Capital prices & Monetary PoliciesReal estate pricesStock prices

InflationMonetary policies

The Model of Aggregate Demand and Aggregate SupplyP

Y

AD

SRAS

P1

Y1

The price level

Real GDP, the quantity of

output

The model determines the eq’m price level

and eq’m output (real GDP).

“ Aggregate

Demand”

“ Short-Run

Aggregate Supply”

The Aggregate-Demand (AD) Curve

The AD curve shows the quantity of all g&s demanded in the economy at any given price level.

P

Y

AD

P1

Y1

P2

Y2

Why the AD Curve Slopes DownwardY = C + I + G + NX

Assume G fixed by govt policy.

To understand the slope of AD, must determine how a change in P affects C, I, and NX.

P

Y

AD

P1

Y1

P2

Y2 Y1

The Wealth Effect (P and C )Suppose P rises.

The dollars people hold buy fewer g&s, so real wealth is lower.

People feel poorer.

Result: C falls.

The Interest-Rate Effect (P and I )

Suppose P rises. Buying g&s requires more dollars. To get these dollars, people sell bonds or

other assets.This drives up interest rates. Result: I falls.

(Recall, I depends negatively on interest rates.)

The Exchange-Rate Effect (P and NX )

Suppose P rises. U.S. interest rates rise (the interest-rate

effect).Foreign investors desire more U.S. bonds.Higher demand for $ in foreign exchange

market.U.S. exchange rate appreciates. U.S. exports more expensive to people abroad,

imports cheaper to U.S. residents.Result: NX falls.

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The Slope of the AD Curve: SummaryAn increase in P reduces the quantity of g&s demanded because:

P

Y

AD

P1

Y1

•the wealth effect (C falls)

P2

Y2

•the interest-rate effect (I falls)•the exchange-rate effect (NX falls)

Why the AD Curve Might ShiftAny event that changes C, I, G, or NX

– except a change in P – will shift the AD curve.

Example: A stock market boom makes households feel wealthier, C rises, the AD curve shifts right.

P

Y

AD1

AD2

Y2

P1

Y1

Why the AD Curve Might Shift

Changes in CStock market boom/crash Preferences re: consumption/saving tradeoffTax hikes/cuts

Changes in IFirms buy new computers, equipment,

factoriesExpectations, optimism/pessimismInterest rates, monetary policyInvestment Tax Credit or other tax incentives

Why the AD Curve Might Shift

Changes in GFederal spending, e.g. defense State & local spending, e.g. roads, schools

Changes in NXBooms/recessions in countries that buy our

exports.Appreciation/depreciation resulting from

international speculation in foreign exchange market

Short Run Aggregate Supply (SRAS)

The SRAS curve is upward sloping:Over the period of 1-2 years, an increase in P

P

Y

SRAS

causes an increase in the quantity of g & s supplied.

Y2

P1

Y1

P2

Why the Slope of SRAS Matters

If AS is vertical, fluctuations in AD do not cause fluctuations in output or employment.

P

Y

AD1

SRAS

LRAS

ADh

i

ADl

oY1

If AS slopes up, then shifts in AD

do affect output and employment.

Plo

Ylo

Phi

Yhi

Phi

Plo

The Aggregate-Supply (AS) CurvesThe AS curve shows the total quantity of g&s firms produce and sell at any given price level.

P

Y

SRAS

LRAS

AS is:

upward-sloping in short run

vertical in long run

The Long-Run Aggregate-Supply Curve (LRAS)

The natural rate of output (YN) is the

amount of output the economy produces when unemployment is at its natural rate.

YN is also called

potential output or full-employment output.

P

Y

LRAS

YN

Why LRAS Is VerticalYN determined by the economy’s stocks of labor, capital, and natural resources, and on the level of technology.

An increase in P

P

Y

LRAS

P1

does not affect any of these, so it does not affect YN.

(Classical dichotomy)

P2

YN

Why the LRAS Curve Might Shift

Any event that changes any of the determinants of YN

will shift LRAS.

Example: Immigration increases L, causing YN to rise.

P

Y

LRAS1

YN

LRAS2

YN’

Why the LRAS Curve Might ShiftChanges in L or natural rate of

unemploymentImmigration Baby-boomers retireGovt policies reduce natural u-rate

Changes in K or HInvestment in factories, equipmentMore people get college degreesFactories destroyed by a hurricane

Why the LRAS Curve Might ShiftChanges in natural resources

discovery of new mineral depositsreduction in supply of imported oilchanging weather patterns that affect

agricultural productionChanges in technology

productivity improvements from technological progress

LRAS1980

Depict LR Growth and Inflation

Over the long run, tech. progress shifts LRAS to the right

P

Y

AD1990

LRAS1990

AD198

0Y1990

and growth in the money supply shifts AD to the right.

Y1980

AD2000

LRAS2000

Y2000

P1980Result: ongoing inflation and growth in output.

P1990

P2000

AA CC TT II VV E LE L EE AA RR NN II NN G G 11: : ExerciseExerciseDraw the AD-SRAS-LRAS diagram

for the U.S. economy, starting in a long-run equilibrium.

A boom occurs in Canada. Use your diagram to determine the SR and LR effects on U.S. GDP, the price level, and unemployment.

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AA CC TT II VV E LE L EE AA RR NN II NN G G 11: : AnswersAnswers

23

LRAS

YN

P

Y

AD2

SRAS2

AD1

SRAS1

P1

P3 C

P2

Y2

B

A

Event: boom in Canada

1. affects NX, AD curve

2. shifts AD right

3. SR eq’m at point B. P and Y higher,unemp lower

4. Over time, PE rises, SRAS shifts left,until LR eq’m at C.Y and unemp back at initial levels.

What cause inflation ?P

Y

SRAD

SRAS

The Effects of increasing the Money Supply

Y

P

M

Interest rate

AD1

MS1

MD

P1

Y1

r1

MS2

r2

AD2Y2

The Fed can decrease r by increasing the money supply.

An decrease in r increase the quantity of g&s demanded.

Money growth and inflationEquilibrium in the money market

M-Money stock, P-Price level, i-Nominal interest rate

Y-Real income , L(.) the demand for real money balances

,ML i Y

P

( , )

MP

L i Y

(1)

(2)

Money Growth and Inflation

Infl

atio

n

(%)

Money supply growth (%)

Money Growth and Interest RatesAssume Y and r are constant at andPrices are complete flexible

Y r

ei r Fisher Identity

(3)

( , )e

MP

L r Y

(4)

is constant, an increase in money supply at time /M P

0t

0t

lnM

e

i

ln( / )M P

0t

ln P

Nominal & Real money stock

ei

Lesson: At the time when there is sudden increase in money supply, inflation exceeds the rate of M does.

lnM

ln( / )M P

The case of incomplete price flexibilityLiquidity effect: the negative effect of

monetary expansions on nominal rates

Y

i

IS

LM 1. The decline in real

interest rate exceeds the increase in expected inflation in the short run . 2. If prices are fully flexible in the long run, the real rate eventually returns to the normal following a shift to higher money growth.

Expectations theory of the term structure: the standard theory of the relationship described above.

An InvestorA bond with continuously compounded rates

of return

Puts the dollar into a sequence of 1-period bonds paying continuously compound rates of return of

over the n periods

exp( )ntni

1 1 11 1, ,.....,t t t ni i i

1 1 11 1exp( ..... )t t t ni i i

Expectations theory of the term structure With certainty

With uncertainty

1 1 11 1.....n t t t n

t

i i ii

n

1 1 11 1.....n t t t t t n

t nt

i E i E ii

n

The changes in the term structure are determined by changes in expectations of future interest rates (rather than by changes in the term premium).

Empirical Application: The response of the term structure to changes in the Federal Reserve’s Federal-Funds-Rate Target Cook and Hahn (1989)

Aim of the study: investigate monetary policy’s impact on interest rates on bonds of different maturities

Study period: 1974-79, when the Federal Reserve was targeting the funds rate

Data: a record of the changes in the Federal Reserve’s target over this period

Data source: Federal Reserve Bank of New York and the reports of the changes in the Wall Street Journal

Cook and Hahn (1989) Cont.Finding 1: the actual funds rate moves

closely with the Federal Reserve’s targetExamine the impact of changes in the Federal

Reserve’s target on longer-term interest rates

is the change in the nominal interest rate on a bond of maturity i on day t

is the change in the target Federal funds rate on that day

1 2i i i it t tR b b FF u

itR

tFF

Cook and Hahn (1989) Cont.Finding 2: The increase in the Federal-funds-

rate target raise nominal interest rates at all horizons100 basis points in FF 55 basis points in 3 month interest

rate 50 basis points in 1 year interest rate 21 basis points in 5 year interest rate 10 basis points in 20 year interest rate

Cook and Hahn (1989) Cont.Assumption from the expectation theory of

the term structure of interest rate : Contractionary monetary policy should immediately lower long-term nominal interest rates

Findings: OppositeWhy?

C. Romer and D. Romer(2000)

is actual inflation, and are the

commercial and Federal reserve forecasts for Finding: is close to one, significant; is

near 0, insignificant.

C F

t tt C F ta b b e

t Ct

t Ft

Fb Cb

C. Romer and D. Romer(2000) Cont.

P is the change in the Federal-funds-rate target.

is estimated around 0.25, but not very precise.

F C

t tt tP

The dynamic inconsistency of low-inflation monetary policyThe increase in the money supply does not

affect long-term outputHowever, it affects short-term output The government has the incentive to deviate

from the expected inflation to push output above its normal level.

If the game continues, people will form a new higher expected inflation in the following periods. Then the higher inflation will not affect the output level.

The dynamic inconsistency of low-inflation monetary policyIn theory, if the public is aware of the

difference, there is no reason for output to behave differently under the low-inflation policy than under the high inflation policy.

Kydland and Prescott(1977): the inability of policymakers to commit themselves to such a low-inflation policy can give rise to excessive inflation despite the absence of a long-run tradeoff.

Addressing the dynamic inconsistency problemA commitment rule

Normative problem Positive problem

ReputationDelegation

Empirical Application: Central-bank independence and inflation Finding: Independence and inflation is

negative correlated among industrialized countriesThe prediction of delegate theory: NoNot sure whether independence is the source

of the low inflation

AA CC TT II VV E LE L EE AA RR NN II NN G G 22: : ExerciseExercisePage 525Problems No. 10.5Policy rules, rational expectations, and

regime changesLucas 1976 , (page 612 for reference),

Sargent 1983, , (page 621 for reference),

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