Week 10_SII2013 [Compatibility Mode].pdf

8/14/2019 Week 10_SII2013 [Compatibility Mode].pdf

1/74

Monetary Policyand thePhillips Curve

Chapter 12


2/74

12.1 Introduction In this chapter, we learn:

How the central bank effectively sets the real interestrate in the short run, and how this rate shows up as the

MP curve in our short-run model.

That the Phillips curve describes how firms set theirprices over time, pinning down the inflation rate.

How the IS curve, the MP curve, and the Phillips curvemake up our short-run model.

How to analyze the evolution of the macroeconomy in

response to changes in policy or economic shocks.


3/74

The monetary policy (MP) curve

Describes how the central bank sets the nominal interest rate

The short-run model summary:

Through the MP curve

the nominal interest rate determines the real interest rate Through the IS curve

the real interest rate influences GDP in the short run

The Phillips curve

describes how booms and recessions affect the evolution ofinflation


4/74


5/74


6/74

12.2 The MP Curve: MonetaryPolicy and the Interest Rates

Large banks and financial institutionsborrow from each other.

Central banks set the nominal interestrate by stating what they are willing tolend or borrow at the specified rate.


7/74

Banks cannot charge a higher rate.

everyone would use the central bank.

Banks cannot charge a lower rate.

They would borrow at the lower rate and lendit back to the central bank at a higher rate.

This is called the arbitrage opportunity.

Thus, banks must exactly match the ratethe central bank is willing to lend at.


8/74

Overnight Cash Rate and Other

Interest Rates


9/74

From Nominal to Real Interest Rates

The relationship between the interestrates is given by the Fisher equation.

Nominalinterestrate

Realinterestrate

Rate ofinflation


10/74

The sticky inflation assumption The rate of inflation displays inertia, or

stickiness, so that it adjusts slowly over time.

In the very short run the rate of inflation does

not respond directly to monetary policy.

Central banks have the ability to set the realinterest rate in the short run.


11/74

Case Study: Ex Ante and Ex Post

Real Interest Rates

A sophisticated version of the Fisher

equation replaces the inflation rate withthe expected rate of inflation.

Expected

rate ofinflation


12/74

Using the expected rate of inflation gives

an ex ante real interest rate:

The ex antereal interest rate is relevantfor investment decisions.

Once inflation is known, we can calculatethe ex postinterest rate:


13/74


14/74


15/74

The economy is at potential when

The real interest rate equals the MPK. There are no aggregate demand shocks.

Short-run output = 0.

If the central bank raises the interest rateabove the MPK

Inflation is slow to adjust. The real interest rate rises.

Investment falls.


16/74


17/74

Examle: The End o! a "ousing

#u$$le

Suppose housing prices had been rising,

but then they fall sharply. The aggregate demand parameter declines.

The IS curve shifts left.

If the central bank lowers the nominalinterest rate in response:

The real interest rate falls as well becauseinflation is sticky.

If judged correctly and without lag, the

economy would not have a decline in output.


18/74


19/74

Case Study: The Term Stru%ture o!

Interest Rates

The term structure of interest rates

The different period lengths for interestrates

It should be the case that interest rateson investments of different lengths oftimes will yield the same return.

If not, everyone would switch investment tothe one with a higher return.


20/74

Interest rates at long maturities are equal to an

average of the short-term rate investors expectin the future

When the Fed changes the overnight rate,interest rates at longer magnitudes change.

Financial markets expect the change will persist for

some time. A change in rates today often signals information

about likely changes in the future.


21/74

12.3 The Phillips Curve

Recall the inflation rate is the percentchange in the overall price level.

Firms set their prices on the basis of

Their expectations of the economy-wideinflation rate

The state of demand for their product.


22/74

Expected inflation

The inflation rate firms think will prevail inthe economy over the coming year.


23/74

Firms expect next years inflation rate to

be the same as this years inflation rate.

Under adaptive expectations firms adjust

their forecasts of inflation slowly.

Expected inflation embodies the sticky

inflation assumption.


24/74

The Phillips curve

Describes how inflation evolves over time asa function of short-run output

If output is below potential

Prices rise more slowly than usual

If output is above potential

Prices rise more rapidly than usual

This

yearsinflation

Last

yearsinflation

Short runoutput


25/74


26/74

Using the equations:

Therefore, the Phillips curve can be expressed as:

Change in

inflation

The parameter measureshow sensitive inflation is

to demand conditions.


27/74

Case Study: A #rie! "istory o! the

Phillis Cur&e

Originally

The Phillips curve showed a relationship

between the level of inflation and economicactivity.

Low inflation implied low output.


28/74

Later critiques

Stimulating the economy would raise output

temporarily

Firms will build high inflation into their pricechanges

Output will return to potential.


29/74

Pri%e Sho%'s and the Phillis Cur&e

We can add shocks to the Phillips curveto account for temporary increases inthe price of inflation:


30/74

The actual rate of inflation now depends

on three things:

Rewrite again:

Expected rate

of inflation

Adjustment

factor for stateof economy

Shock to

inflation


31/74

Oil price shock

The price of oil rises

Results in a temporary upward shift in thePhillips curve


32/74


33/74

Cost-Push and Demand-PullIn!lation

Price shocks to an input in production Cost-push inflation

Tends to push the inflation rate up

The effect of short-run output oninflation in the Phillips curve

Demand-pull inflation Increases in aggregate demand pull up the

inflation rate.


34/74

Case Study: The Phillis Cur&e andthe (uantity Theory

An increase in the growth rate of realGDP would reduce inflation.

The Phillips curve, however, seems tosay a booming economy causes therate of inflation to increase.

Which one is correct?


35/74

The quantity theory Long-run model

An increase in real GDP reflects an

increase in the supply of goods, whichlowers prices.

The Phillips curve

Part of our short-run model

An increase in short-run output reflects an

increase in the demand for goods.


36/74

12.4 Using the Short-RunModel

Disinflation Sustained reduction of inflation to a stable

lower rate

The Great Inflation of the 1970s Misinterpreting the productivity slowdown

contributed to rising inflation.


37/74


38/74


39/74

Because of the stickiness of inflation

The classical dichotomy is unlikely to holdexactly in the short run.

Just a reduction in the rate of money growth

may not slow inflation immediately.

Thus, the real interest rate must increaseto induce a recession.

The recession causes inflation to become

negative.

As demand falls firms raise their prices lessaggressively to sell more.


40/74


41/74


42/74


43/74


44/74

The *reat In!lation o! the +,.s

Inflation rose in the 1970s for threereasons:

1. OPEC coordinated oil price increases.

Oil shock as shown in the model


45/74

2. The U.S. monetary policy was too loose. The conventional wisdom was that reducing

inflation required permanent increases in

unemployment. In reality, disinflation requires only a

temporary recession.


46/74

3. The Federal Reserve did not have

perfect information. Thought the productivity slowdown was a

recession

it was actually a change in potentialoutput.

The Fed lowered interest rates in response

to what they perceived was a demandshock.

which increased output above potential

generated more inflation


47/74


48/74


49/74


50/74

The Short-Run Model in a Nutshell


51/74


52/74

12.5 Microfoundations:


53/74

12.5 Microfoundations:

Understanding Sticky Inflation The short run model

Changes in the nominal interest rate affect the real interest rate.

There are bargaining costs to negotiating prices and wages.

Social norms: Cause concerns about whether the nominal wageshould decline as a matter of fairness

in the short run:

Imperfect information

Costs of setting prices

Contracts also set prices and wages in nominal rather than realterms.


54/74

How does inflation move?


55/74

Case Study: The 0endero! 0ast Resort

Central banks ensure a sound, stablefinancial system by:

Making sure banks abide by certain rules

Including the maintenance of a certainamount of reserves to be held on hand

Central banks ensure a sound stable


56/74

Central banks ensure a sound, stable

financial system by: Acting as the lender of last resort

lending money when banks experience

financial distress

Having deposit insurance on small- and

medium-sized deposits can increase risky behavior

12.6 Microfoundations: How


57/74

12.6 Microfoundations: How

Central Banks ControlNominal Interest Rates

The central bank controls the level of thenominal interest rate by supplying the

money that is demanded at that rate. The money market clears through

changes in velocity.

Which is driven by changes in the nominal

interest rate


58/74

The nominal interest rate Is the opportunity cost of holding money

Is the amount you give up by holding money

instead of keeping it in a savings account Is pinned down by equilibrium in the money

market

If the nominal interest rate is higher thanits equilibrium level

Households hold their wealth in savings ratherthan currency.

The nominal interest rate falls.


59/74

The demand for money


60/74

y

Is a decreasing function of the nominalinterest rate

Is downward sloping

Higher interest rates reduce the demand formoney.

The supply of money

Is a vertical line for the level of money the

central bank provides

Changing the Interest Rate


61/74

g g

To raise the interest rate

The central bank reduces the money

supply

Creates an excess of demand over supply

A higher interest rate on savings accountsreduces excess demand.

The markets adjust to a new equilibrium.


62/74

1hy itinstead o! M

t2


63/74

The interest rate is crucial even whencentral banks focus on the money supply.

The money demand curve is subject tomany shocks, which shift the curve.

Changes in price level

Changes in output

If the money supply is constant

The nominal interest rate fluctuates

Resulting in changes in output


64/74

The money supply schedule is effectivelyhorizontal at a targeted interest rate.

An expansionary (loosening) monetary policy Increases the money supply

Lowers the nominal interest rate

A contractionary (tightening) monetary policy

Reduces the money supply

Increases the nominal interest rate


65/74

12.7 Inside the Federal Reserve


66/74

Reserves

Deposits held in accounts with the central

bank

Pay no interest

Reserve requirements Banks required to hold a certain fraction of

their deposits

Discount rate

Interest rate charged by the Federal Reserve

on loans made to commercial banks

Con&entional Monetary Poli%y

3en-Mar'et 3erations: "o4 the Fed


67/74

Controls the Money Suly

Open-market operations

The central bank trades interest-bearinggovernment bonds in exchange for currency or

non-interest bearing reserves.

To increase the money supply, the Fed sellsgovernment bonds in exchange for currency

or reserves.

The price at which the bond sells determines thenominal interest rate.

12.8 Conclusion


68/74

12.8 Conclusion

Policymakers exploit the stickiness ofinflation.

Changes in the nominal interest rate changethe real interest rate.

Through the Phillips curve booms andrecessions alter the evolution of inflation.

Because inflation evolves gradually, the

only way to reduce it is to slow theeconomy.


69/74


70/74

The Phillips curve

Reflects the price setting behavior of


71/74

Reflects the price-setting behavior of

individual firms

Expected rateof inflation

Currentdemandconditions

Shocks toinflation

The Phillips curve can also be written as:


72/74

This equation shows that in order to

reduce inflation, actual output must bereduced below potential temporarily.

The Volcker disinflation of the 1980s is theclassic example illustrating thismechanism.


73/74

Three important causes contributed to theGreat Inflation of the 1970s:

The oil shocks of 1974 and 1979

The mistaken view that reducing inflation

required a permanent reduction in output

The fact that the productivity slowdown wasinitially interpreted as a recession


74/74

Week 10_SII2013 [Compatibility Mode].pdf

Documents