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Permanent Unfinanced Financial Shocks.lyx
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Permanent Unfinanced Financial Shocks.lyx
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Permanent unfinanced financial shocks
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\begin_layout Standard
In this chapter, we look at unfinanced financial shocks.
Financial shocks all have elements of a negative supply shock, as increased
costs of finance for investments shift production and make it more expensive.
It is also a demand shock as it affects private consumption through asset
prices and asset returns.
The fundamental mechanisms of the shocks are given by:
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Initial shock changes usercost, returns and asset prices through 'finance'
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\begin_layout Itemize
Returns and asset prices are affected and in turn affect demand for private
consumption
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\begin_layout Itemize
Increased finance costs of housing will decrease demand for housing investments
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\begin_layout Itemize
Increased finance costs of firm capital works like a negative supply shock
to capital augmented productivity
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\begin_deeper
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More production inputs for given production
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Higher unit costs in production
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Higher unit costs leads to higher output prices
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Higher output prices leads to higher demand prices
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Higher prices decrease demand over time
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Decreased demand: Directly to investments and indeirectly to others
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Decreased demand leads to decreased sectoral production
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Decreased sectoral production leads to decreased sectoral production inputs
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Decreased intermediate inputs leads to decreased imports and domestic sectoral
output
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Decreased capital demand leads to decreased investments from imports and
domestic sectoral output
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Decreased labor demand leads to decreased wages, employment and labor supply
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Decreased employment and wages leads to lower household income and decreased
demand for private consumption and housing
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Decreased housing demand leads to decreased housing prices and investments
in housing
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Decreased housing prices leads to decreased liquidity and demand for private
consumption and housing
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Decreased production leads to lower output prices
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Lower output prices leads to lower demand prices
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Decreased prices dampens fall in demand over time
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Full crowding out in employment
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Note that all shocks are unfinanced - see 'The reaction of the public sector'
in the introduction.
It should also be noted that all the shocks are synthetic shocks as foreign
demand and interest rates are unchanged.
This helps analyzing the mechanisms at work, but is not very realistic.
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Interest rate
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The ECB key interest rate is increased permanently by 1 percentage point.
This is a synthetic shock as foreign prices and foreign demand are unchanged.
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Note:
\end_layout
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There is a strong negative effect on domestic stock prices in the first
period
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As a higher discount rate lowers the value of the firm
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This lowers the real pension wealth and the real wealth of the households
\end_layout
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User cost for housing increase in the long run as finance is more costly,
but is in the short run strongly affected by expected changes in future
housing prices due to lower housing demand stemming from lower household
income
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The economy will react as if hit by a negative demand shock to investments,
but with a large substitution effect away from capital the negative effects
on GVA and GDP will be more severe
\end_layout
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Scale effects in exports will set in as structural GVA is decreased.
This will hinder crowding out in exports and increase the severity of the
shock
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Strong negative short run effect on government budget due to large temporary
drop in employment
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Long run effect on government budget and fiscal sustainability can very
well be positive as lower expenses due to lower wages and higher revenue
from household and pension returns might outweigh the lower revenue from
income taxes
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