Monetary Economics Introduction · 2018. 10. 2. · Bilgin Bari Monetary Economics Introduction....

Aggregate DemandAggregate Supply

Monetary Policy TheoryMonetary Policy Analysis

Monetary EconomicsIntroduction

Bilgin Bari

Bilgin Bari Monetary Economics Introduction



God put macroeconomists on earth not to propose andtest elegant theories but to solve practical problems.The problems He gave us, moreover, were not modest indimension.

Gregory Mankiw




1 Aggregate DemandThe Goods Market and the IS ModelThe Money Market and the LM CurveThe Short-Run Equilibrium in the IS-LM ModelDerivation of Aggregate Demand

2 Aggregate SupplyThe Basic Theory for Aggregate SupplyAggregate Supply and Phillips Curve

3 Monetary Policy TheoryMonetary Policy and Aggregate DemandMonetary Policy and Interest Rate Rule

4 Monetary Policy AnalysisThe Objectives of Monetary PolicyThe Effects of PolicyTools of Monetary Policy




The Goods Market and the IS ModelThe Money Market and the LM CurveThe Short-Run Equilibrium in the IS-LM ModelDerivation of Aggregate Demand

Aggregate Demand I

Great Depression

Classical theory was incapable of explaining the GreatDepression.

According to Classical theory, national income depends on- factor suppplies ( capital and labor) - avaliable technology

They didn’t change substantially from 1929 to 1933.

So many economists believed that a new model was needed.





Aggregate Demand II

Keynes (1936), The General Theory of Employment, Interest, andMoney





Aggregate Demand III

Aggregate Demand : The total amount of outputdemanded in the economy.

Keynes proposed that low aggregate demand is responsible forlow income and high employment.

He criticized classical theory which assumes aggregate supplyalone determines national income.





Using Models

In the long-run, prices are flexible, and aggregate supplydetermines income.

In the short-run, prices are sticky, and aggregate demandinfluence income.

We focus on aggregate demand to study economicfluctuations.

The model of aggregate demand : IS-LM model.





IS-LM Model

The goal of the model :

to show what determines national income for a given pricelevel (sticky prices).to show what causes the aggregate demand curve to shift.

IS (Investment-Saving) : markets for goods and services

LM (Liquidity-Money) : markets for money

The key determinant is the interest rate, because it influencesboth investment and money demand.





Importance of Expenditures

Keynes proposes that

In the short-run, economy’s total income is determined largelyby the spending of plans of households, firms, and thegovernment.

The problem during recessions was inadequate spending.





Planned Expenditure

Actual expenditure (AE): the amount households, firms andthe government spend on goods and services (GDP)

Planned expenditure (PE): the amount households, firms andthe government would like to spend on goods and services.

Planned Expenditure = Aggregate Demand

Ype = C + I + G + NX





Keynesian Cross I

Keynesian Multiplier

Y = C + I + G + NXY = C + (mpc × YD) + I + G + NXY = C + I + G + NX + (mpc × Y )− (mpc × T )

subtracting mpc × Y from both dies of equation

Y − (mpc × Y ) = Y (1−mpc) = C + I + G + NX − (mpc × T )

dividing both sides of equation (1−mpc)

Y = 11−mpc × [C + I + G + NX − (mpc × T )]





Keynesian Cross II

Keynesian cross gives that the relation between expenditure andincome (production).

Y = 11−mpc × [C + I + G + NX − (mpc × T )]

For example

When there is a change in one of the autonomouscomponents (e.g. goverment expenditures: ∆G ), the changein production (or income) will be :

∆Y

∆G=

1

1−mpc





Keynesian Cross III





Keynesian Cross IV

When there is a change in one of the autonomouscomponents (e.g. goverment expenditures: ∆G ), the changein production (or income) will be :

∆Y

∆T=−mpc

1−mpc





Keynesian Cross V





Derivation of IS Curve

IS curve describes the relationship between interest rate andaggregate output when goods market is in equilibrium for a givenprice level.





Shifts in IS Curve





The Theory of Liquidity Preference I

The theory is the building block for the LM curve.

The theory assumes that there is a fixed supply of real moneybalances:

(M

P)s =

M

P

The theory posits that interest rate is one determinant ofmoney demand. It is the opportunity cost of holding money.

Economy’s level of income (Y) also effect the demand ofmoney.

The demand for real money balances :

(M

P)d = L(r ,Y )





The Theory of Liquidity Preference II





Derivation of LM Curve





Shifts in LM Curve





Planned Expenditure

Planned Expenditure : The total amount of spending ondomestically produced goods and services.

Planned Expenditure = Aggregate Demand

Ype = C + I + G + NX





Consumption Expenditure (C)

C = C + (mpc × YD)− cr

C : autonomous consumption expenditurempc : marginal propensity to consumeYD : disposable income (Y-T)c : a parameter reflects how consumption respond changes in thereal interest rater : real interest rate

⇒ Real interest rate affects on savings decisions.





Planned Investment Spending (I)

I = I − dr

I : Fixed Investmentd : a parameter reflects how investment respond to changes in thereal interest rate.

⇒ Real interest rate affects on investment decisions through costof finance.

Goverment Purchases and Taxes

Goverment Purchases : G = GTaxes T = T → disposable income : Y − T





Net Exports (NX)

NX = NX − xr

NX : autonomous net exportx : a parameter reflects how net export respond to changes in thereal interest rate

⇒ real interest rate affect net export through the exchange rate :

changes in real interest rate → changes in return → capital flow →changes in export and import prices → changes in net export





Goods Market Equilibrium

Y = Ype

Y = C + I + G + NXY = C + (mpc × YD)− cr + I − dr + G + NX − xrY = C + I + G + NX + (mpc × Y )− (mpc × T )− (c + d + x)r

subtracting mpc × Y from both dies of equation

Y − (mpc × Y ) = Y (1−mpc) =C + I + G + NX − (mpc × T )− (c + d + x)r

dividing both sides of equation (1−mpc)

Y = [C + I + G + NX − (mpc × T )]× 11−mpc −

c+d+x1−mpc r





IS Curve

Y = [C + I + G + NX − (mpc × T )]× 1

1−mpc︸︷︷︸−c + d + x

1−mpcr︸︷︷︸

The equation shows how to determine aggregate output whengoods market is in equilibrium.

It shows the relationship between aggregate output and thereal interest rate when the goods market is in equilibrium.

First component of the equation explains shifts in IS curve(given interest rate)

Second component of the equation explains movements on IScurve (changes in real interest rate)




The Basic Theory for Aggregate SupplyAggregate Supply and Phillips Curve

Introduction I

Aggregate supply behaves differently in the short-run than in thelong-run.

In the long-run, prices are flexible, and the aggregate supplycurve is vertical.

shifts in aggregate demand curve affect the price level andoutput remains its natural level.

In the short-run, prices are sticky, and the aggregate supplycurve is not vertical.

shifts in aggregate demand curve affect the output and docause fluctuations in output.





Introduction II

The aim is to understand upward sloping short-run AS curve.

Some prices are sticky and others not.This is the better reflection of the real world.

All prices are fixed (horizontal AS curve) is an extremesituation.





The Basics I

There are two types of market imperfection in the economy.

These imperfections (frictions) cause the output of economyto deviate from its natural level.

As a result of these imperfections, the short-run aggregatesupply curve is upward sloping.

As a result of upward sloping AS curve, shifts in aggregatedemand curve cause output to fluctuate.

This devations of output from its natural level represent thebooms and busts of the business cycle.

The equation for the short-run AS curve :

Y = Y + α(P − EP)





The Basics II

Y = Y + α(P − EP)

The equation states that output deviates from its natural levelwhen the price level deviates from the expected price level.

α indicates how much output respond to unexpected changesin the price level.

The model explains :why unexpected movements in the price level are related tofluctuations in aggregate output.





The Sticky-Price Model I

The model emphasizes that firms do not instantly adjust theprices they charge in response to changes in demand.

Building the model

we first consider the pricing decisions of individual firmsthen we add together the decisions of many firms to explainthe behavior of the economy as a whole.

Main assumption : Firms have at least some monopolisticcontrol over the prices they charge.





The Sticky-Price Model II

Desired price p depends on two macroeconomic variables:

The overall level of prices : P⇒ A higher price level implies that the firm’s cost are higher.

The level of aggregate income : Y⇒ A higher level of income raises the demand for the firm’sproduct.⇒ And marginal cost increases at higher levels of production.

Firms with flexible prices:

p = P + a(Y − Y )

a > 0 : measures how much the firm’s desired price responds tothe level of aggregate output.





The Sticky-Price Model III

Firms with sticky prices:

p = EP + a(EY − EY )

for simplicity, assume that these firms expect output to be at itsnatural level : a(EY − EY ) = 0

then, these firms set the price : p = EP





The Sticky-Price Model IV

In the overall economy, there are two pricing group as flexible andsticky.The weighted average of the pricing :s: fraction of firms with sticky prices1-s: fraction with the flexible prices

Then the overall price level

p = sEP + (1− s)[P + a(EY − EY )]

substract (1− s)P from both sides

sP = sEP + (1− s)[a(Y − Y )]





The Sticky-Price Model V

divide both sides by S

P = EP + [(1− s)a

s](Y − Y )

When firms expect a high price level, they expect high costs.

When output is higher, the demand for goods is higher. Sofirms set prices higher.

When we use α = s(1−s)a ;

Y = Y + α(P − EP)

The Result: The sticky-price model says that the deviation ofoutput from the natural level is positively associated with thedeviation of price level from the expected price level.





The Imperfect Information Model I

Assumptions :

Markets clear. (flexible prices)

The short-run and long-run aggregate supply curves differbecause of temporary misperceptions about prices.

Each supplier in the economy produces single good andconsume many goods.

They monitor closely the prices of what they produce but lessclosely the prices of all the goods they consume.

Because of imperfect information, they sometimes confusechanges in overall price level with changes in relative prices.





The Imperfect Information Model II

The result: This confusion influences decisions about how muchto supply, and it leads to positive relation between the price leveland output in the short-run.

Actual prices exceed expected prices, suppliers raise their output :

Y = Y + α(P − EP)





Implications for the Model I

Y = Y + α(P − EP)

If the price level is higher than the expected price level, outputexceeds its natural.

If the price level is lower than the expected price level, outputfalls short of its natural level.





Phillips Curve

A.W.Phillips (1958), ”The Relationship Between Unemploymentand the Rate of Change of Money Wages in the United Kingdom:1861-1957”, Economica 25

”periods of low unemployment were associated with rapidrises in wages, while periods of high unemployment wereassociated by low growth in wages”

Phillips curve shows the negatif relationship betweenunemployment and inflation.When labor markets are tight (the unemployment rate is low)

firms may have difficulty hiring qualified workers and may havehard time keeping their present employees.Because of shortage of workers in the labor market, firms willraise wages to attract needed workers and raise their prices ata more rapid rate.





Modern Phillips Curve I

M. Friedman (1967), ”The Role of Monetary Policy”, AmericanEconomic Review 58E. Phelps (1968), ”Money-Wage Dynamics and Labor-MarketEquilibrium”, Journal of political Economy 76

Real wages ⇒ When workers and firms expect the price levelto rise, they will adjust nominal wages upward so that the realwage does not decrease.

The Long Run ⇒ In the long run, all wages and prices areflexible. This is called natural rate of unemployment

π = πe − ω(U − Un)





Modern Phillips Curve II





Modern Phillips Curve III

The short run and the long run :

There is a short-run trade-off between inflation andunemployment.

There is no long-run trade-off between inflation andunemployment.

1973-1979 Oil Price Shocks

oil price shock → negative supply shock

import price shock → cost-push shock

workers push wages to keep nominal wages constant

π = πe − ω(U − Un) + ρ





Modern Phillips Curve

Firms and households form their expectations about inflationby looking at past inflation.πe = π−1

π = π−1 − ω(U − Un) + ρ

Inflation expectations are formed by looking at the past andtherefore change only slowly over time. (sticky)

Negative unemployment gap (tight labor market) causes theinflation rate to rise :∆π = π − π−1 = −ω(U − Un) + ρ

U = Un : inflation stops accelerating (changing).NAIRU: non-accelerating inflation rate of unemployment





Aggregate Supply Curve I

U − Un : Unemployment gapY − Yp : Output gap

A.M. Okun (1970), ”The Political Economy of Prosperity”

Okun’s Law :

for each percentage point that output is above potential,the unemployment rate is one-half of a percentage pointbelow the natural rate of unemployment.

U − Un = −0.5× (Y − Yp)





Aggregate Supply Curve II

We get the inflation equation :

π = πe + γ(Y − Yp) + ρ

whereπe = π−1

γ : how inflation respond to the output gap

higher γ → more flexible wages (ω ↑) → steeper PC → steeper AS





The Short-Run and The Long-Run AS Curve





Shifts in AS Curve

The Short-Run : Inflation depends on inflation expectations,output gap and price shocks.

π = πe + γ(Y − Yp) + ρ

The Long-Run : Output is determined by production function.

Y = F (K , L) = AKαLβ





The relationship between the long-run and the short-runAS Curve




Monetary Policy and Aggregate DemandMonetary Policy and Interest Rate Rule

The Aggregate Demand

Y = [C + I + G + NX − (mpc × T )]× 1

1−mpc︸︷︷︸−c + d + x

1−mpcr︸︷︷︸

The equation shows how to determine aggregate output whengoods market is in equilibrium.

It shows the relationship between aggregate output and thereal interest rate when the goods market is in equilibrium.

First component of the equation explains demand shocks.

Second component of the equation explains policy shocks.





Monetary Policy

Central Banks use a very short-term interest rate as theirprimary policy tool.

The interest rate is overnight interest rate at which bankslend to each other.

We need real interest rate : r = i − πe- changes in nominal interest rate → changes in real interestrate (only if actual and expected inflation remain unchangedin the short-run)- We know prices are sticky in the short-run.

Central bank can determine the real interest rate in theshort-run.





MP Curve I

MP curve indicates the relationship between the real interestrate which central bank sets and the inflation rate.

r = r + λπ

MP has an upward slope :- Policy makers follow Taylor principle to stabilise inflation.- Interest rate is raised more than any rise in expectedinflation.- Real interest rate rise if there is a rise in inflation.





MP Curve II





The Taylor Rule I

Taylor rule was invented by John Taylor, a Stanfordeconomist, outlined the rule in his precedent-setting 1993study ”Discretion vs. Policy Rules in Practice.”

It’s a proposed guideline for how central banks should alterinterest rates in response to changes in economic conditions.

It’s a forecasting model used to determine what interest rateswill, or should, be as shifts in the economy occur.

It makes the recommendation that the central bank should- raise interest rates when inflation is high or whenemployment exceeds full employment levels.- decrease interest rate when inflation and employment levelsare low.





The Taylor Rule II

Real federal funds rate :

r = 2.0 + 0.5(π − πT ) + 0.5(Y − Y P)

Nominal federal funds rate :

i = π + 2.0 + 0.5(π − πT ) + 0.5(Y − Y P)





The Taylor Rule III

Example :

Long-term GDP growth : 2.5 %Current GDP growth : 3.5 %Inflation target : 2.0 %Current inflation : 4 %

i = 3% + 2.0% + 0.5(4%− 2%) + 0.5(3.5%− 2.5%)

6.5% = 3% + 2.0% + 0.5(2%) + 0.5(1%)





The Taylor Rule IV




The Objectives of Monetary PolicyThe Effects of PolicyTools of Monetary Policy

The Policy Objectives

There are two primary objectives:

Stabilizing economic activity

Achieving natural rate of unemployment is equivalent tostabilizing the economy.At the natural level of unemployment, the economy moves toits natural level of output, which we refer to more commonlyas potential output.Minimizing output gap: Y − Yp

Stabilizing inflation around a low level

Price stabilityMaintanig inflation (π) close to a target level (πT )Minimizing inflation gap: π − πT

Loss Function: L = α(π − πT )2 + (1− α)(Y − Y p)2





Lags and Policy Implementation

The data leg: It is the time it takes for policymakers toobtain the data that describe what is happening in theeconomy.

The recognition lag: It is the time it takes for policymakersto feel confident about the signals the data are sending aboutthe future course of the economy.

The legislative lag: It is the time it takes to get legislationpassed to implement a particular policy.

The implementation lag: It is the time it takes forpolicymakers to change policy instruments once they havedecided on a new policy.

The effectiveness lag: It is the time it takes for the policy tohave real impact on the economy.





Transmission Mechanism of Monetary Policy





Equilibrium in the Market for Reserves





Demand and Supply in the Market for Reserves

The demand for reserves

Required reserves : required reserve ratio x the amount ofdepositsExcess reserves : the additional reserves banks choose to hold.Opportunity cost of holding excess reserves is the interest rate.

The supply for reserves

Nonborrowed reserves (NBR): the amount of reserves that aresupplied by open market operations.Borrowed reserves (BR): The amount of reserves borrowedfrom the central bank.





Monetary Policy Tools

Open Market Operations

Open market purchases expand reserves and the monetarybase,increasing money supply and lowering short-term interest rates.Open market sales shrink reserves and the monetary base,decreasing money supply and raising short-term interest rates.

Discount policy

The facility at which banks can borrow reserves form thecentral bank.The central bank change the discount rate.

Reserve Requirements

Changes in reserve requirements affects the money supply bycausing the money supply multiplier to change.A rise in reserve requirements increases the demand forreserves and raises the interest rate.





The Interest Rate Corridor





Turkey data





Price Stability

Price stability is so crucial to the long-term health of aneconomy.

Low and stable inflation rates promotes economic growth inthe long-run

Inflation target gives net signals to economic agents.Risk premium of investment instruments and interest rate fallsSustainable economic growth and employment are experienced.

A central element in successful monetary policy is pricestability.





Inflation Targeting

Public announcement of medium-term numerical objectives(targets) for inflation.

An institutional commitment to price stability as the primarygoal of monetary policy and a commitment to achieving theinflation goal.

Inflation target gives net signals to economic agents.

Increased transparency of the monetary policy strategy.

Increased accountability of the central bank for attaining itsinflation objectives.





Turkey data





Pros and Cons of Inflation Targeting

Inflation targeting can reduce political pressures on the centralbank to pursue inflationary monetary policy and therebyreduce the likelihood of the time-inconsistency problem.

Inflation targeting has the advantage that it is readilyunderstood by the public and is thus highlytransparent.(communication policy)

Transparency and communication go hand in hand withincreased accountability.

Inflation targeting promotes the accountability of the centralbank to elected officials.

Inflation targeting countries seem to have significantlyreduced both the rate of inflation and inflation expectations.

’Inflation nutter’ polices lead to large output fluctuations.





Prerequisites for The Inflation Targeting Regime

Strict commitment to price stability

Independent, accountable and reliable the central bank

Strong and advanced financial markets

Low fiscal dominance

Providing technical infrastructure





Implementation of Inflation Targeting

Target setting (central bank / government)

Target variable (CPI / core inflation)

Point or band target

Target horizon

Decision-making mechanism

Accountability

Communication policy


Monetary Economics Introduction · 2018. 10. 2. · Bilgin Bari Monetary Economics Introduction....

Documents

Transcript of Monetary Economics Introduction · 2018. 10. 2. · Bilgin Bari Monetary Economics Introduction....