Chapter 12 and 13 Macroeconomics Revision PDF

Chapter 12 The Structure of the Short-Run Model 12.2 The MP Curve: Monetary Policy and Interest Rates Banks borrowing from each other must match the central bank lending rate. Banks cannot charge a higher rate. o Everyone would use the central bank. Banks cannot charge a lower rate....

Chapter 12 The Structure of the Short-Run Model 12.2 The MP Curve: Monetary Policy and Interest Rates Banks borrowing from each other must match the central bank lending rate. Banks cannot charge a higher rate. o Everyone would use the central bank. Banks cannot charge a lower rate. o Everyone would borrow at the lower rate and lend it back to the central bank at a higher rate (arbitrage). o The lender would run out of resources quickly. From Nominal to Real Interest Rates Fisher equation: 𝑖𝑡 = 𝑅𝑡 + 𝜋𝑡 Where: it nominal interest rate Rt real interest rate 𝜋t inflation rate Solve for the real interest rate 𝑅𝑡 = 𝑖𝑡 − 𝜋𝑡 From Nominal to Real Interest Rates Sticky inflation assumption In the short run, inflation displays inertia, or stickiness. adjusts slowly over time. does not respond directly to monetary policy. Central banks can set the real interest rate in the short run. The IS/MP Diagram (1 of 2) The MP curve Illustrates the central bank’s ability to set the real interest rate at a particular value (horizontal line) The IS curve Recall: Illustrates the negative relationship between interest rates and short-run output The MP Curve in the IS/MP Diagram The IS/MP Diagram (1 of 2) The economy is at potential when Real interest rate = MPK No aggregate demand shocks Short-run output = 0 If the central bank raises the interest rate above the MPK Inflation is Real interest Investment sticky rate ↑ ↓ Raising the Interest Rate in the IS/MP Diagram 12.3 The Phillips Curve Recall: The inflation rate is the percent change in the overall price level. (𝑃𝑡+1 − 𝑃𝑡 ) 𝜋𝑡 ≡ 𝑃𝑡 Firms set their prices on the basis of their expectations of the economy-wide inflation rate. the state of demand for their product. The Phillips Curve (1 of 4) Expected inflation 𝜋𝑡 = 𝜋𝑡𝑒 + 𝑣ҧ 𝑌෨𝑡 where 𝜋𝑡𝑒 represents expected inflation, and 𝑣ҧ 𝑌෨𝑡 represents demand conditions and 𝜋𝑡𝑒 = 𝜋𝑡−1 Adaptive expectations Firms expect next year’s inflation rate to be the same as this year’s inflation rate. Firms adjust their forecasts of inflation slowly. Firms embody the sticky inflation assumption. The Phillips Curve (2 of 4) The Phillips curve Describes how inflation evolves over time as a function of short-run output 𝜋𝑡 = 𝜋𝑡−1 + 𝑣ҧ 𝑌෨𝑡 If output is below potential, prices rise more slowly than usual. If output is above potential, prices rise more rapidly than usual. The Phillips Curve (3 of 4) Using the equations: 𝜋𝑡 = 𝜋𝑡−1 + 𝑣ҧ 𝑌෨𝑡 ∆𝜋𝑡 = 𝜋𝑡 − 𝜋𝑡−1 Therefore, the Phillips curve can be expressed as: ∆𝜋𝑡 = 𝑣ҧ 𝑌෨𝑡 The Phillips Curve (4 of 4) Price Shocks and the Phillips Curve We can add shocks 𝑜ҧ to the Phillips curve: 𝜋𝑡 = 𝜋𝑡−1 + 𝑣ҧ 𝑌෨𝑡 + 𝑜ҧ Rewrite: ∆𝜋𝑡 = 𝑣ҧ 𝑌෨𝑡 +𝑜ҧ Inflation depends on: Expectations of inflation Demand conditions Shocks to inflation Cost-Push and Demand-Pull Inflation Price shocks to an input in production Cost-push inflation Tends to push the inflation rate up Changes in short-run output Demand-pull inflation Increases in AD pull up the inflation rate. The Disinflation over Time (Volcker Disinflation) The Great Inflation of the 1970s (1 of 2) Inflation rose in the 1970s for three reasons: OPEC coordinated oil price increases: Oil shock U.S. monetary policy was too loose. o Policymakers thought that reducing inflation required permanent increases in unemployment. o In reality, disinflation requires only a temporary recession. The Great Inflation of the 1970s (2 of 2) Inflation rose in the 1970s for three reasons: The Federal Reserve did not have perfect information. o Thought the productivity slowdown was a recession o The Fed lowered interest, which increased output above potential and generated more inflation. o However, the slowdown was a change in potential output. Mistaking a Slowdown in Potential for a Recession Covid-19 as an Aggregate Demand Shock Covid-19 acted as a “tax” on consumption Possibility of contracting Covid-19 reduced in-person retail, in-person dining, travel, and in-person entertainment activity Consumption fell sharply ↓ 𝑎ത𝑐 ⟹ ↓ 𝑎ത ⟹ ↓ 𝑌෨𝑡 ⟹ ↓ 𝜋𝑡  ഥ Covid-19 as a Shock to 𝒀 Covid-19 acted as a “tax” on working Possibility of contracting Covid-19 if you left home to go to work reduced employment both voluntarily and involuntarily Employment declined sharply, reducing production 𝑌ത declines Combined Shock An aggregate demand shock combined with a shock to the economy’s production function resulted in a sharp decline in output with a minimal decline in inflation The Classical Dichotomy in the Short Run (1 of 2) Can the classical dichotomy hold at all points in time? All prices, including wages and rental prices, must adjust in the same proportion immediately. The Classical Dichotomy in the Short Run (2 of 2) Reasons that the classical dichotomy fails in the short run: Imperfect information Costs of setting prices Contracts set prices and wages in nominal terms Bargaining costs Social norms and money illusion 12.7 Microfoundations: How Central Banks Control Nominal Interest Rates The central bank controls the level of the nominal interest rate by supplying the money that is demanded at that rate. The nominal interest rate The opportunity cost of holding money Quantity demanded of money is negatively related to the nominal interest rate. How the Central Bank Sets the Nominal Interest Rate Money Supply and Demand The demand for money Decreasing function of the nominal interest rate Downward sloping The supply of money The level of money the central bank provides Vertical line Changing the Interest Rate To raise the interest rate New ↓ MS QMD>QMS ↑i ↓ QMD equilibrium Higher i Raising the Nominal Interest Rate Why it instead of Mt? (1 of 2) The interest rate is crucial even when central banks focus on the money supply. The money demand curve is subject to many 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. Why it instead of Mt? (2 of 2) The money supply schedule is effectively horizontal 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 Targeting the Nominal Interest Rate 12.8 Inside the Federal Reserve Reserves Deposits held in accounts with the central bank The Federal Reserve pays interest on reserves 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 Chapter 13 Simple Monetary Policy Rule A monetary policy rule is a set of instructions that determines the stance of monetary policy for a given situation in the economy. 𝑅𝑡 − 𝑟ҧ = 𝑚 ഥ 𝜋𝑡 − 𝜋ത Where: 𝑅𝑡 the central bank’s desired real interest rate 𝑟ҧ the marginal product of capital ഥ monetary policy’s aggressiveness to inflation 𝑚 𝜋𝑡 current inflation rate 𝜋ത inflation target set by central bank The AD Curve (1 of 2) Substitute the policy rule into the IS curve: Policy rule: 𝑅𝑡 − 𝑟ҧ = 𝑚 ഥ 𝜋𝑡 − 𝜋ത ത 𝑡 − 𝑟)ҧ IS curve: 𝑌෨𝑡 = 𝑎 − 𝑏(𝑅 To get the aggregate demand (AD) curve: AD curve: 𝑌෨𝑡 = 𝑎ത − 𝑏ത 𝑚 ഥ 𝜋𝑡 − 𝜋ത Short-run output is a function of the inflation rate. Moving along the AD Curve Movement along the AD Curve happens when actual inflation 𝜋𝑡 differs from the inflation target 𝜋ത Central banks respond to inflation according to the monetary policy rule such that: 𝜋𝑡 > 𝜋ത ⟹ ↑𝑅𝑡 ⟹↓𝑌෨ < 𝑌ത 𝜋𝑡 < 𝜋ത ⟹ ↓𝑅𝑡 ⟹↑𝑌෨ = 𝑌ത The Aggregate Demand Curve: 𝑌෨𝑡 = 𝑎 − 𝑏ത 𝑚 ഥ 𝜋𝑡 − 𝜋ത An Aggressive Monetary Policy Rule Shifts of the AD Curve AD curve shifts are caused by: Demand shocks 𝑎ത Changes in the central bank’s inflation target 𝜋ത 13.3 The Aggregate Supply Curve The aggregate supply (AS) curve is the price-setting equation used by firms. the Phillips curve with a new name. AS curve equation: 𝜋𝑡 = 𝜋𝑡−1 + 𝑣ҧ 𝑌෨𝑡 + 𝑜ҧ The Aggregate Supply Curve: 𝜋𝑡 = 𝜋𝑡−1 + 𝑣ҧ 𝑌෨𝑡 + 𝑜ҧ The Aggregate Supply Curve The AS curve will shift due to A change in expected inflation 𝜋𝑡−1 Input price shocks 𝑜ҧ 13.4 The AS/AD Framework Combining the AS and AD curve Two equations Two unknowns: inflation rate and short-run output o AD curve 𝑌෨𝑡 = 𝑎ത − 𝑏ത 𝑚 ഥ 𝜋𝑡 − 𝜋ത o AS curve 𝜋𝑡 = 𝜋𝑡−1 + 𝑣ҧ 𝑌෨𝑡 + 𝑜ҧ The AS/AD Framework (steady state) The Initial Response to an Inflation Shock Event 1: An Inflation Shock (1 of 3) In period 2, 𝑜ҧ returns to normal. The AS curve does not shift back because 𝜋1 > 𝜋ത Inflation is now: 𝜋2 = 𝜋1 + 𝑣ҧ 𝑌෨2 + 𝑜ҧ In the steady state, 𝜋𝑡−1 = 𝜋ത So, 𝜋2 > 𝜋ത Two Periods after an Inflation Shock Event 1: An Inflation Shock (3 of 3) Transition dynamics: Movement back to the steady state is fastest when the economy is furthest from its steady state. In summary, a price shock raises inflation directly. keeps inflation higher for a longer period of time due to sticky inflation. results in a prolonged slump. causes the economy to suffer from stagflation. The Effects of an Inflation Shock: Summary Event 2: Disinflation (1 of 3) The economy begins in steady state. Suppose policymakers decide to lower the inflation target. The AD curve shifts down. The new rule calls for an increase in interest rates. The Initial Response to Disinflation The Dynamics of Disinflation Event 3: A Positive AD Shock (1 of 3) The economy begins in steady state. Suppose there is a temporary increase in the aggregate demand parameter, 𝑎ത The AD curve will shift out. Prices increase. A Positive AD Shock Dynamics as the AS Curve Shifts The Unraveling after the AD Shock Ends Rules versus Discretion The time consistency problem Even though agents support a particular policy, once the future comes, they have incentives to renege on their promises. Firms and workers form expectations about inflation. Expectations are built into prices and contracts. Central bankers pursue an expansionary policy. Firms and workers anticipate the policy and build it in. No benefit to output The Paradox of Policy and Rational Expectations (1 of 4) The goal of macroeconomic policy Full employment Output at potential Low, stable inflation The presence of a policymaker willing to generate a large recession to fight inflation makes policy use less likely. The Paradox of Policy and Rational Expectations (2 of 4) Under adaptive expectations, we assume 𝜋𝑡𝑒 = 𝜋𝑡−1 We assume the equation does not change with policy rule changes. Due to sticky inflation The Paradox of Policy and Rational Expectations (3 of 4) Rational expectations People use all information at their disposal to make their best forecast of the rate of inflation. This information may include the costs resulting in sticky inflation but may also add the target rate of inflation. The Paradox of Policy and Rational Expectations (4 of 4) The central bank’s willingness to fight inflation is a key determinant of expected inflation. If firms know the bank will fight aggressively to keep inflation low, they are less likely to raise prices after an inflation shock.