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8/30/2009 What is the difference between rules ECON 206 and discretion? MACROECONOMIC ANALYSIS • Rules mean set-in-stone reactions: For example, if inflation goes up, the Fed will raise interest rates • Discretion means nothing is set for sure: If the Fed feels that an increase in inflation is OK, maybe because it is caused by more p growth than normal, it might not act rapid g , g Roumen Vesselinov • Rules are clearly easier to implement and understand, and more importantly, rules may also help produce more macroeconomic stability Chapter # 12a • Why might this happen? People’s expectations are important, and the effectiveness of discretionary policy may be weakened if people expect it — which they should if policymakers use it a lot — so a rule might be better • We’ll discuss this more in the next class Let’s imagine that the Fed follows a simple rule between inflation and the real interest rate Aggregate Supply & • Whenever inflation gets too high above some standard Aggregate Demand acceptable level, , then the Fed will raise the real interest rate, Rt, above the marginal product of capital, • The Fed then sets the difference between Rt and based on the difference between and : • This means that if and inflation is 0.02 or 2% above its long-run acceptable level, then the Fed will raise the real Chapter 12 (1 of 2) interest rate by 0.01 or 1% above the marginal product of capital • Supposing the Fed followed this rule, what does the IS-MP-PC framework, our short-run model, imply about economic activity? Our objectives today This monetary policy rule allows us to combine the IS and MP curves into an Aggregate Demand Curve • So far, we have thought of monetary policy as a reaction • The IS Curve relates short-run output to the difference to particular events with the IS-MP-PC model between the real interest rate and the marginal product of capital (MPK): • Today, we consider systematic use of monetary policy, through rules, to stabilize the economy through all kinds events of events, rather than case-by-case • yp y The monetary policy rule relates the difference between the real interest rate and the MPK to the difference between • When monetary policy is rule-based, we can view the IS actual and desired long-run inflation: Curve and MP Curve together as Aggregate Demand, • Combining these together, by substituting for , gives • While the Phillips Curve is Aggregate Supply us an equation in output and inflation: • Why do this? It gets us to output and inflation quicker This is the Aggregate Demand Curve 1 8/30/2009 The Aggregate Demand Curve relates short-run output and inflation What is equilibrium or steady state in this model? •How does this look? •For there to be a steady state, inflation must be •It’s a downward sloping steady at: Inflation, πt line, just like all demand Inflation, πt curves! Inflation is like the price, and short-run •Since we know inflation output the quantity is steady, and there are no shocks, then we also •The reason this know from the Aggregate relationship exists is because the Fed is AS Supply (Phillips) Curve that short-run output is following a monetary zero in the steady state: policy rule: •When inflation is higher than normal, the Fed , raises interest rates (not shown) and thus reduces •So Aggregate Supply and AD output AD Demand intersect at this •Note that is the point intercept and thus also ’ 0 Short-run output, the shock shifting AD 0 Short-run output, What determines the slope of Aggregate Demand? Why have we developed this framework? •We have two parameters that multiply • Aggregate Supply and Aggregate Demand allow us to quickly ascertain how macroeconomic events will affect output and Inflation, πt •When , their inflation product, is large, then deviations in inflation,πt, • IS-MP-PC is underneath it all, but sometimes we don’t really care away from its long-run level will produce big about the real interest rate — so it’s like we’re fast-forwarding swings in short-run ahead to the good part output • T review: Why does A To i Wh d Aggregate D t Demand slope d d l ? down? •That means that an increase in either one • The Fed raises interest rates when inflation increases, to lower short-run makes AD flatter output and pull inflation back down • is high if the Fed • So higher inflation is associated with lower output: AD slopes down raises interest rates a lot • Shocks to demand will shift the curve when inflation rises, • • And: Why does Aggregate Supply slope up? AD is high if investment declines a lot when • Firms set their prices relative to demand conditions interest rates rise • So higher output is associated with higher inflation: AS slopes up 0 Short-run output, • Shocks to inflation shift the curve Next: We will use the AS/AD model to What about an Aggregate Supply Curve? predict macroeconomic behavior •It turns out we already have an Aggregate Supply Curve • We’ll describe what happens to output and inflation over Inflation, πt time following macroeconomic events like oil shocks and •The Phillips Curve tells us demand shocks using Aggregate Supply and Aggregate how firms behave in setting their prices relative to how Demand AS’ they perceive demand — πt rises when demand is • Shocks will initially shift either AS or AD (or both together) ’ AS higher: upward sloping • W ’ll pay special attention t A We’ll i l tt ti to Aggregate Supply, which will t S l hi h ill •When output is equal to move slowly over time to achieve a steady state where potential, , and inflation is equal to what it inflation is stable and the output gap is zero: was last period: • To see how AS responds, it might help to write it as •An increase in inflation means πt–1 becomes instead of πt–1’ > πt–1. Aggregate Supply must start shifting upward With ∆πt in the equation, you can see that πt increases when 0 is positive, so AS must be shifting up Short-run output, 2 8/30/2009 Ex.#1: Suppose the price of oil spikes up and Let’s review the time path of output and produces an inflation shock inflation after this oil price shock •The math of this is that the parameter in AS •Before the oil price Inflation, πt increases from zero: Inflation, πt shock hits, inflation is stable and output is AS’ •What happens to AS? growing at potential • It shifts upward: at •When the oil shock hits, Aggregate Supply shifts every level of output, up, immediately raising AS inflation is higher i fl ti i now hi h inflation and lowering •The economy short-run output below ’ immediately jumps to a time, t potential new temporary Short-run output, equilibrium at a lower •Since output is below level of short-run output potential, firms set their and a higher level of prices lower, reducing inflation 0 inflation; Aggregate AD •It turns out that’s only Supply slowly shifts down, increasing short- the short-run effect; what run output back to zero happens next? ’ 0 Short-run output, time, t After the oil shock subsides, inflation expectations update slowly, and AS will slowly shift back •We can see from the Inflation, πt Aggregate Supply curve that inflation stays high because it was high last Next time AS’ period, even though the shock subsides and AS’’ decreased output pulls it AS down: • Finishing up Chapter 12 ’ Now higher Now zero • Rules versus discretion: when and how ” Now negative (lower) should authorities act to smooth •So next, AS shifts temporary fluctuations down but not all the way •Inflation falls a little AD while output increases •Another perspective: ’ ”0 Short-run output, But we are still not yet back to the steady state, so the whole process repeats itself, with AS shifting slowly •The same logic applies: Inflation, πt even with no oil shock this period, and with AS’ output below potential AS’’ pulling inflation down, inflation will still remain above its long run level, AS ith d l t with gradual steps b k back toward steady state ” •The steps get smaller and smaller as the economy nears steady state ... •Sound familiar? This is AD like the Solow Model •An oil shock takes a while to dissipate! ”0 Short-run output, 3