Advanced Macroeconomics - Lecture 8: Monetary Policy I
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Questions and Answers

What does the IS-Curve represent in the IS-PC-MR model?

  • A negative relationship between output and interest rates (correct)
  • A positive relationship between output and interest rates
  • The responsiveness of inflation to changes in output
  • The long-run neutrality of monetary policy

Which statement is true regarding the effects of monetary policy in the long-run?

  • Monetary policy is fully effective with no time lags.
  • Monetary policy can effectively increase real output.
  • Monetary policy only influences inflation over the long-run. (correct)
  • Monetary policy has no impact on inflation.

What kind of expectations does the Phillips Curve take into account?

  • Rational expectations, either forward or backward looking (correct)
  • Only backward-looking expectations
  • Only forward-looking expectations
  • Random expectations that have no specific structure

What is the role of the central bank according to the consensus on monetary policy?

<p>To set interest rates with the goal of controlling inflation (B)</p> Signup and view all the answers

Which of the following influences does the IS-PC-MR model predominantly reflect?

<p>Predominantly New Keynesian, with influences from Monetarism and New Classical economics (D)</p> Signup and view all the answers

What does the Phillips Curve primarily illustrate?

<p>A contemporaneous, positive relationship between output and inflation (C)</p> Signup and view all the answers

What is the meaning of the term 𝛼 in the Phillips Curve equation?

<p>The sensitivity of inflation to the output gap in the same period (C)</p> Signup and view all the answers

What does the equation $y_1 = A - ar_0$ represent in the context of the IS-Curve?

<p>The relation between real output and real interest rates over time (A)</p> Signup and view all the answers

In the IS-PC-MR model, what can cause crowding-out effects on fiscal policy?

<p>The influence of the central bank's interest rate decisions (A)</p> Signup and view all the answers

Why are inflation expectations set as equal to previous period's inflation in the inertial Phillips Curve?

<p>To support the notion of adaptive expectations and price/wage stickiness (D)</p> Signup and view all the answers

What is indicated by a positive output gap (𝑦1 > 𝑦𝑒) in the context of the Phillips Curve?

<p>A rise in inflation rates (B)</p> Signup and view all the answers

What type of rigidities do monetary policy interventions mainly rely on?

<p>Nominal and/or real rigidities (D)</p> Signup and view all the answers

What does the nominal interest rate set by the central bank influence in the short run?

<p>Real interest rates affecting future aggregate demand (B)</p> Signup and view all the answers

What assumption underpins the idea that inflation in period t=0 is predetermined?

<p>The time lag in the effects of monetary policy (C)</p> Signup and view all the answers

According to the assumptions of the Phillips Curve, what contributes to the stickiness in prices and wages?

<p>Adaptive expectations and inertia in price setting (B)</p> Signup and view all the answers

What happens to inflation when the output gap is negative (𝑦1 < 𝑦𝑒)?

<p>Inflation decreases (C)</p> Signup and view all the answers

What does the term $y_e$ represent in the model?

<p>Potential output level (A)</p> Signup and view all the answers

How does the interest rate $r_0$ relate to the stabilizing interest rate $r_s$ according to equation (3)?

<p>$r_0$ differs from $r_s$ causing output deviations. (A)</p> Signup and view all the answers

What occurs if interest rates differ from the stabilizing rate $r_s$?

<p>Output will deviate from $y_e$. (A)</p> Signup and view all the answers

What is the role of the Central Bank (CB) in relation to the output gap?

<p>To select interest rates to close the output gap. (A)</p> Signup and view all the answers

What factors influence inflation at time t=0 (𝜋0)?

<p>Current output (𝑦0) and past inflation (𝜋−1) (B)</p> Signup and view all the answers

What does the equation $y_1 - y_e = -a(r_0 - r_s)$ represent?

<p>The output adjustment mechanism. (A)</p> Signup and view all the answers

What is the main concern of the central bank in its monetary policy rule?

<p>Minimizing fluctuations away from inflation target and potential output (A)</p> Signup and view all the answers

Why is fiscal policy (FP) not accounted for in the model?

<p>It interferes with monetary policy targets. (A)</p> Signup and view all the answers

In the loss function (L) of the central bank, what does the parameter 𝛽 indicate?

<p>The weight of inflation concerning output (B)</p> Signup and view all the answers

What is indicated by the expression $y_1 - y_e$?

<p>Output gap or deviations of output from potential output. (B)</p> Signup and view all the answers

How does the value of 𝛽 affect the central bank's response to inflation and output?

<p>𝛽&gt;1 indicates more concern for inflation than output (A)</p> Signup and view all the answers

What does a positive output gap ($y_1 > y_e$) suggest about the current interest rate ($r_0$)?

<p>$r_0$ is higher than $r_s$. (B)</p> Signup and view all the answers

In the IS-PC-MR model, what does the IS curve represent?

<p>The relationship between output gap and interest rates (D)</p> Signup and view all the answers

What is the purpose of the inertial Phillips Curve (PC) in this model?

<p>To relate current inflation to past inflation and output (D)</p> Signup and view all the answers

What does the central bank consider when setting its current policy (𝑟0)?

<p>Future inflation targets and potential output (A)</p> Signup and view all the answers

Which statement accurately describes the impact of 𝜷 on the monetary policy rule (MR)?

<p>Higher values of 𝜷 lead to a flatter MR curve (A)</p> Signup and view all the answers

What does the Taylor Rule primarily indicate about interest rates and inflation?

<p>The change in real interest rates is dependent on the difference between current and target inflation. (C)</p> Signup and view all the answers

Which condition triggers Central Bank intervention according to the given content?

<p>If the current real interest rate cannot deliver the target inflation and expected output. (A)</p> Signup and view all the answers

How does an increase in the inflation aversion parameter ($eta$) affect the Central Bank's interest rate decisions?

<p>Interest rates will increase more to combat inflation. (D)</p> Signup and view all the answers

What happens when the Phillips curve is steeper, indicated by an increase in $oldsymbol{eta}$?

<p>The Central Bank will raise interest rates moderately. (A)</p> Signup and view all the answers

According to the Taylor Rule, what relationship does Eq.(7) illustrate?

<p>The change in real interest rates is determined by inflation compared to the target. (C)</p> Signup and view all the answers

What is a key characteristic of the New Consensus in Macroeconomics (NCM)?

<p>There is non-money neutrality in the short run due to rigidities. (C)</p> Signup and view all the answers

What did Bernanke (2015) find regarding the actions of the US Fed from 1995 to 2015?

<p>A modified Taylor Rule better explains the Fed's actions during that time. (C)</p> Signup and view all the answers

In the context of the content, what does a flatter IS-curve imply about the Central Bank's interest rate adjustments?

<p>The Central Bank will raise interest rates less. (B)</p> Signup and view all the answers

What does the long-run neutrality of money imply?

<p>Money supply changes have no long-term effect on real variables. (B)</p> Signup and view all the answers

What is represented by NAIRU in macroeconomic theory?

<p>The level of unemployment consistent with a stable rate of inflation. (D)</p> Signup and view all the answers

What does the IS-PC-MR model emphasize in terms of economic policy?

<p>The dynamic interactions between output, inflation, and interest rates. (D)</p> Signup and view all the answers

What does the optimal problem of the Central Bank focus on?

<p>Balancing deviations from potential output and target inflation. (B)</p> Signup and view all the answers

According to the Taylor Rule, what does the adjustment of the interest rate depend on?

<p>The deviation of actual inflation from the inflation target. (A)</p> Signup and view all the answers

What role does fiscal policy play according to the content provided?

<p>It can crowd out the central bank's aims. (B)</p> Signup and view all the answers

How is the output gap represented in the IS equation?

<p>$y_1 - y_e = -a(r_0 - r_s)$ (B)</p> Signup and view all the answers

What does the PC equation illustrate in the context of inflation?

<p>Inflation depends on the output gap and persists over time. (C)</p> Signup and view all the answers

Flashcards

Potential output (ye)

The level of output where both wage-setters and price-setters are satisfied with the real wage and do not seek to change it.

Output gap

The difference between actual output (y1) and potential output (ye).

Stabilizing interest rate (rs)

The interest rate that would bring output to its potential level (ye).

IS Curve

The relationship between output and the real interest rate.

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Interest rate differential

The difference between the current interest rate (r0) and the stabilizing interest rate (rs).

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Policy lag

The time lag between a change in interest rates and its effect on output.

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Central Bank's (CB) role

The ability of the central bank to use the interest rate to influence output.

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Closing the output gap

The process of adjusting interest rates to close the output gap.

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Monetary Policy Consensus

The prevailing view on how to conduct monetary policy, emphasizing short-term impacts on output due to demand fluctuations and sticky prices, with long-term neutrality regarding output and influence on inflation.

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IS Curve Slope (a)

The sensitivity of real output (y) to changes in real interest rates (r). It represents how much output changes for every unit change in interest rates.

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IS-PC-MR Model

A model that combines three key components: the IS curve (representing demand), the Phillips Curve (representing inflation), and the Monetary Rule (representing central bank policy), to analyze macroeconomic outcomes.

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Phillips Curve (PC)

A curve that describes the relationship between inflation rate and output gap (deviation of actual output from potential output). It shows that higher output gaps tend to lead to higher inflation.

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Monetary Rule (MR)

A rule that outlines the central bank's policy for setting interest rates. It aims to control inflation and stabilize the economy.

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Taylor Rule

A specific type of monetary rule where the central bank adjusts interest rates based on the inflation rate and output gap. The rule is formulated to minimize deviations of inflation and output from their target levels.

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Long-Run Monetary Neutrality

The principle that monetary policy has no long-run impact on real output, only on inflation. This is due to the presence of a long-run equilibrium where supply and demand forces determine output.

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Equation of the Phillips Curve

The equation representing the Phillips Curve that includes inflation expectations, output gap, and the sensitivity of inflation to the output gap.

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Inflation Expectations

Inflation expectations are what individuals anticipate the future rate of inflation to be. They play a crucial role because they influence how businesses set prices and workers demand wages, ultimately affecting the actual inflation rate.

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Inertial Phillips Curve

A version of the Phillips Curve where current inflation depends on past inflation and the output gap. It reflects the idea that inflation has a tendency to stick, meaning past inflation influences current inflation.

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Monetary Policy Rule (MR)

The Monetary Policy Rule (MR) sets the central bank's guidelines for adjusting interest rates in response to inflation and output indicators. The MR helps to control inflation and stabilize the economy.

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Real Interest Rate

The nominal interest rate minus the inflation rate. It reflects the real cost of borrowing or the real return on savings.

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Central Bank's Loss Function

The central bank's goal is to minimize deviations of output from its potential level (ye) and inflation from its target rate (𝜋T). This is reflected in the loss function.

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Inflation Aversion Parameter (𝛽)

A measure of how much the central bank cares about inflation relative to output. It influences the shape of the monetary policy rule (MR).

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Interest Rate (𝑟0)

The central bank's policy instrument used to influence output and inflation. It's set in response to the current economic situation, particularly deviations from the inflation target and potential output.

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Potential Output (𝑦𝑒)

The point where the economy is operating at its full potential, meaning there's no cyclical unemployment. It's the output level when both price and wage setters are satisfied.

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Output Gap (𝑦1 - 𝑦𝑒)

The difference between the current level of output (y1) and the potential output (ye). A positive gap means the economy is operating above potential, while a negative gap means the economy is operating below potential.

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Central Bank's role

The central bank's ability to influence output by adjusting interest rates. It plays a major role in managing the economy.

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Study Notes

Advanced Macroeconomics - Lecture 8: Monetary Policy I

  • Monetary Policy Consensus: Business cycles are demand-driven, but demand effects are limited to the short-run. Monetary policy (MP) impacts short-run output due to nominal and/or real rigidities. Short-run effects are not seen in the long-run.
  • Long-Run Monetary Neutrality: In the long run, MP doesn't affect output but does affect inflation. Supply-side equilibrium (like NAIRU) is independent of monetary policy.
  • Phillips Curve and Expectations: The Phillips curve must account for expectations (forward or backward looking).
  • Rational Expectations: Central banks (CB) set interest rates to control inflation. CBs must account for a lag in policy implementation.
  • Fiscal Policy Considerations: Fiscal policy can be subject to crowding-out effects and can interfere with CB aims.
  • Predominant Theoretical Approach: The model presented is primarily New Keynesian, though influenced by Monetarist and New Classical economics.

Building Blocks of the IS-PC-MR Model

  • IS-Curve: A negative relationship between real output (y) and real interest rates (r) exists, although with a time lag. Output depends on real interest rates in the previous period. Fiscal policy also impacts output.

  • Stabilizing Interest Rate: There's a target interest rate (rs) to stabilize the economy in period T+1. The difference between the current and target rate will affect output.

  • Fiscal Policy: Fiscal policy has no impact within this economic model due to the assumed crowding-out problem.

  • Potential Output/NAIRU: The model deals with the level of output where there is no pressure on wages or prices. This is similar to a long-run concept/full-employment output or NAIRU, depending on how the market functions.

  • Phillips Curve (PC): A contemporaneous positive relationship between output and inflation (including inflation expectations). Inflation in the next period depends on current output gap and past expected inflation.

  • Inflation Expectations: Inflation expectations are equal to inflation in the previous period, indicating inertia.

  • Graphical PC Properties: The slope represents the sensitivity of inflation changes to output fluctuations, and shifts occur as the past inflation rate influences the present.

  • Monetary Policy Rule (MR): A policy lag exists. The central bank aims to minimize deviations from a target inflation rate and potential output through a loss function. The Taylor Rule is one form of monetary policy rule, which is a reaction function of the CB.

  • Policy Lag: Actions taken at time t do not have an immediate impact. There's a delay in the effect of the measures in period t on the next period's (i.e., t+1) output and inflation.

  • CB Target: The Central Bank sets nominal interest rates to affect real interest rates, but inflation expectations are a key factor in the process

Full IS-PC-MR Model

  • CB Targeting: The central bank targets inflation and potential output using interest rate changes.
  • Policy Lag: CB considerations involve anticipating how policy will influence inflation and output in the future.

Interest Rate Rule (Taylor Rule)

  • Optimal Interest Rate Adjustment: The rule describes how the CB should change real interest rates based on the difference between actual and target inflation. This adjustment depends on the values of variables like β, a, and a. Different values imply different responses to inflation and output gaps.
  • Inflation Aversion vs. Output Gap Concern: The model shows that the Taylor Rule is dependent on the central bank's response to inflation vs concerns on unemployment. A higher sensitivity to inflation than unemployment causes interest rates to be adjusted more significantly.

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Description

This quiz covers the key concepts in Lecture 8 of Advanced Macroeconomics, focusing on monetary policy's impact on business cycles and inflation. It delves into the principles of long-run monetary neutrality, the Phillips curve, and the role of central banks in setting interest rates. Explore how different economic theories interact and influence fiscal policy outcomes.

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