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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