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Transcript of Week 10_SII2013 [Compatibility Mode].pdf
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Monetary Policyand thePhillips Curve
Chapter 12
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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.
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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
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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.
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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.
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Overnight Cash Rate and Other
Interest Rates
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From Nominal to Real Interest Rates
The relationship between the interestrates is given by the Fisher equation.
Nominalinterestrate
Realinterestrate
Rate ofinflation
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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.
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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
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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:
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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.
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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.
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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.
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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.
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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.
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Expected inflation
The inflation rate firms think will prevail inthe economy over the coming year.
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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.
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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
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Using the equations:
Therefore, the Phillips curve can be expressed as:
Change in
inflation
The parameter measureshow sensitive inflation is
to demand conditions.
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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.
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Later critiques
Stimulating the economy would raise output
temporarily
Firms will build high inflation into their pricechanges
Output will return to potential.
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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:
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The actual rate of inflation now depends
on three things:
Rewrite again:
Expected rate
of inflation
Adjustment
factor for stateof economy
Shock to
inflation
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Oil price shock
The price of oil rises
Results in a temporary upward shift in thePhillips curve
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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.
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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?
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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.
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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.
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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.
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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
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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.
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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
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The Short-Run Model in a Nutshell
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12.5 Microfoundations:
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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.
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How does inflation move?
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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
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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
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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
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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.
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The demand for money
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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
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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.
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1hy itinstead o! M
t2
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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
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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
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12.7 Inside the Federal Reserve
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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
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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
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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.
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The Phillips curve
Reflects the price setting behavior of
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Reflects the price-setting behavior of
individual firms
Expected rateof inflation
Currentdemandconditions
Shocks toinflation
The Phillips curve can also be written as:
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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.
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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
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