.LF,CU.K) where
CU = 1. Actual output will thus be given by Y = (A L;CU K), so we can define scaled output ~ Y
as …... Estimating scaled output is relatively easy taking the equation in logs. The point is still
that the capacity utilization rate is nothing but clear-cut, and is open to biases and
imprecisions.
2. Another way to calculate potential output is via the Non Accelerating Inflation Rate of
p p α 1-α
Unemployment, the NAIRU: Y t = A t [(1 - NAIRUt)LF] K
Congressional Budget Office’ potential output definition is the level of output when economy
is opertaing at high rate of resources use consistent with a stable rate of inflation.
CBO metodh stands with Cobb-Dauglas production Function. Total factor productivity (TFP:A in
formula) rises in booms and falls in slumps. CBO assume capital stock is used at full potential
level. The key element is labour input. The fraction of LF that would be available if an economy is
operating at NAIRU. (1-NAIRU). LF. The idea is when labour is at NAIRU inflation will remain
stable.
Filtered trend: ∑
One such detrending procedure Is that suggested by Hodrick and Prescott which contains the
linear trend as a special case. λ is smoothing weight on potential output and S is the sample size,
lambda measures how responsive the potential output to movements in actual output. The
advantage of the HP is allowing the trend overtime. But it also has disadvantages that selecting
of smoothing weight is arbitrary and that matters in estimation.

2
What is Okun’s Law and How do you estimate it?

Okun stated that to a shortfall of 3% in the GDP growth it was possible to match a 1% decrease
in employment. More recently, it has been estimated that a 2% of fall in GDP corresponds to a
1% fall in employment. It is possible to estimate the Okun’s law in difference rather than in
levels, and it runs out to be meaningful for equilibrium reasons. First consider the standard
relation
Ut = α +βYt + Ɛt
Ut-1 = α +βYt-1 + Ɛt-1
Taking the first differences of the two yields
ΔUt = α +β t + ηt
where t is the GDP growth, supposing we are taking the variables in logs. Then, re-arranging the
terms we can also write ΔUt =β( t + )+ ηt = - γ( t - t*)+ ηt where t is called the modified
balanced growth rate.

t is a critical growth of GDP:below this rate unemployment rises,

above this rate unemploymnet falls. It is called balanced rate of
*
t growth

What is the modifeid balanced growth rate?and how do you estimate it?

Let again LF be the labour force, while L are the employed workers. Thus, ut = and

(1 - ut) = ( )-1. Set labour productivity to = and let the labour participation rate be PR =
LF/POP, where POP is total population. Denoting with a the growth rates, we have ̂ =
Lt - ̂ t .
Then by simple algebraic passages, we have ΔUt (1-ut ( L -L ) = (1-ut) ( t - - ̂ - ̂ )= (1-ut)
( t - t*)
Where t* ≡ ( + ̂ - ̂ ). As it can be seen, Okun’s law can also be tested with respect to the
relationship between the change in the scaled output and the GDP growth. In this case, we
exploit the fact that we expect a negative relationship between variations in the scale
output and employment decreases.

Which of macroeconomics model does imply an output-inflation trade-off

First in chronological order, the Keynesians, within neoclassical apparatus, argued that wages
and prices are sticky. Then, there is no reason why the labour market should clear at the full
employment level, and therefore there could be real reasons for business cycles. We now
consider a stylized Keynesian model. Let W = ̅ be fixed nominal wage, P are flexible and there is
perfect competition. Money wage bargaining obeys to Wt=Apt-1. where Yt = F(Lt), so that perfect
competition implies Wt/Pt = F’(Lt). Assume an increase in the AD due to an exogenous shock: Y1 >
Y0 and then L1 > L0, P1 > P0. Then, in the second period money wages are pushed upward:
therefore, if prices change up, inflation rises and Y stays higher than Y0. If prices stay constant,
the increase in money wages reduces output back to the original Y0. This trivial example is useful
3
insofar it highlights that lagged money wage bargaining implies inflation to maintain a high
output level, and therefore a high employment rate.

What is naturalrate of unemployment and hod do you estimate it?

In the ’70s, the Phillips curve collapsed. No more stable tradeoff between inflation and
unemployment could be found in the data, and this largely came out of two factors:
1. The exogenous shock in the price of raw materials, which pinned prices up without
affecting unemployment, the so-called stagflation;
2. The discretionary monetary policy and the Phillips Curve which had been seen as a policy
menu by policymakers
The main school of thought which came out with a clear critique was the monetarist school,
embodied by Milton Friedman. The main claim Friedman posed with respect to this issue was
that expectations were to be inserted in the PC. Friedman criticizies interpretation of PC which
states that workers would be irrational. However rational agents understand that their wages
can be eroded by inflation. If they expect inflation, they wll demnad higer wage settlements to
keepup with the prices. Ifreal wages adjust, the unemploymenn rate stand at lveluniquely
associated with thatreal wage is the natural rate of unemployment. According to friedman,
there is normal or natural one which cant be permanently affected by nominal forces, which is
ultimately determined byreal forcesonly. Consider vertical long-run aggregate suppy: prices and
wgaes are fully flexible. Formulation of Philipis Curve After Friedman:

Πt =πt* + λ(log Yt- Log t + Ɛt* where λ > 0

Assuming adaptive expectation and take πt*= πt-1. So that we get formulation that is actually fits
data in a better way. ̂ = λ(log Yt- LogYt* + Ɛts →πt = πte + λ(ut – un + Ɛts
Now the trade off is no longer with inflaion,but with accelerating path of inflation. An
alternative is to consider rational expectation so that πt *=πte = Et-1 [πt ]. The nw keynesian
reached to a compromise and new formulation
πt = Φπte + (1- Φ) πt-1 + λ(log Yt- Log t + Ɛts .

is there any difference between natural rate of unemployment and NAIRU?

We shouldconsider expectation augmented phlip curve πt = πt* + λ(log Yt- Log t + Ɛts . The
Okun’s law lets us write the Phillips curve in terms of unemployment. We can rewrite πt =πt* -
β(ut – ut* + Ɛts . where u_ is the unemployment rate which makes the rate of growth of inflation
equal to zero, that is, the NAIRU. It is basically the unemployment rate such that inflation does
not accelerate overtime. NAIRU is the non-acceleratinginflation rate of unemployment
namelyrate of unemployment thatwould ensure a stable inflation rate. In much economic
discussion natural rate of unemployment is used interchangeble with NAIRU. However, there
are important differences:

1. NAIRU unlike thenatural one does not suggest that unemployment rate is socially optimal
2. Since it is defined as the Ut at which inflation isstable, it is reduced form not a structural
variable.

4
 3. While natural one is a general equilibrium concept,NAIRU is a micro-founded as a blance
of power betweeen workers and firm in imperfecct competitive settings.

Discus different method to empirically estimate the relationship betweeen money and
output?
Classical economics, as well as Real Business Cycle theorists claimed that no relation was to
be between real and nominal variables. Monetarists and New Classicals argued that there
could be a relationship in the short run, but in the long run monetary policy was the ultimate
cause of business cycles. In the Keynesian framework, money can effectively influence output
via the money market and the investment schedule. The are ways to investigate the
relationaship.
1. The St. Louis Equation
Keynesians and neoclassicals claimed that output was positively correlated with the
money stock. This rathe rough assertion is based upon a simple theoretical argument: the
more money in the market, the least the interest rate and therefore the higher
investment. Andersen & Jordan (1968) developed a very -too much- simple method.
Yt= α + γt+ ∑ βimt-i + Ɛt
. where yt is the log-income, m is the log-money measured as M2.

This approach has some problems:

1. Non stationarity. The authors themselves addressed the issue by taking the first
difference of the variables. Then, the model to be estimated becomes
ΔlogYt = α + Δlog mt + Δlog mt-1 +.....+ Δlog mt-4 + Ɛt.
2. Endogenity, Mainly, it can be stylized as Y → m instead of m → Y. Endogeneity, or
reversal causation, makes errors not orthogonal to the regressors, and thus makes
all the coefficients completely biased. In fact, it can be plausible that changes in the
money stock advance output movements. Also, even if m ! Y , if the central bank
adjusts m to offset other factors influencing Y then fluctuations in m will not be
correlated with those of output
2. Structural equation modeling
It is a sumof statistical and mathematical tools used in orde to explain the so-called latent
variables. Requires a good instrumental variables that is not always easy to find.
3. Narative Approach
Friedman is one of protagonist for this approach and he approached the problem of the
relationship between money and output. Thakns to the study of the past, without a
strong quantitative basis.
How doyou estimate the effect of monetary shock on output using VAR?
Before 1980, the far most common approach to macroeconometrics was the socalled Cowles
Commission’s. Models built in this tradition were large structural systems of equations1 where
exogenous variables were theory-driven. Given an underlying model, mostly the Keynesian one,
some variables appearing in certain equations were assumed to be exogenous, and this made
such models estimable. More specifically, consider the following couple of equations:
mt=αyt + Ɛm ; yt = βmt + Ɛy
Clearly, this model cannot be estimated with ordinary procedures because of endogeneity,
which implies non-orthogonality of errors w.r.t. the regressors. But assume δ and be such that
5
δ→m and →y
δ↛ y and ↛ m
meaning that they are correlated only to their matched variable.

The VAR approach has been used to investigate a number of theoretical realtion, for example
the influence of money on output. Sims (19800) represented the approach by strongly criticzing
thecommon view on econometric modelling. That has mentioned above. Thecritic was mainly
focus on identification problem, take the example of supply and demand equation, it is not
possible to identifythemodel since there is theneed for exogenous variables, in orderto find
reliable estimators.
The approach of VAR is an attempt to assess the effects of shocks on variables in the economic
system. The main aim is to find impulse resonse function, to do do, itis necessary to clearly
identify the shocks. VAR implies thestudy oof avector variables. It isvectro variables that allows
us to account for the effect of a change in a variable lasting p periods
Xt = Γ1Xt-1 + Γ2Xt-2 + .....+ ΓpXt-p + ut
Where Xt, Xt-1 are vectors (K X 1 , and the error term is ( K X 1 , Γ1...., Γp are (KxK) metrices. The so-
called reduced form above present a feature thatshouldbe considered.Ut is collecting all the
things that are not included in the model. Xt isnot a proper shock but an omitted variable.the
consequences of this will yield autocorrelation. In order words E[U t, U’t]= Ω. We can of course
estimate it by residuals.
Sims proposed a solutionto this problem using the Cholesky decomposition, namely the
possibility todecompose apositive definite matrix in the product o a lower triagular matrix and
this conjugate transpose Ω = AA’. So we can transform the error term:
Ɛt= A-1Ut Var [Ɛt] = E[A-1UtUt’(A-1 ’]
= A-1 E[UtUt’](A-1 ’= A-1 Ω(A-1 ’= A-1 AA’(A-1 ’= I
We have found th true shock of the system that are nolonger autocorrelated. This transfrmation
leads to the so-called SVAR, structural autoregressive process
SVAR: A-1 Xt = A-1 Γ1Xt-1 + A-1 Γ2Xt-2 + .....+ A-1 ΓpXt-p + Ɛt
Xt = βXt+ γ1Xt-1 + .....+ γpXt-p + Ɛt
The aim of the SVAR is to identify the true shocks that will be used in the step that leads to the
impuld function. Now we can write Xt as the sum of the infinite shocks usingthe reduced form:
Xt= ∑j=0∞ΦjUt-j.
we know that Ɛt= A-1Ut , so that; Xt= ∑j=0∞ΦjAUt-j= ∑j=0∞ψjEt-j. This is the final step in ordert to find
the effect of a shock

what is cointegration? Which is economic variable can be expected to be cointegrated ?

technically if we take two non-tatinary time series Vx and y after differencing such that some
linear combination of x and y are stationary then we can say that X and y are cointegrate. In
other words if x and yseries do not move around constant values, but if their linear combination
do do, then x and y are cointegrated. Cointegrtaion technics allows non-stationary dat to
beused so that false economic regression result are avoided. It also gives the chance to test the
validity of economic theory. If postulated economic ralation exists, the variable under
consideration would be cointegrated.consumption and disposible income are cointegrated.
Permanent income hypothesis also suggestit. But empirical evidence of stability of cointegration

6
is too few. An empirical analysis by King (1991) using US quarterly data shows that a cointegratin
between linear combination of c and , i and y, m –> p and y, c –> y and r -Δp, i -> y and r-Δp.

How is governement budget defisit linked to the private sector and foreign sector deficit?
Both fiscal policy and monetary policy areaction of govvernment aimed to influence
macroeconomic variable through a number of channels. The difference between fiscal and
monetary policy lies in the instrument used to exploit these channels, a fiscalpolicy is an actionof
government via taxes and expenditure of the government. A monatary policyis an action of the
government (CB) in the financial sector.
Lets cosider the income expeniture identity and disposible income identity

Y = C + I + G + (N - X) and Y D = C + S = Y - T + TR
Putting them together (G – T + TR) + (I-S) + (N-X) = 0

which implies that the government’s budget constraint cannot be higher than the joint private
and foreign deficit Notice that such relation is a simple accounting identity. Thus, the
government’s budget constraint in a closed economy reads out G - T + TR = ΔBG + ΔMB. where
ΔBG is the change in public debt held by the private sector, whereas ΔMB is a change in the
monetary base. In more specific terms, we say that fiscal policy (on the left hand side) needs to
be matched by a related monetary policy (on the right hand side).
What are the assets and libilities of a central bank?

The relationship between CBS and comercial banks is easy to seefrom CB’s balance sheet

Assets Liabilities Assets Liabilities

Goverment bonds Bank notes Reserves deposits
Discount loans Reserve loans Discount loans
Coins held by CB Vault Cash Vault cash
Foreign currency Fixed assets Funds borrowed
Gold Net worth
Funds lent Net worth

- Government bond is the main asset for CB alprofits from goverment bonds go to treasury.
- Discoount loan: shortterm loans that CB gives to comercial bank
- Coins: CB is the distribution center ofcoins needed to cmercial bank
- Foreign currency: Cb can buy foreign currencies as it buys government bond
- Gold: in CB’s asset is legacy from period before 1973 when gold was an instrumen of
settlement
- Banknotes: banknotes remain as libility for accounting prchases
- Reserves: balances in account of commercial bank loans
- Net worth: asset of CB-libilities of CB

7
How is the interset rate determined in the interbank market?
The interbank market is the market in which commercial banks borrow funds from the central
bank, or lend as reserves. On the interbank market we can determine the equilibrium interest
rate.

In order to understand how the interestrate is determined, we should first focus on, whichon is
the interest of interest since there are many. For what concern of US (FFR) and EU (EONIA). The
central bank targets the interest rate by anumber of operations among which themost
important one is the open market operation purchasing and selling government bonds

What is the main channels of monetary policy?

Monetary Policy. Government (also central bank) actions aimed at influencing macroeconomic
performance though the financial system, which comprises markets in which financial
instruments, i.e. records/papers that specify claim to valuable goods, and money are exchanged.
Monetary policy is in principle effective via three distinct channels:
1. the interest rate channel, which acts on the opportunity cost of investment; The functioning
of the interest rate channel is rather straightforward. Consider an increase in the nominal
interest rate which determines, if the central bank is the marginal lender, and given inflation,
also an increase in the real interest rate. Such increase in the real interest rate alters the
opportunity costs of firms, making standing-profitable investment unprofitable. As a
consequence, investment falls and so does aggregate demand. The opposite holds for a decrease
in the nominal interest rate. The point here is however that the central bank attains lending
marginality thanks to the interbank market system. On the repos market, the central authority
lends requiring highquality collateral charging the policy interest rate: then, other banks will
require less valued collateral but also charge a higher interest rate1. Thus, if the policy interest
rate increases, so will the interbank interest rate, and the opposite holds for a decrease. As such,
the central bank is indeed the marginal lender.
2. the credit channel, influencing the willingness of commercial bank to issue loans; The
functioning of the credit channel directly acts on the portfolios of commercialbanks. By requiring
ahigher lending-reserves ratio, banks will tend to charge a higher interest rate upon firms
because of the increased “financial constraints” they must face. As such, the credit channel
achieves a result which is pretty much in line with the interest rate one.

3. the foreign exchange rate channel, which affects the foreign sector deficit.

8
What is the taylor rule
or a longtime there has bee a debate concernig to CB”S, should theyfolow a rule or the should
have discriptionary behaviour, depending ondifferent situations. Taylor rules appear as
ananswer in this context. It is a descriptive and forcasting rule. It is suggesting that the inflation
rate shouldbe trageted by CB accounting for deviation of inflation rate and output from their
targets. The rules represent implicit answer to the question above. CB should follow the rules in
orderto avoid time inconsistency and to make people develope trus to the CB.
The rule : it = rt* + πt +α (πt - πt*) + β(yt-yt*)
it: target nominal iterest rate, rt*: ntural rate ( desired rate) of ineterset rate, πt: inflation, πt*:
targetrate of inflation, yt: the log of GDP, yt*: the log of potential output. Where α and β are
usually equal to 0.5. it is a suggestion for policis.indeed when inflation and output are higher,
their target rate should higher too in order to cool down the inflationary pressure. When the
inflation and ouput are low then the interest rate should be low to faster the economy.
Define and explain the types of fiscal policy

Fiscal policy. government actions aimed at influencing macroeconomic performance through

taxes and government spending, e.g. purchases of goods and services and transfer payments.
Fiscal policy can either be long-run or short-run oriented, ruled or discretionary, and cyclical or
countercyclical, this latter distinction depending on the aim: we say that fiscal policy is
countercyclical if it aims at recovering from a depression or a recession, whereas it is procyclical
if it pursues an overheating of the economy during recoveries. Most fiscal policy is short run and
discretionary. We can analyze the effects of fiscal policy in a simple IS-LM framework, given the
IS schedule

( )

All those measures which come to existence automatically are said to be the automatic
stabilizers, and are embodied in the shape of the IS curve. More specifically, is the IS is linear,
they appear in its slope, that is the multiplier. Discretionary fiscal policy, on the other hand,
translates into a shift of the IS curve, to the right or to the left respectively if the policy is
expansionary or contractionary. Countercyclical fiscal policy consists in discretionary policies
aiming at offsetting a negative demand shock, i.e. a shift to the left in the IS curve. Still,
countercyclical fiscal policy is affected by a fundamental major problem, that is, the difficulty in
ascertaining whether a shock is demand or supply-sided. Also, timing may be an issue, as well as
coordination and centralization of policies. In the long run, the government’s budget constraint
is given by the following,

which states that public expenditure can either be financed via new debt or via money printing.
This latter instance is called monetization of debt, but can result in hyperinflation risks and
debasement problems.

9
What does determine the growath rate of the ratio o the governement debt to GDP? The
concept of functional finance th need to adjust governmen deficit according to circumtances.
What is the effect on aggregate demand?

The debt of a country follows a simple rule:

Government deficit can be decomposed in

where PD is the primary deficit and r is the

nominal interest rate. Hence,

or, denoting with a hat the growth rates.

̂ In turn, the growth rate of the ratio of government debt over GDP can be
expressed in the following equation, given that we define

̂
( ̂ ̂ ( ̂) ̂

where clearly pt is inflation at time t and r -p is the real interest rate.

Empirical implication of the keynesian vs friedman’s approach to consumption

In the general theory Keynes states that fiscal authorities can stimulate aggregate demand by
boosting consumption expenditure via taxcuts. Keynes argued that amount of consumption is a
function of disposible income: .

riedman’s theory of consumption starts from acrucial assumption. Income at time t is the sum
of two different components: a permanent one and a transitory one Y t = Yp + YT where C = αYP.
Permanent income isthe average of the future flows of income for each agent.

Yp = A0 + ∑Yt/N
Then we move to this framework we should notice it is an intertemporal one,with a rational
maximizing agents. ∑ u(c(t is the utility function that should be optimized s.t ∑
∑ using lagrangian and use OC we get u’(c(t = λ that is the marginal utility is constant,
hnce the cnsumption is constant so ∑ so tht from the budget constraintwe get
∑

We reached to conclusion extremely difference from keynesian one. The consumption does not
depend on being rich or poor, but on the expectation of future flows of income. As for
consumption, the same applies for savings that is the difference from
the expected permanent income.
Assume permanent income hypothesis
Let’s consider the model , starting from the assumption that

and the permanent income and transitory one are independent:

10
 and .

We have . as we know from is a function of permanent income.

The graph in time t is different from the on taking a pooled model. This difference might be
explained with difference of variation of . The variation of is usually higherfor rich
people. When we tak data for one periode, the variation of temporary income is higher than 0
and β is lower than 1.
What is the random walk hypothesis of consumption?

It is proposed by hall in 1978. The maximizaton is now a problem of expectation

∑ s.t ∑ ∑

Where . The consumption follow the euler equation :

where ( for t = 2, 3, ....T)

The consumption at time t is equal to the expected value of consumption at time t for all
the following periods ∑

We can get to the random wal hypothesis:

; where
Consumption does not depend on income but on expectation.
Why and how should consumption vary?

∑ ∑

∑ ∑ ∑

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 ∑ ∑

∑ ∑

Discus an empirical test of the random walk hypothesis?

Compbell and mankiew used instrumental variable approach to test RW hypothesis
againts alternative one

: no effects (fully rejected)

Income:rela disposible income per person
They measure consumption as real purchases of non-durables, the results they reached is
consumption is appeared to increase by 50 cents in response to an anticipated $1
increase in income.

12