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Modern Monetary Policy &
Aggregate Demand
Chapter 20, 21
Inflation and Demand
• Assume that monetary policy did not adjust
to inflation so that money growth did not
respond to inflation.
• Increasing inflation and constant money
growth results in a reduction in real
balances. M
Real Balances
P
• Ability to purchase real goods depends on
real balances and velocity. Given velocity,
higher inflation means lower demand for
goods.
Negative Relationship between inflation and
demand for goods
π
AD
Y
Monetary Policy and Aggregate
Demand
• Monetary policy is about shaping the
relationship between inflation and the
demand for goods, indeed, making demand
for goods more sensitive to inflation.
• Main tool is a monetary policy that allows
interest rates to adjust to inflation.
Monetary policy and real interest rates
• Nominal interest rates are equal to real
interest rates plus expected inflation.
• Inflationary expectations change only
slowly.
• Rises in nominal interest rates translate
into changes in the real interest rate.
• In long run, inflation expectations reflect
actual inflation so real interest rate cannot
be maintained above the natural rate of
interest
Real Interest Rates and Demand
• Components of aggregate demand are
sensitive to the real interest rate in a
negative way.
– Consumer Durables
– Residential Housing
– Corporate Investment
• High interest rates means an exchange
rate appreciation which hurts the trade
balance.
Potential Output
• Potential output is not the maximum output
possible for a country.
• Potential output is the level of production
when supply and demand are in equilibrium
in labor market.
– When output is higher than potential, it is
because real labor costs/real wages are low so
there is excess demand for labor.
• Market forces will push wages up!
– When output is lower than potential, real wages
are high so labor is in excess supply.
• Market forces will push wages down!
Aggregate Supply in Labor Market
π
Excess Excess
Supply in Demand In
Labor Market Labor Market
•Downward •Upward
Pressure on Pressure on
Wages Wages
Y
YP
Natural rate of interest
• Demand for goods is a negative function
of real interest rate.
• The natural interest rate is the real
interest rate at which demand for goods is
set at potential output.
• Potential output is determined by:
– Size of workforce
– Value of Physical plant and equipment
– Level of technological sophistication
Monetary Policy Committee
The central bank will try to stabilize the price
level using their interest rate target.
• If inflation is above inflation target, πTGT,
Central bank will raise interest rate &
engage in open market purchase.
• If inflation is below inflation target, πTGT,
central bank will cut interest rate & engage
in open market sale
Monetary Policy Reaction Curve
• Real interest • r* - Natural real interest target
rate is an πTGT - Target inflation rate
increasing
function of the
interest rate
rt r b t
* TGT
Positive Relationship between inflation and real
interest rate
r MPR
r*
π
πTGT
Taylor Rule as MPR
• U.S. Federal Reserve Interest Rate Target
itTGT r * t 1 2 ( t TGT ) ....
• Inflation Forecasts Adapt to Current Realities
E
t 1 t rt it E
t 1 it t
i TGT
t t rt r * 2 ( t
1 TGT
) ....
Change in Monetary Policy: A rise in the
inflation target will shift the MPR out.
r
MPR′
r*
MPR
π
πTGT πTGT′
Inflation and Demand
• The reaction of monetary policy to inflation
exacerbates the effect of inflation on AD.
Increasing π→Increasing r → Decreasing AD
• The more sharply that monetary policy
responds to inflation, the more sharply
demand responds to inflation.
Relationship between inflation and aggregate
demand depends on how sensitive MPC is to inflation
Sensitive π
r Insensitive
MPR
MPR
Insensitive
MPR
Sensitive
MPR
π Y
Under fixed exchange rate, domestic interest rate &
demand may be insensitive to domestic inflation
Sensitive π
r
MPR Fixed S
AD
Fixed S
MPR
Sensitive
AD
π Y
Shifting Demand
1. Business Cycle Shocks
• Various events may shift demand out for
goods at any given interest rate
– Household consumption may increase because
of optimism or wealth effect
– Corporate investment may increase because of
optimism
– Government Deficit Spending
• If long-lasting, these will 1) shift out demand
and 2) raise the natural rate of interest.
Rise in Household-Business Confidence\Stock-Real
Estate Market Booms\Expansionary Fiscal policy The
AD Curve Shifts Out
π AD'
AD
Y
Inflation Persistence
• Premise of business cycle theory is that prices of
goods do not respond quickly to macroeconomic
events.
• Firms choose pricing strategies and it is time
consuming to change them frequently.
• In the short-run, inflation does not respond to
changes in demand.
• In the long-run, pricing strategies will respond to
changes in cost.
Aggregate Supply
Short-run & Long Run
π •Downward •Upward
Pressure Pressure
On Inflation On Inflation
SRAS
Y
YP
Business Cycles
• Demand fluctuates due to events including
waves of optimism and pessimism that
affect household and business confidence.
• At any point in time, the level of demand
will be away from potential output.
– If demand is below potential, the economy is
in a recession, high unemployment will put
downward pressure on wage growth and
ultimately inflation.
– If is above potential the economy is in an
expansion and upward pressure on wage
growth will put pressure on inflation
Recession Short –run
Demand Shifts Down
π
YP
1
2 SRAS
AD
AD′
Y
Recessionary Output Gap
Expansion Short –run
Demand Shifts Up
π
YP
1 2
SRAS
AD′
AD
Y
Inflationary Output Gap
Recession Medium–run
Inflation Declines, Central Bank Cuts Interest Target
π
YP
2 1
SRAS
3
AD
AD′
Y
Gap Closing
Expansion Medium –run
Inflation Begins to Accelerate
π
YP
3
1 2 SRAS
AD′
AD
Y
Inflationary Output Gap
Role of MPR Curve
• The more sensitive is the monetary policy
committee, the flatter is the aggregate
demand curve.
• The flatter the aggregate demand curve,
the less that inflation will need to decline to
return the economy to potential output.
YP
π SRAS
Will take longer for
AD
disinflation to end
Sensitive
recession if MPR is
insensitive AD
Insensitive Y
Inflation Targeting:
Inflation Sensitive Interest Rate Rule
• Under inflation targeting, central bank is
sensitive to the inflation rate in setting the
interest rate, raising interest rates in response to
increasing inflation, cutting interest rates
• A benefit of this approach is not only stable
inflation and inflation expectations, but also
more stability of output and shorter duration
business cycles in the face of demand shocks.
The Great Moderation
•The Great Moderation by Federal Reserve Bank of Dallas
Supply Shocks
• Inflation itself may be subject to cost-push
shocks such as energy prices etc.
• A monetary policy committee which strives
to maintain a fixed inflation target with a
very sensitive MPR will face a relatively
large decline in output to maintain the
target.
• Central bank often adjusts the inflation
target to supply side conditions
Supply Shock
Stagflation
π
YP
SRAS′
2
1
SRAS
AD′
AD
Y
Inflationary Output Gap
B A
YP
π SRAS
AD
Sensitive
AD
Insensitive Y
Supply Shock
Adjusting the Interest Target
π
YP
3 SRAS′
2
1 SRAS
AD′
AD
Y
Inflationary Output Gap
An MPR for HK
• Remember in HK, the nominal interest rate
is equal to the US$ interest rate.
• Again, assume that inflation expectations
respond to actual inflation
E
t 1 t rt HK
it
HK
E,
HK ,t 1
rt HK
r t
US
USA
t t
HK
• In HK, as inflation rises, real interest rate
falls!
Negative Relationship between inflation and real
interest rate with fixed exchange rates
r
MPRHK
π
Shifting HK’s MPR
1. An increase in US interest rate will
increase HK real interest rate at every
level of interest.
2. An increase in expected depreciation
rate will increase nominal & real interest
rate at every level of inflation.
rt HK itUS t 1 HK ,t 1
E,
rt HK
r
t
US
t 1 USA
t t
HK
Shifting Demand
Monetary Policy and Hong Kong
• Change in the Expected Depreciation Rate
If the market expects a future depreciation,
economy’s interest rates will rise.
• Change in the US Interest Rate In the case
of a fixed exchange rate, an increase in the
US interest rate will raise the local rate.
Rise in Target Inflation/Cut in Anchor Rate/Cut in
US Rate (in HK): The AD Curve Shifts Out
π
AD'
AD
Y
Closed Book Midterm
• Date: Tuesday, October 21st , 2008.
• Time: Normal class time 1:30 PM through 2:50
AM.
• Place: Room 4619
• Bring: Calculator, Writing Instruments
• Lectures through October 16th.
• Office Hours
– Tuesday, October 14th , 3 to 4.
– Friday: October 17th, 9 to 11
– Monday October 20th 9 to 11
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