Transcript M-P

ECO 3311
Ch 11: Monetary Policy
Introduction
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In this chapter, we learn:
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how the central bank effectively sets the real
interest rate 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
their prices over time, pinning down the inflation
rate.
how the IS curve, the MP curve, and the Phillips
curve make up our short-run model.
how to analyze the evolution of the
macroeconomy—output, inflation, and interest
rates—in response to changes in policy or
economic shocks.
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The federal funds rate is the interest rate paid
from one bank to another for overnight loans.
The monetary policy (MP) curve describes
how the central bank sets the nominal
interest rate and exploits the fact that the real
and the nominal interest rates move closely
together in the short run.
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The short-run model is summarized as
follows:
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Through the MP curve, the nominal interest rate
set by the central bank determines the real
interest rate in the economy.
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 of inflation.
The MP Curve: Monetary Policy and
the Interest Rates
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Large banks and financial institutions borrow
from each other from one business day to the
next.
To set the nominal interest rate on overnight
loans, the central bank states that it is willing
to borrow or lend any amount at the specified
rate.
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Banks cannot charge a higher rate because
everyone would use the central bank.
Banks cannot charge a lower rate because
banks would borrow at the lower rate and
lend it back to the central bank at a higher
rate.
This opportunity for pure profit is called the
arbitrage opportunity.
Thus, banks must exactly match the rate the
central bank is willing to lend at.
From Nominal to Real Interest Rates
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The relationship between the nominal interest
rate and the real interest rate is given by the
Fisher equation.
Changes in the nominal interest rate lead to
changes in the real interest rate so long as
they are not offset by corresponding changes
to inflation.
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The sticky inflation assumption implies that
the rate of inflation displays inertia, or
stickiness, so that it adjusts slowly over time.
In the very short run (6 months or so), we
assume the rate of inflation does not respond
directly to monetary policy.
It implies central banks have the ability to set
the real interest rate in the short run.
The IS-MP Diagram
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The MP curve illustrates the central bank’s
ability to set the real interest rate.
Central banks set the real interest rate at a
particular value and the MP curve is a
horizontal line.
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The IS-MP diagram is a graph of the IS and
the MP curves.
The economy is at potential when the real
interest rate equals the MPK and when there
are no aggregate demand shocks.
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short-run output = 0
If the central bank raises the interest rate
above the MPK, inflation is slow to adjust so
the real interest rate rises and investment
falls.
Example: The End of a Housing
Bubble
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Suppose housing prices had been rising, but
they fall sharply.
This episode implies that the aggregate
demand parameter declines and the IS curve
shifts left.
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If the central bank lowers the nominal interest
rate in response, the real interest rate falls as
well because inflation is sticky.
If judged correctly and without lag, the
economy would not have a decline in output.
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In reality, policymakers are unsure of the
severity of shocks and it takes 6 to 18 months
for changes in the interest rate to impact the
economy.
The Phillips Curve
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Recall that the inflation rate is the percentage
change in the overall price level for the
coming year.
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Firms set their prices on the basis of their
expectations of the economy-wide inflation
rate and the state of demand for their
product.
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Expected inflation is the inflation rate firms
think will prevail in the rest of the economy
over the coming year.
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Assume that firms expect the inflation rate in
the coming year to equal the rate of inflation
that prevailed during the last year.
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Under adaptive expectations firms adjust
their forecasts of inflation slowly.
Expected inflation embodies the sticky
inflation assumption.
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The Phillips curve describes how inflation
evolves over time as a function of short-run
output.
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If output is below potential prices rise more slowly
than usual.
If output is above potential prices rise more rapidly
than usual.
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Let
denote the change in the rate of inflation:
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Therefore, the Phillips Curve can be expressed as:
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The parameter
measures how sensitive inflation is
to demand conditions.
If it is low, it takes a larger recession to reduce the rate
of inflation by a percentage point.
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Price Shocks and the Phillips Curve
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We can add shocks to the Phillips curve to
account for temporary increases in the price
of inflation:
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The actual rate of inflation now depends on
three things:
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The expected rate of inflation, which equals the
inflation rate from last year by adaptive
expectations:
An adjustment factor for the state of the
economy:
A shock to inflation:
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An oil price shock, which when the price of oil
rises, will result in a temporary upward shift in
the Phillips curve.
Cost-Push and Demand-Pull Inflation
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Price shocks to an input in production are
cost-push inflation because higher input
prices (akin to negative supply shocks) tend
to push the inflation rate up.
The effect of short-run output on inflation in
the Phillips curve is demand-pull inflation
because increases in aggregate demand pull
up the inflation rate.
Using the Short-Run Model
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Disinflation is sustained reduction of inflation
to a stable lower rate.
The Great Inflation of the 1970s was when
misinterpreting the productivity slowdown
contributed to rising inflation.
The Volcker Disinflation
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Reducing the level of inflation requires a
sharp reduction in the rate of money growth –
a tight monetary policy.
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Because of the stickiness of inflation, the
classical dichotomy is unlikely to hold exactly
in the short run and just a reduction in the
rate of money growth may not slow inflation
immediately.
Thus, the real interest rate must increase to
induce a recession.
The recession causes a reduction in inflation
because as demand falls firms raise their
prices less aggressively to sell more.
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Lowering the inflation rate comes with a cost
of a slumping economy, which implies high
unemployment and lost output.
Once inflation has declined sufficiently, the
real interest rate can be raised back to the
MPK allowing output to rise back to potential.
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Panel (a): The Volcker policy starts at date 0
and continues until time t*.
Panel (b): Output stays below potential.
Panel (c): Through the Phillips curve, this
leads the rate of inflation to decline gradually
over time.
The Great Inflation of the 1970s
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Inflation rose in the 1970s for three reasons:
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OPEC coordinated oil price increases.
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The U.S. monetary policy was too loose because
the conventional wisdom was that reducing
inflation could only be accomplished with
permanent increases in employment.
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Actually, disinflation requires only a temporary
recession.
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The Federal Reserve did not have perfect
information on the economy and thought the
productivity slowdown was a recession, when it
was actually a change in potential output.
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The Fed lowered interest rates in response to what they
perceived was a demand shock, which increased output
above potential and generated more inflation.
The Short-Run Model in a Nutshell
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The MP curve implies that increases in the
nominal interest rate increase the real
interest rate:
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The IS curve implies that increases in the real
interest rate decrease short-run output:
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The Phillips curve implies that decreases in
short-run output decrease the change in
inflation:
Case Study: The 2001 Recession
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The recession of 2001 had a “jobless
recovery” because even after the return of
strong GDP, employment continued to fall.
This is an exception to Okun’s law, which
assumes employment and GDP move
together.
Microfoundations: Understanding
Sticky Inflation
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The short run model says that changes in the
nominal interest rate affect the real interest rate
because inflation does not adjust immediately.
Recall the classical dichotomy says that
changes in nominal variables have only nominal
effects on the economy and the real side is
determined solely by real forces.
If monetary policy affects real variables, the
classical dichotomy fails in the short run.
The Classical Dichotomy in the ShortRun
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For the classical dichotomy to hold at all
points in time, all prices in the economy,
including wages and rental prices must adjust
in the same proportion immediately.
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Reasons why the classical dichotomy fails in
the short run are that:
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Imperfect information and the costly computation
of prices imply that there are costs of setting
prices – thus firms do not update prices
immediately.
Contracts also set prices and wages in nominal
rather than real terms – and these contracts
prevent wages from adjusting immediately.
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There are bargaining costs to negotiating
prices and wages.
Social norms and money illusions create
feelings about whether the nominal wage
should decline as a matter of fairness.
Money illusion refers to the idea that people
sometimes focus on nominal rather than real
magnitudes.
Case Study: The Lender of Last
Resort
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Central banks ensure a sound, stable
financial system by:
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Making sure banks abide by certain rules
including the maintenance of a certain amount of
reserves to be held on hand.
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Acting as the lender of last resort by lending
money when banks experience financial distress.
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This borrowing occurs at the discount window and the
interest rate on such a loan is the discount rate.
Having deposit insurance on small- and mediumsized deposits.
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In the 1980s, this encouraged financial institutions to
gamble on higher risks.
Microfoundations: How Central Banks
Control Nominal Interest Rates
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The way that the central bank controls the level
of the nominal interest rate is by supplying
whatever money is demanded at that rate.
In the short-run model, the price level does not
respond immediately to changes in the money
supply.
The money market clears through changes in
velocity driven by changes in the nominal
interest rate.
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The nominal interest rate is the opportunity
cost of holding money.
It is the amount you give up by holding
money instead of keeping it in a savings
account.
The demand for money is a decreasing
function of the nominal interest rate.
Higher interest rates reduce the demand for
money.
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The supply of money is a vertical line for
whatever level of money the central bank
provides.
Demand for money is downward sloping.
The nominal interest rate is pinned down by
equilibrium in the money market.
If the nominal interest rate is higher than its
equilibrium level, then households hold their
wealth in savings rather than currency and
this pressures the nominal interest rate to fall.
Changing the Interest Rate
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To raise the interest rate the central bank
reduces the money supply creating an
excess of demand over supply.
Households demand currency but the banks
do not have enough so they pay a higher
interest rate on savings accounts and the
markets adjust to a new equilibrium.
Why it instead of Mt?
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The interest rate is crucial even when central
banks focus on the money supply.
The money demand curve is subject to many
shocks – as changes in price level or output
shift money demand.
If the money supply is constant, the nominal
interest rate fluctuates resulting in changes in
output if the central bank does not act.
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The money supply schedule is effectively horizontal at
a targeted interest rate.
When the central bank sets an interest rate, it is willing
to supply whatever amount of money is demanded at
the interest rate.
An expansionary (loosening) monetary policy
increases the money supply and lowers the nominal
interest rate.
A contractionary (tightening) monetary policy reduces
the money supply and leads to an increase in the
nominal interest rate.
Conclusion
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Policymakers exploit the stickiness of inflation
so changes in the nominal interest rate
change the real interest rate.
Through the Phillips curve booms and
recessions alter the evolution of inflation.
Because inflation evolves gradually, the only
way to reduce it is to slow the economy.
Summary
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The short-run model consists of the IS curve,
the MP curve, and the Phillips curve.
Central banks set the nominal interest rate.
Through the MP curve – and because of
sticky inflation – they thus control the real
interest rate. The real interest rate then
influences short-run output through the IS
curve. The IS-MP diagram allows us to study
the consequences of monetary policy and
shocks to the economy for short-run output.
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The Phillips curve reflects the price-setting
behavior of individual firms. The equation for
the curve is
. Current inflation
depends on expected inflation (
),
current demand conditions ( ), and price
shocks ( ).
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The Phillips curve can also be written as:
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This equation shows clearly that the change
in inflation depends on short-run output: in
order to reduce inflation, actual output must
be reduced below potential temporarily. The
Volcker disinflation of the 1980s is the classic
example illustrating this mechanism.
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Three important causes contributed to the
Great Inflation of the 1970s: the oil shocks of
1974 and 1979; a loose monetary policy
resulting in part from the mistaken view that
reducing inflation required a permanent
reduction in output; and a loose monetary
policy resulting from the fact that the
productivity slowdown was initially interpreted
as a recession.
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Central banks control short-term interest
rates by their willingness to supply whatever
money is demanded at a particular rate.
Through the term structure of interest rates,
long-term rates are an average of current and
expected future short-term rates. This
structure allows changes in short-term rates
to affect long-term rates.