12.1 Introduction The MP Curve: Monetary Policy and the Interest Rates 1/24/2013. Monetary Policy and the Phillips Curve

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1 Chapter 12 Monetary Policy and the Phillips Curve By Charles I. Jones Media Slides Created By Dave Brown Penn State University 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 of 12.1 Introduction In this chapter, we learn: How the central bank effectively sets the real interest rate 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 their prices over time, pinning down the rate. How the IS curve, the MP curve, and the Phillips curve make up our short-run model. How to analyze the evolution of the macroeconomy in response to changes in policy or economic shocks. The federal funds rate The interest rate paid from one bank to another for overnight loans The monetary policy (MP) curve Describes how the central bank sets the nominal interest rate 12.2 The MP Curve: Monetary Policy and the Interest Rates Large banks and financial institutions borrow from each other. Central banks set the nominal interest rate by stating what they are willing to lend or borrow at the specified rate. 1

2 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 lend it back to the central bank at a higher rate. This is called the arbitrage opportunity. Thus, banks must exactly match the rate the central bank is willing to lend at. The sticky assumption The rate of displays inertia, or stickiness, so that it adjusts slowly over time. In the very short run the rate of does not respond directly to monetary policy. Central banks have the ability to set the real interest rate in the short run. Case Study: Ex Ante and Ex Post Real Interest Rates A sophisticated version of the Fisher equation replaces the rate with the expected rate of. Expected rate of From Nominal to Real Interest Rates The relationship between the interest rates is given by the Fisher equation. Using the expected rate of gives an ex ante real interest rate: The ex ante real interest rate is relevant for investment decisions. Nominal interest rate Real interest rate Rate of Once is known, we can calculate the ex post interest rate: 2

3 The IS-MP Diagram The MP curve Illustrates the central bank s ability to set the real interest rate Central banks set the real interest rate at a particular value. The MP curve is a horizontal line. Example: The End of a Housing Bubble 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 nominal interest rate in response: The real interest rate falls as well because is sticky. If judged correctly and without lag, the economy would not have a decline in output. 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 rate above the MPK Inflation is slow to adjust. The real interest rate rises. Investment falls. 3

4 Case Study: The Term Structure of Interest Rates The term structure of interest rates The different period lengths for interest rates It should be the case that interest rates on investments of different lengths of times will yield the same return. If not, everyone would switch investment to the one with a higher return. Expected The rate firms think will prevail in the economy over the coming year. Interest rates at long maturities are equal to an average of the short-term rate investors expect in the future Firms expect next year s rate to be the same as this year s rate. 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. Under adaptive expectations firms adjust their forecasts of slowly. Expected embodies the sticky assumption The Phillips Curve The Phillips curve Describes how evolves over time as a function of short-run output Recall the rate is the percent change in the overall price level. Firms set their prices on the basis of Their expectations of the economy-wide rate The state of demand for their product. This year s Last year s 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 4

5 Later critiques Stimulating the economy would raise output temporarily Firms will build high into their price changes Output will return to potential. Using the equations: Price Shocks and the Phillips Curve Change in Therefore, the Phillips curve can be expressed as: We can add shocks to the Phillips curve to account for temporary increases in the price of : The parameter measures how sensitive is to demand conditions. Case Study: A Brief History of the Phillips Curve The actual rate of now depends on three things: Originally The Phillips curve showed a relationship between the level of and economic activity. Low implied low output. Expected rate of Rewrite again: Adjustment factor for state of economy Shock to 5

6 Oil price shock The price of oil rises Results in a temporary upward shift in the Phillips curve Case Study: The Phillips Curve and the Quantity Theory An increase in the growth rate of real GDP would reduce. The Phillips curve, however, seems to say a booming economy causes the rate of to increase. Which one is correct? The quantity theory Long-run model An increase in real GDP reflects an increase in the supply of goods, which lowers prices. The Phillips curve Part of our short-run model An increase in short-run output reflects an increase in the demand for goods. Cost-Push and Demand-Pull Inflation Price shocks to an input in production Cost-push Tends to push the rate up The effect of short-run output on in the Phillips curve Demand-pull Increases in aggregate demand pull up the rate Using the Short-Run Model Dis Sustained reduction of to a stable lower rate The Great Inflation of the 1970s Misinterpreting the productivity slowdown contributed to rising. 6

7 The Volcker Dis Reducing the level of requires a sharp reduction in the rate of money growth a tight monetary policy. Because of the stickiness of The classical dichotomy is unlikely to hold exactly in the short run. Just a reduction in the rate of money growth may not slow immediately. Thus, the real interest rate must increase to induce a recession. The recession causes to become negative. As demand falls firms raise their prices less aggressively to sell more. Lowering the rate Can create the cost of a slumping economy High unemployment and lost output Once has declined sufficiently Real interest rate can be raised back to MP K Allowing output to rise back to potential 7

8 3. The Federal Reserve did not have perfect information. Thought the productivity slowdown was a recession it was actually a change in potential output. The Fed lowered interest rates in response to what they perceived was a demand shock. which increased output above potential generated more The Great Inflation of the 1970s Inflation rose in the 1970s for three reasons: 1. OPEC coordinated oil price increases. Oil shock as shown in the model 2. The U.S. monetary policy was too loose. The conventional wisdom was that reducing required permanent increases in employment. In reality, dis requires only a temporary recession. The Short-Run Model in a Nutshell 8

9 Case Study: The 2001 Recession The recession of 2001 had a jobless recovery. Even after the return of strong GDP, employment continued to fall. This is an exception to Okun s law. The Classical Dichotomy in the Short Run How to make the classical dichotomy hold at all points in time? All prices, including wages and rental prices, must adjust in the same proportion immediately. Reasons that the classical dichotomy fails in the short run: Imperfect information Costs of setting prices Contracts also set prices and wages in nominal rather than real terms Microfoundations: Understanding Sticky Inflation The short run model Changes in the nominal interest rate affect the real interest rate. The classical dichotomy Changes in nominal variables have only nominal effects on the economy. If monetary policy affects real variables, the classical dichotomy fails in the short run. There are bargaining costs to negotiating prices and wages. Social norms and money illusions Cause concerns about whether the nominal wage should decline as a matter of fairness Money illusion The idea that people sometimes focus on nominal rather than real magnitudes 9

10 Case Study: The Lender of Last Resort Central banks ensure a sound, stable financial system by: Making sure banks abide by certain rules Including the maintenance of a certain amount of reserves to be held on hand 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 than its equilibrium level Households hold their wealth in savings rather than currency. The nominal interest rate falls. 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 Central Banks Control Nominal Interest Rates The central bank controls the level of the nominal 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 The demand for money Is a decreasing function of the nominal interest rate Is downward sloping Higher interest rates reduce the demand for money. The supply of money Is a vertical line for the level of money the central bank provides 10

11 Changing the Interest Rate 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 accounts reduces excess demand. The markets adjust to a new equilibrium. The money supply schedule is effectively horizontal 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 Why i t instead of M t? The interest rate is crucial even when central banks focus on the money supply. The money demand curve is subject to many 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 12.7 Inside the Federal Reserve Conventional Monetary Policy 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 11

12 Open-Market Operations: How the Fed Controls the Money Supply Open-market operations The central bank trades interest-bearing government bonds in exchange for currency or non-interest bearing reserves. To increase the money supply, the Fed sells government bonds in exchange for currency or reserves. The price at which the bond sells determines the nominal interest rate Conclusion Policymakers exploit the stickiness of. Changes in the nominal interest rate change the real interest rate. Through the Phillips curve booms and recessions alter the evolution of. Because evolves gradually, the only way to reduce it is to slow the economy. The Phillips curve Reflects the price-setting behavior of individual firms Expected rate of Current demand conditions Shocks to Summary The short-run model IS curve MP curve Phillips curve Central banks set the nominal interest rate. The IS-MP diagram allows us to study the consequences of monetary policy and shocks to the economy for short-run output. The Phillips curve can also be written as: This equation shows that in order to reduce, actual output must be reduced below potential temporarily. The Volcker dis of the 1980s is the classic example illustrating this mechanism. 12

13 Three important causes contributed to the Great Inflation of the 1970s: The oil shocks of 1974 and 1979 The mistaken view that reducing required a permanent reduction in output The fact that the productivity slowdown was initially interpreted as a recession Central banks control short-term interest rates by their willingness to supply whatever money is demanded at a particular rate. Long-term rates are an average of current and expected future short-term rates. This structure allows changes in short-term rates to affect long-term rates. This concludes the Lecture Slide Set for Chapter 12 Additional Figures for Worked Exercises Macroeconomics Second Edition by Charles I. Jones W. W. Norton & Company Independent Publishers Since

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