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 • Increa by po6734

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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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