zero lower bound econ 191: monetary policy at the zero ...€¦ · or not, rms ask: \will this...

$Page 1: Zero Lower Bound Econ 191: Monetary Policy at the Zero ...€¦ · or not, rms ask: \will this project yield a return greater than the real interest rate (r)?" Econ 191: Monetary$

Econ 191:Monetary

Policy at theZero Lower

BoundPreparatorylecture for

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Econ 191:Monetary Policy at the Zero Lower Bound

Preparatory lecture for Prof. David Romer

Issi Romem

March 20, 2012

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Introduction

The central bank plays an important role in dampeningbusiness cycles:

Raising the interest rate when output above its naturalrate ⇒ bring production back down to “normal” capacity,and prevent escalating inflation.

Lowering the interest rate when output below its naturalrate ⇒ stimulate production, and prevent deflation anddepression.

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Introduction

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Introduction

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Introduction

The nominal interest rate cannot be negative ⇒ the centralbank cannot stimulate the economy when interests rates arealready low.

This situation is known as the liquidity trap, and is veryrelevant today.

Next lecture Prof. Romer will discuss the liquidity trap.Today’s lecture will give us the necessary background.

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Introduction

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Introduction

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Introduction

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Introduction

Today’s lecture:

Output (and interest) in the short-run - the IS-MPmodel.

The Keynesian Cross and the IS curve.The central bank and the MP curve.Analysis using the IS-MP model.The central bank’s control of the interest rate.

Output and inflation in the medium-run - extendingthe model to include aggregate supply.

Extending the model.Changes on the aggregate demand side of the economy.Changes on the aggregate supply side of the economy.

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Introduction

Today’s lecture:

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Introduction

Today’s lecture:

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Sources

The slides on the Keynesian Cross and the IS curve arebased on section 10.1 of Mankiw’s ”Macroeconomics”textbook (2007 edition).

The remainder of the slides are based on the Prof.Romer’s notes titled “Short-Run Fluctuations”, which ison the syllabus.

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Sources

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Sources

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

The Keynesian Cross

The Keynesian Cross underlies the IS curve in the IS-MPmodel.

Assumption: E = C + I + G

E - Planned expenditure.

C - Consumption (consumers).

I - Investment (producers).

G - Government expenditure.

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

The Keynesian Cross

The Keynesian Cross underlies the IS curve in the IS-MPmodel.

Assumption: E = C + I + G

E - Planned expenditure.

C - Consumption (consumers).

I - Investment (producers).

G - Government expenditure.

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

The Keynesian Cross

Suppose C = C (Y − T ) is an increasing linear functionwith slope < 1.

Suppose also that I = I ,G = G ,T = T , where T is taxes.

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

The Keynesian Cross

In equilibrium, planned expenditure (E ) equals output (Y )(also referred to as income), so:

Assumption: E = Y

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

The Keynesian Cross

How does the economy reach equilibrium?

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

The Keynesian Cross

What happens, for example, if gov’t expenditure increases?

Can we calculate the effect of G ↑ on output?(Hint: if 0 < a < 1 then 1 + a + a2 + a3 · · · = 1

1−a).

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

The IS curve

How does the IS curve come about and how is it relatedto the Keynesian Cross?

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

The IS curve

How does the IS curve come about and how is it relatedto the Keynesian Cross?

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

The investment function

When deciding whether to (borrow to) invest in a projector not, firms ask: “will this project yield a return greaterthan the real interest rate (r)?”

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

The Keynesian Cross and the IS curve

What happens if the real interest rate (r) increases?

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

The central bank and monetary policy

The IS curve by itself does not tell us what the interestrate and output are. The economy must be on the curve,but where?

Monetary policy ⇒ a second relationship (the MP curve)between r and Y that helps pin down the outcome.

Monetary policy is conducted by central banks. In the US,the central bank is called the Federal Reserve.

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

A key feature of how the central bank conducts monetarypolicy is how it responds to changes in output:

When output rises, the central bank raises the realinterest rate. When output falls, the central banklowers the real interest rate.⇒ r = r(Y ), where r(·) is an increasing function.

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

When output rises, the central bank raises the realinterest rate. When output falls, the central banklowers the real interest rate.

⇒ r = r(Y ), where r(·) is an increasing function.

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Why does the central bank behave this way?

Because of policymakers goals for output and inflation:

All else equal, they prefer that output be higher, so if Y islow, r ↓.As we will see later, if Y too high then inflation (π) rises.To keep inflation from rising too high, r ↑.

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

All else equal, they prefer that output be higher, so if Y islow, r ↓.

As we will see later, if Y too high then inflation (π) rises.To keep inflation from rising too high, r ↑.

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Analyzing an increase in government purchases

What happens to output and the real interest rate following anincrease in Government purchases?

The Keynesian Cross diagram shows planned expenditure(E ) as a function of output (Y ) for a given interest rate(r). G ↑⇒ E curve ↑ for any r ⇒ IS curve shifts out.Monetary policy is unchanged ⇒ MP curve fixed.IS-MP diagram ⇒ Y ↑, r ↑.What happens to investment (I ) and consumption (C )?

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

The Keynesian Cross diagram shows planned expenditure(E ) as a function of output (Y ) for a given interest rate(r). G ↑⇒ E curve ↑ for any r ⇒ IS curve shifts out.

Monetary policy is unchanged ⇒ MP curve fixed.IS-MP diagram ⇒ Y ↑, r ↑.What happens to investment (I ) and consumption (C )?

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

The Keynesian Cross diagram shows planned expenditure(E ) as a function of output (Y ) for a given interest rate(r). G ↑⇒ E curve ↑ for any r ⇒ IS curve shifts out.Monetary policy is unchanged ⇒ MP curve fixed.

IS-MP diagram ⇒ Y ↑, r ↑.What happens to investment (I ) and consumption (C )?

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

The Keynesian Cross diagram shows planned expenditure(E ) as a function of output (Y ) for a given interest rate(r). G ↑⇒ E curve ↑ for any r ⇒ IS curve shifts out.Monetary policy is unchanged ⇒ MP curve fixed.IS-MP diagram ⇒ Y ↑, r ↑.

What happens to investment (I ) and consumption (C )?

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

The Keynesian Cross diagram shows planned expenditure(E ) as a function of output (Y ) for a given interest rate(r). G ↑⇒ E curve ↑ for any r ⇒ IS curve shifts out.Monetary policy is unchanged ⇒ MP curve fixed.IS-MP diagram ⇒ Y ↑, r ↑.What happens to investment (I ) and consumption (C )?

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Analyzing a shift to tighter monetary policy

Suppose the central bank changes its monetary policy rule sothat it chooses a higher level of real interest at a given level ofoutput than before. What happens?

MP curve ↑.IS curve fixed.

IS-MP diagram → Y ↓, r ↑.How are C , I and G affected?

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

MP curve ↑.

IS curve fixed.

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

IS-MP diagram → Y ↓, r ↑.

How are C , I and G affected?

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Analyzing a fiscal and monetary policy mix

Suppose the government raises taxes, while the central bankchanges its interest rate rule as a function of output by enoughto keep output at its initial level.

T ↑→ IS curve inwards.

Which way does the MP curve need to shift to keepoutput at its initial level?

...MP curve ↓.

IS-MP diagram → Y fixed, r ↓.What happens to C , I and G?

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

...MP curve ↓.

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

...MP curve ↓.IS-MP diagram → Y fixed, r ↓.What happens to C , I and G?

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Which way does the MP curve need to shift to keepoutput at its initial level? ...MP curve ↓.

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Which way does the MP curve need to shift to keepoutput at its initial level? ...MP curve ↓.IS-MP diagram → Y fixed, r ↓.

What happens to C , I and G?

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Which way does the MP curve need to shift to keepoutput at its initial level? ...MP curve ↓.IS-MP diagram → Y fixed, r ↓.What happens to C , I and G?

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Analyzing a decrease in consumer confidence

Suppose that for some reason consumers become more worriedabout the future, so they consume less and save more at agiven level of income than before. What happens?

⇒ IS curve shifts inwards.

MP curve fixed.

IS-MP diagram → Y ↓, r ↓, i.e. a recession.

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

MP curve fixed.

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

MP curve fixed.

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

MP curve fixed.

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

MP curve fixed.

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

How does the central bank set the interest rate?

The central bank cannot set the interest rate by decree.

It controls the interest rate by setting the supply of money.

How does this work?

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

How does this work?

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

How does this work?

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

How does this work?

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Equilibrium in the money market

When the money market is in equilibrium:

M

P= L(i ,Y ),

where:

The supply of real balances (M/P) is the quantity ofmoney, measured in terms of the goods it can buy.(M - the nominal supply of money; P - the price of goods.)

The demand for real balances (L, from ”liquidity”).

i is the nominal interest rate.

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

The demand for money (L)

L = L(i ,Y ),

L is an:

Increasing function of income (Y ), because as incomeincreases people make more purchases with money.

Decreasing function of nominal interest (i), because as i ↑the opportunity cost of holding money increases.

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

L = L(i ,Y ),

L is an:

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

L = L(i ,Y ),

L is an:

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

By definition:

r = i + πe ,

where πe is expected inflation.

Thus:

M

P= L(r + πe ,Y )

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

By definition:

r = i + πe ,

where πe is expected inflation. Thus:

M

P= L(r + πe ,Y )

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

M

P= L(r + πe ,Y ),

The central bank controls M.

Suppose for a moment that prices are fixed, so P = P,and πe = 0.

Suppose the central bank sets M ↑, so MP> L(r ,Y ).

For the economy to return to equilibrium either r ↓, orY ↑, or both.

Which is it?

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

M

P= L(r + πe ,Y ),

Which is it?

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

M

P= L(r + πe ,Y ),

Which is it?

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

M

P= L(r + πe ,Y ),

Which is it?

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

M

P= L(r + πe ,Y ),

Which is it?

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

In money market equilibrium:M

P= L(r ,Y ),

If M ↑⇒ r ↓ only:

We move from E0 to A below, which is not on the IScurve (...and on the Keynesian Cross? Excess demand forgoods (E > Y ) - try at home).

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

P= L(r ,Y ),

If M ↑⇒ r ↓ only:

We move from E0 to A below, which is not on the IScurve (...and on the Keynesian Cross? Excess demand forgoods (E > Y ) - try at home).

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

P= L(r ,Y ),

If M ↑⇒ Y ↑ only:

We move from E0 to B below, which is not on the IScurve (...and on the Keynesian Cross? Excess supply ofgoods (E < Y ) - try at home).

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

P= L(r ,Y ),

If M ↑⇒ Y ↑ only:

We move from E0 to B below, which is not on the IScurve (...and on the Keynesian Cross? Excess supply ofgoods (E < Y ) - try at home).

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

P= L(r ,Y ),

Thus, in order to be consistent with the goods market, the newequilibrium in the money market must be such that:

M ↑⇒ r ↓ and Y ↑.We move from E0 to E1 below - on the IS curve.

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

P= L(r ,Y ),

M ↑⇒ r ↓ and Y ↑.

We move from E0 to E1 below - on the IS curve.

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

P= L(r ,Y ),

M ↑⇒ r ↓ and Y ↑.We move from E0 to E1 below - on the IS curve.

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

What if we no longer suppose that P = P and πe = 0?

P= L(r + πe ,Y ),

Suppose some prices adjust immediately, and others adjustsluggishly. Then:

Real money balances still increase (M1/P1 > M0/P0),though not as much as when P = P.

Expected inflation increases (πe1 > πe0) because peopleforesee the sluggish price adjustment.

⇒ M1P1

> L(r0 + πe1 ,Y0)⇒ our previous analysis continuesto hold, i.e. r ↓ and Y ↑.

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

P= L(r + πe ,Y ),

⇒ M1P1

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

P= L(r + πe ,Y ),

⇒ M1P1

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

P= L(r + πe ,Y ),

⇒ M1P1

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

P= L(r + πe ,Y ),

⇒ M1P1

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Aggregate Supply

So far:

Our analysis of short-run fluctuations has focused on thefactors that determine output and the interest rate at apoint in time.

This analysis goes under the heading of aggregatedemand, since it is based on the idea that output isdetermined by the overall demand for goods and services.

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Aggregate Supply

So far:

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Aggregate Supply

So far:

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Aggregate Supply

We now want to extend the analysis to incorporate inflation:

The behavior of inflation stems from how firms respond tothe demand for their goods and services. This behaviorgoes under the heading of aggregate supply.

Together, aggregate demand and supply determine notonly output and inflation at a point in time, but how theychange over time.

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Aggregate Supply

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Aggregate Supply

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

The behavior of inflation

Assumption:

At a point in time, the rate of inflation is given.

When output is above its natural rate, inflation rises.

When output is below its natural rate, inflation falls.

When output equals its natural rate, inflation is constant.

Why?

When output is below natural rate, firms have idlecapacity and little trouble finding and retaining workers, sothey raise prices by less than before.

When output is above natural rate, firms run extra shiftsand have difficulty finding and retaining workers, so theyraise prices by more than before.

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Assumption:

Why?

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Assumption:

Why?

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Assumption:

Why?

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Assumption:

Why?

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Assumption:

Why?

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Assumption:

Why?

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Assumption:

Why?

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Policymakers’ reaction to inflation

We do not have a complete understanding of inflations effects,but there is some evidence that it may have substantial harms:

For example, inflation appears to lower investment of allkinds by creating uncertainty and reducing confidence infuture government policies.

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

We do not have a complete understanding of inflations effects,but there is some evidence that it may have substantial harms:

For example, inflation appears to lower investment of allkinds by creating uncertainty and reducing confidence infuture government policies.

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Central bankers dislike inflation:

When it rises, they raise the real interest rate to reduceoutput and thereby control inflation.

When it falls, their need to restrain output is smaller, andso they cut the real interest rate.

In terms of the IS-MP diagram, this means that the MPcurve shifts up when inflation rises and shifts down whenit falls.

Formally, assume bankers follow a rule:

r = r(Y , π),

such that r(Y , π) is increasing in both Y and π.

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

r = r(Y , π),

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

r = r(Y , π),

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

r = r(Y , π),

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

r = r(Y , π),

Econ 191:Monetary

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Introduction

The IS-MPmodel

Output andinflation

The inflation adjustment (IA) curve

Inflation at a point in time is given. It does not depend onoutput.

The IA curve shifts up or down over time, depending onwhether output is above or below its natural rate.

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

The aggregate demand (AD) curve

When inflation is higher, the realinterest rate that the centralbank sets at a given level ofoutput is higher.

⇒ a rise in inflation shifts theMP curve up.

⇒ the AD curve emerges.

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

The AD-IA diagram

The AD and IA curves together determine output andinflation at a point in time.

The AD curve tells us what output is given inflation, andthe IA curve tells us what inflation is.

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

The behavior of output and inflation over time

Although inflation at a point in time is given, it rises ifoutput is above its natural rate and falls if it is below.

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Although inflation at a point in time is given, it rises ifoutput is above its natural rate and falls if it is below.

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

What is going on in the background?

The increases in inflation cause the central bank to raisethe real interest rate for a given level of output, and thesechanges in monetary policy are causing output to fall.

These shifts of the MP curve in response to changes ininflation in the IS-MP diagram correspond to movementsalong the AD curve in the AD-IA diagram.

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

The process continues until output reaches its natural rate.

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Aggregate demand - Fiscal Policy

Suppose government purchases permanently increase. Whathappens in the long-run?

Should we assume that the economy is initially at its“natural” long-run levels?

In the short-run, the IS curve shifts outwards ⇒ Y ↑, r ↑.This is true for any current level of inflation, so the ADcurve shifts outwards, too.

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

In the short-run, the IS curve shifts outwards ⇒ Y ↑, r ↑.

This is true for any current level of inflation, so the ADcurve shifts outwards, too.

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Continuing:

Because output is now greater than its natural rate(Y > Y ), inflation increases over time (IA curve ↑), untiloutput reverts to its natural rate.The movement along the AD curve reflects the centralbank’s behavior. As π ↑, the central bank (gradually)shifts the MP curve up.How are C and I affected?

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Continuing:

Because output is now greater than its natural rate(Y > Y ), inflation increases over time (IA curve ↑), untiloutput reverts to its natural rate.

The movement along the AD curve reflects the centralbank’s behavior. As π ↑, the central bank (gradually)shifts the MP curve up.How are C and I affected?

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Continuing:

Because output is now greater than its natural rate(Y > Y ), inflation increases over time (IA curve ↑), untiloutput reverts to its natural rate.The movement along the AD curve reflects the centralbank’s behavior. As π ↑, the central bank (gradually)shifts the MP curve up.

How are C and I affected?

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Continuing:

Because output is now greater than its natural rate(Y > Y ), inflation increases over time (IA curve ↑), untiloutput reverts to its natural rate.The movement along the AD curve reflects the centralbank’s behavior. As π ↑, the central bank (gradually)shifts the MP curve up.How are C and I affected?

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Aggregate demand - Monetary Policy

Suppose the central bank permanently tightens its policy rule,setting higher r for any level of (Y , π). What happens in thelong-run?

In the short-run, the MP curve shifts upwards ⇒ Y ↓, r ↑.This is true for any current level of inflation, so the ADcurve shifts downwards.

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

In the short-run, the MP curve shifts upwards ⇒ Y ↓, r ↑.

This is true for any current level of inflation, so the ADcurve shifts downwards.

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

In the short-run, the MP curve shifts upwards ⇒ Y ↓, r ↑.This is true for any current level of inflation, so the ADcurve shifts downwards.

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Continuing:

Because output is now less than its natural rate (Y < Y ),inflation decreases over time (IA curve ↓), until outputreverts to its natural rate.The movement along the AD curve reflects the centralbank’s behavior. As π ↓, the central bank (gradually)shifts the MP curve down, until it yields Y again.How are C and I affected? How is π affected in thelong-run? (Volcker, early 1980’s)

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Continuing:

Because output is now less than its natural rate (Y < Y ),inflation decreases over time (IA curve ↓), until outputreverts to its natural rate.

The movement along the AD curve reflects the centralbank’s behavior. As π ↓, the central bank (gradually)shifts the MP curve down, until it yields Y again.How are C and I affected? How is π affected in thelong-run? (Volcker, early 1980’s)

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Continuing:

Because output is now less than its natural rate (Y < Y ),inflation decreases over time (IA curve ↓), until outputreverts to its natural rate.The movement along the AD curve reflects the centralbank’s behavior. As π ↓, the central bank (gradually)shifts the MP curve down, until it yields Y again.

How are C and I affected? How is π affected in thelong-run? (Volcker, early 1980’s)

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Continuing:

Because output is now less than its natural rate (Y < Y ),inflation decreases over time (IA curve ↓), until outputreverts to its natural rate.The movement along the AD curve reflects the centralbank’s behavior. As π ↓, the central bank (gradually)shifts the MP curve down, until it yields Y again.How are C and I affected? How is π affected in thelong-run? (Volcker, early 1980’s)

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Monetary policy and inflation in the long-run

In the long-run:

Monetary policy does not affect Y or r . They equal Yand rLR .

Monetary policy does (crucially) affect inflation (π).

Suppose central banks monetary policy rule, r = r(Y , π), takesthe form:

r = a + bπ + c[Y − Y ],

such that a, b and c are positive.

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

In the long-run:

r = a + bπ + c[Y − Y ],

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

In the long-run:

r = a + bπ + c[Y − Y ],

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

In the long-run:

r = a + bπ + c[Y − Y ],

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

r = a + bπ + c[Y − Y ]

In the long-run:

rLR = a + bπLR + c · 0 ↔ πLR =rLR − a

b

a ↑ - a rule that sets a higher real interest rate for any(Y , π) pair) ⇒ πLR ↓.Supposing rLR − a > 0 (necessary for πLR > 0), then b ↑ -a rule that reacts more sharply to inflation ⇒ πLR ↓.Central banks typically engage in “inflation targeting”.Note that different combinations of a, b and c can achievethe same πLR .

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

r = a + bπ + c[Y − Y ]

In the long-run:

b

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

r = a + bπ + c[Y − Y ]

In the long-run:

b

a ↑ - a rule that sets a higher real interest rate for any(Y , π) pair) ⇒ πLR ↓.

Supposing rLR − a > 0 (necessary for πLR > 0), then b ↑ -a rule that reacts more sharply to inflation ⇒ πLR ↓.Central banks typically engage in “inflation targeting”.Note that different combinations of a, b and c can achievethe same πLR .

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

r = a + bπ + c[Y − Y ]

In the long-run:

b

a ↑ - a rule that sets a higher real interest rate for any(Y , π) pair) ⇒ πLR ↓.Supposing rLR − a > 0 (necessary for πLR > 0), then b ↑ -a rule that reacts more sharply to inflation ⇒ πLR ↓.

Central banks typically engage in “inflation targeting”.Note that different combinations of a, b and c can achievethe same πLR .

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

r = a + bπ + c[Y − Y ]

In the long-run:

b

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Aggregate supply shocks

Inflation shocks:

A disturbance to the usual behavior of inflation that shiftsthe inflation adjustment line.

Supply shocks:

A change in the natural rate of output.

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Inflation shocks:

Supply shocks:

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Inflation shocks:

Supply shocks:

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Aggregate supply - an inflation shock

Suppose inflation suddenly increases, e.g. as a result of a shockto world oil prices. What happens?

IA curve ↑⇒ Y ↓, r ↑.This scenario describes the situation in the US followingthe early 1970’s oil shocks.

The resulting combination of recession (low output) andhigh inflation throughout the 1970’s dubbed “stagflation”.

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

IA curve ↑⇒ Y ↓, r ↑.

This scenario describes the situation in the US followingthe early 1970’s oil shocks.

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Aggregate supply - a supply shock

Suppose the natural rate of unemployment (u) falls, e.g.because of a demographic shift. What happens?

In the short-run, the IS and MP curves are not affected,and the IA curve is fixed, so... nothing happens.

Because u ↓⇒ Y ↑, inflation begins to fall gradually.

In the long-run Y ↑ and πLR ↓.

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Inflation expectations and inflation shocks

When firms set their wages and prices, they take intoaccount their inflation expectations.

If firms expect higher inflation, they will set higher wagesand prices now.

Suppose that in order to reduce inflation the central bankannounces a tightening of monetary policy.

What happens?

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

What happens?

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

What happens?

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

What happens?

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

If the central bank is not credible - it has not stood up toits word in the past - our previous analysis holds: πLR ↓....but this occurs at the cost of a recession, because in theshort-run Y ↓ substantially.

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

If the central bank is not credible - it has not stood up toits word in the past - our previous analysis holds: πLR ↓.

...but this occurs at the cost of a recession, because in theshort-run Y ↓ substantially.

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

If the central bank is not credible - it has not stood up toits word in the past - our previous analysis holds: πLR ↓....but this occurs at the cost of a recession, because in theshort-run Y ↓ substantially.

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

If the central bank is credible, then the news of the changein monetary policy will prevent some raising of wages andprices ⇒ a positive inflation shock in the short-run.

Thus, πLR ↓, but with a much lighter recession!

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Econ 191:Monetary

Prof. DavidRomer

Issi Romem

Introduction

The IS-MPmodel

Output andinflation

Thank you for your attention.

Good night!

zero lower bound econ 191: monetary policy at the zero ...€¦ · or not, rms ask: \will this...

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