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Aggregate demand, aggregate supply, and monetary policy

Understand how aggregate demand is determined.

Explain the relationship between aggregate supply and the Phillips curve.

Use the aggregate demand and aggregate supply model to analyze macroeconomic conditions.

Discuss the implications of rational expectations for macroeconomic policymaking.

Discuss the pros and cons of the central bank’s operating under policy rules rather than using discretionary policy.

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Learning Objectives
After studying this chapter, you should be able to:
14.1
14.2

14.3

14.4

14.5

Did the Fed create and then kill the Great Moderation?

Most economists believe business cycles make households and firms worse off.

Macroeconomic policy has often failed to reduce economic fluctuations.

Policy in the 1930s and 1970s may have made fluctuations worse.

Fed often blamed for creating instability.

After the 1981-1982 recession, the economy expanded for 92 straight months.

Expansion after brief 1990-1991 recession was a record 120 months long.

Record expansion followed by brief recession in 2001.

Inflation was a moderate 2.6% between 1982 and 2007.

The “Great Moderation” period was the longest period of stability in U.S. history.

Fed received credit from some for causing the Great Moderation.

Fed has also received blame from some for causing the 2007-2009 recession.

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Between the early 1980s and 2007, the U.S. economy experienced a period of macroeconomic stability known as the Great Moderation.

Did discretionary monetary policy kill the Great Moderation?

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Key Issue and Question

Issue:

Question:

Understand how aggregate demand is determined.

14.1

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Learning Objective

Aggregate demand revisited

One of the main goals of central banks is price stability.

Central banks may have implicit or explicit inflation targets.

Examples: Reserve Bank of New Zealand has an inflation target specified by law; Fed announces inflation targets, but has no legal obligation to meet them.

When inflation is greater than target, central banks raise interest rates; when inflation is less than target, they lower interest rates.

It is useful to think of the central bank as having a reaction function, specifying what interest rate it will set depending on the inflation rate.

Central bank reaction function A rule or formula that a central bank uses to set interest rates in response to changing economic conditions.

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Central bank reaction function

The reaction function sloped upward, because increases in inflation are met with increased interest rates.

A relatively steep reaction function means the central bank responds aggressively to changes in inflation.

A relatively flat reaction function means the central bank is relatively passive with respect to inflation.

The central bank reaction function

Figure 14.1

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Are reaction functions realistic?

Does such a simple function really describe what a central bank does?

No, central banks try to achieve other goals than price stability also, such as high employment and financial market stability.

But for now, this is a useful simplification.

The central bank reaction function

Figure 14.1

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The aggregate demand curve

Aggregate demand (AD) curve A curve that shows the relationship between aggregate expenditure on goods and services by households and firms and the inflation rate.

Increases to the inflation rate lead the central bank to respond by increasing interest rates to maintain their target using the monetary policy rule.

The AD curve holds all but the rate of inflation fixed.

The central bank reaction function is critical for deriving the AD curve.

A central bank focused on price stability will lead to a flatter AD curve, because of the aggressive interest rate changes by the central bank.

A central bank focused on factors like unemployment will have a steeper AD curve.

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Deriving the aggregate demand curve

Beginning at point A (in both panels), the output gap is Ỹ1 = 0 and inflation is equal to the target rate 1 = Target.

Using the monetary policy rule, the central bank sets the long-term real interest rate equal to r1, yielding MP1.

If inflation rose to 2, the central bank would raise the real interest rate to r2 by shifting the MP curve up to MP2.

At the higher interest rate r2, output falls, reducing the output gap to Ỹ2 at 2. The new equilibrium is at point B.

Deriving the aggregate demand curve

Figure 14.2

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Shifts of the aggregate demand curve

Shifts to the IS curve will shift the AD curve.

IS shifts right, AD shifts right.

IS shifts left, AD shifts left.

Example: An increase to government spending would lead the IS curve and the AD curve to both shift to the right.

If  remains constant, the output gap shifts to Ỹ2.

An increase in government purchases shifts the aggregate demand curve

Figure 14.3

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AD and the central bank reaction function

Changes to the slope of the monetary policy rule or the inflation target will also shift the AD curve.

An increase in the inflation target will cause the central bank to choose a lower interest rate. The resulting increase in consumption and investment will shift the AD curve to the right.

A central bank less concerned with inflation deviations from target has a lower real interest rate for any given rate of inflation.

So changing to a shallower sloped (less aggressive central bank) monetary policy rule shifts AD to the right.

The AD curve incorporates both the IS and MP curves into a single curve.

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Factors that shift the AD curve.

Factors that shift the aggregate demand curve

Table 14.1

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When are shifts to the AD curve permanent?

Shifts in the IS curve temporarily shift the AD curve.

Increased government spending which shifts the IS curve has temporary effects on the AD curve.

In the long run, aggregate expenditure, real GDP, and potential GDP are equal. Aggregate expenditures in the long run are 100% of potential GDP.

Real GDP can return to potential GDP after an IS curve shift in two ways.

With a temporary change to government spending (or other autonomous expenditure), AD shifts back to the left.

Permanent change to government spending reduces consumption, investment, and net exports in the long run as real interest rates rise.

Changes to the monetary policy rule permanently shift the AD curve.

A higher inflation target means each output gap is associated with a higher rate of inflation permanently.

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Explain the relationship between aggregate supply and the Phillips curve.

14.2

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Learning Objective

Aggregate supply and the Phillips curve

Aggregate supply (AS) curve A curve showing the total quantity of output, or real GDP, that firms are willing and able to supply at a given inflation rate.

The AS curve should remind you of the Phillips curve definition.

The two curves are the same!

Three sources of inflationary pressure in the short run:

Changes in expected inflation rate

Demand shocks (b measures responsiveness of inflation to output gap)

Supply shocks (positive supply shock s drives prices down)

Assume adaptive expectations here, such that previous rate of inflation is expected to prevail in the next period:

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The aggregate supply curve

Same slope and axes as the Phillips curve.

Changes in the output gap cause a movement along an aggregate supply curve.

Increases to aggregate expenditures push against firm capacity constraints, leading to increased inflation rate.

The aggregate supply curve

Figure 14.4

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Shifts in the aggregate supply curve

Supply shocks and expected inflation held constant along an AS curve.

Decline in inflation expectations—as the Fed caused in the early 1980s—shifts AS down.

At same potential GDP, inflation in the future will adjust downward to account for expectations.

A decrease in inflationary expectations and the aggregate supply curve

Figure 14.5

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Factors that shift the aggregate supply curve

Table 14.3

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Use the aggregate demand and aggregate supply model to analyze macroeconomic conditions.

14.3

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Learning Objective

Equilibrium in the AD-AS model

Aggregate demand and aggregate supply (AD-AS) model A model that explains short-run fluctuations in the output gap and the inflation rate.

Equilibrium in the aggregate demand and aggregate supply model

Figure 14.6

Long-run equilibrium occurs where:

Real GDP = potential GDP:

Inflation equals the central bank’s target rate and expected inflation rate:

That is, equilibrium occurs where AD meets AS.

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The effects of a supply shock

In 1983, James Hamilton showed that seven of the eight post-WWII recessions up to that time had been preceded by large unexpected increases in the price of oil.

The three recessions since then have also had large increases in the price of oil.

Oil prices can play a role in causing stagflation.

Stagflation A combination of high inflation and recession, usually resulting from a supply shock such as an increase in the price of oil.

Example: In December 1973 OPEC issued an oil embargo against the U.S. and Europe.

Price of oil increased 135% in one month.

Large increase in price passed along to consumers, generating inflation.

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A supply shock

A supply shock moves the AS curve upward.

Equilibrium shifts from point A to point B.

Eventually, the supply shock ends, and inflation expectations adjust back downward, restoring long-run equilibrium.

The long-run and short-run effects of a supply shock

Figure 14.7

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A supply shock

What can the central bank do about the initial supply shock?

Not much; since unemployment and inflation rose, the central bank cannot combat one without making the other worse. There is no trade-off between inflation and unemployment—even in the short run—in response to a supply shock.

The long-run and short-run effects of a supply shock

Figure 14.7

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A permanent demand shock

Suppose the zero bound constraint on nominal interest rates is binding.

The Fed could reduce real interest rates by increasing its target inflation rate:

The long-run and short-run effects of an increase in the target inflation rate

Figure 14.8

At the lower real interest rate, consumption, investment, and net exports would rise, resulting in real GDP and employment both rising—the AD curve shifts to the right.

But eventually inflation expectations rise, and AS shifts up in response, restoring a zero output gap.

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A permanent demand shock

What effect did the permanent change in the central bank’s reaction function have?

A temporary increase in employment and real GDP.

The long-run and short-run effects of an increase in the target inflation rate

Figure 14.8

A permanent increase in inflation.

There is no trade-off between the inflation rate and the unemployment rate in the long run.

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Are oil supply shocks really that important?

Lutz Kilian challenges the view that the OPEC oil embargo and other cost shocks caused the 1970s stagflation.

Argues demand, rather than supply, caused price increases.

Estimates an oil supply shock increases CPI inflation by about 1%.

Kilian and Robert Barsky (both of University of Michigan) argue the Fed’s “stop-and-go” monetary policy was what caused stagflation: stimulating the economy in 1972, then stopping in 1973.

Athanasios Orphanides (current governor of Central Bank of Cyprus): because policymakers receive economic data with a lag, they are likely to overestimate the need for expansionary policy.

Tend to believe inflation is lower than it really is, and potential GDP is higher than it really is.

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Macro Data

The end of stagflation and the Volcker recession

Inflation and output tradeoff assumes the AS curve is constant while the AD curve shifts.

In the 1970s, supply shocks may have caused an upward shift in the AS curve, increased unemployment, and increased inflation.

Inflation rates rose during the 1973-1975 and 1980 recessions, remaining above 12% after the 1980 recession.

Many doubted the Fed was serious about controlling inflation rates.

The Fed, chaired by Paul Volcker from 1979 to 1987, allowed the federal funds rate to rise to 22% by the end of 1980.

Increases to interest rates slowed the economy substantially in 1982-1983.

Inflation fell, unemployment rose.

Short-run trade-off between inflation and unemployment reappeared.

Increased interest rates were an effective signal that the Fed was serious about controlling inflation.

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Making the Connection

Temporary demand shocks

Collapse of the dot-com bubble between 2000-2002, led to a dramatic decline in wealth.

The NASDAQ stock index, where many dot-com stocks were traded, rose 579% in the five years before 3/10/2000.

By October 2002, the NASDAQ had declined to 1,100.

Consequent recession began in March 2001.

Declining wealth led to reduced household consumption.

Increased business uncertainty decreased firms’ willingness to invest.

Demand shocks temporarily change real GDP and the output gap. Eventually the economy adjusts to move real GDP back to potential GDP.

Output gap is zero in the long run.

Inflation is equal to the target rate in the long run.

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Temporary negative demand shock

A temporary shock, such as the bursting of the dot-com bubble, shifts the AD curve to the left.

With the reduction in inflation expectations, the AS curve shifts down, restoring GDP to potential, at a lower level of inflation.

Short-run and long-run effects of a negative demand shock

Figure 14.9

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Temporary negative demand shock

Eventually, the demand shock ends, and the AD curve shifts back to the right. Output and employment are above potential.

Inflation expectations rise, and the AS curve shifts up, restoring the output gap back to zero.

Short-run and long-run effects of a negative demand shock

Figure 14.9

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Applying the AD-AS model to a housing boom

In the mid-2000s, the U.S. economy underwent a housing boom. Use the AD–AS model to analyze the short-run and long-run effects on real GDP and inflation of the surge in residential construction.

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Solved Problem

Applying the AD-AS model to a housing boom

Step 1 Review the chapter material.

Step 2 Draw the AD-AS graph that shows the initial equilibrium and discuss which curve will shift was a result of the positive demand shock. The economy starts at point A, in long-run equilibrium. A positive demand shock due to increased household wealth shifts AD right from AD1 to AD2 leading to a positive output gap, and inflation rising above the target in the short-run.

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Solved Problem

Applying the AD-AS model to a housing boom

Step 3 Explain the move back to potential GDP. After the initial demand shock, inflation rises to π2 and expected inflation will rise shifting the AS curve up from AS1 to AS2. The Fed’s policy rule leads to increased real interest rates, moving equilibrium along the AD2 curve and back towards potential GDP at point C.

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Solved Problem

Applying the AD-AS model to a housing boom

Step 4 Explain how the aggregate demand curve shifts to restore long-run equilibrium. Point C is not a long-run equilibrium because π3 > πTarget. The demand shock ends because of reduced profitability in housing, and the AD curve returns to AD1.

Step 5 Explain the move back toward long-run equilibrium: The aggregate supply curve shifts again. Expected inflation responds to the lower rate of inflation at point D relative to point C. The AS curve shifts down over time from AS2 to AS1, returning the economy to long-run equilibrium at point A.

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Solved Problem

Discuss the implications of rational expectations for macroeconomic policymaking.

14.4

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Learning Objective

Adaptive vs. rational expectations

Under adaptive expectations, if a central bank is willing to accept the costs associated with permanently higher inflation, they can increase real GDP temporarily.

Assumed expected inflation lags behind actual inflation.

Pricing mistakes are costly however, and adaptive expectations assumes people and firms do not react to current inflation information.

If people become aware of new target inflation rates today, they should behave accordingly

Alternative theory of behavior: rational expectations.

Rational expectations The assumption that people make forecasts of future values of a variable using all available information; formally, the assumption that expectations equal optimal forecasts, using all available information.

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Rational expectations and anticipated policy changes

If central bank credibility is high, announcements about policy changes are anticipated policy.

Under adaptive expectations, actual inflation must change before expected inflation.

Rational expectations would mean expected inflation would shift to react to the new anticipated policy.

Central bank credibility The degree to which households and firms believe the central bank’s announcements about future policy.

Suppose the Fed announces it will raise the target rate of inflation. If people believe the announcement:

Expected inflation increases.

The AS curve shifts up immediately.

There is no trade-off between inflation and unemployment, even in the short-run!

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The policy ineffectiveness proposition

If people’s expectations are rational, and the Fed announces its higher inflation target, the intermediate step (point B) in Figure 14.8 will not occur.

The economy will move straight from point A to point C.

The long-run and short-run effects of an increase in the target inflation rate

Figure 14.8

This is known as the policy ineffectiveness proposition: that announced changes of the inflation target will not affect real GDP, assuming that there is no cost to adjusting wages and prices.

Proposition developed by Robert Lucas, Thomas Sargent, Neil Wallace.

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Rational expectations and unanticipated policy changes

Rational expectations do not imply that all monetary policy is ineffective.

Only that anticipated policy changes are ineffective.

Policy changes that are a surprise can be effective at changing real GDP.

Alternatively, If firms and households do not believe the central bank is credible, the central bank can also impact real GDP.

In these cases, shifts to the AS curve will not be immediate.

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Rational expectations and demand shocks

Any anticipated demand shock should affect only the inflation rate.

Demand shocks can still affect the economy if they are not anticipated.

Shifts to the AS curve are not immediate when demand shocks are not anticipated, and real GDP can rise or fall depending on the direction of the demand shock.

In order for there to be no impact of a demand shock:

Firms and households must have rational expectations.

Shifts of the demand curve must be anticipated.

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Are anticipated, credible policy changes really ineffective?

Rational expectations is an appealing assumption; consistent with ideas like:

Households maximize utility.

Firms maximize profit.

But some economists argue that even if expectations are rational, policy ineffectiveness may not hold:

Firms must change prices in response to changes in expected inflation.

Costly to change prices.

Rational expectations may not have realistic assumptions for households and firms. It is assumed in rational expectations that households and firms:

Know the actual model of how the economy operates.

Have all relevant information.

Know how to use information to make predictions about variables.

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Are anticipated, credible policy changes really ineffective?

Policy ineffectiveness not hold; firms and households may

Actually have adaptive expectations.

Not be able to correctly judge economic parameters like the multiplier.

Are anticipated changes to monetary policy really ineffective?

The debate is not settled, but real GDP does seem to be affected even by anticipated policy changes.

But possibly by less than unanticipated policy changes.

Fed believes its actions have more temporary effect when unanticipated.

Hence goes to great lengths to ensure households and firms view its policies as credible.

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Discuss the pros and cons of the central bank’s operating under policy rules rather than using discretionary policy.

14.5

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Learning Objective

Monetary policy: rules vs. discretion

Inflation rose from 1.3% to 13.5% between 1963 and 1980.

Fed raised the fed funds rate to over 20% in an effort to reduce inflation.

In the 1970s the Fed followed a discretionary policy.

Conducted policy any way it believed would achieve goals of price stability and high employment.

Rule-based central banks are the alternative to discretionary behavior.

Monetary rule An attempt by the central bank to follow specific and publicly announced guidelines for policy.

Some examples of monetary rules:

Friedman proposed a constant rate of nominal money stock growth.

Currency boards keep a specific domestic exchange rate against another.

Gold standard is a special type of currency board.

The Taylor rule is a proposed method of setting nominal interest rates.

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The Taylor rule

Taylor rule A monetary policy guideline developed by economist John Taylor for determining the target for the federal funds rate.

The Taylor rule explicitly accounts for the Fed’s dual mandate by responding to both inflation and changes in real GDP.

g represents how much the nominal target fed funds rate iTarget responds to deviations of inflation away from Target.

h is how much iTarget responds to the output gap.

g and h are both estimated at 0.5.

Target and r* are both estimated at 2%.

Taylor rule often fairly accurately describes what the Fed will do.

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How accurate is the Taylor rule?

The Fed does not follow an official policy rule, but the Taylor rule approximates historical Fed policy rather well when g = 0.5, h = 0.5, r* = 2%, and πtarget = 2%.

The Taylor rule and Federal Reserve behavior, 1955-2012

Figure 14.10

A greater level of divergence between actual policy and the Taylor rule occurred during the late 1960s to early 1970s.

Widely held view that the Fed should have been raising interest rates faster than they did to counter rising inflation.

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The Taylor rule

Some economists have disparaged the level of the federal funds rate after the 2001 recession as being “too low for too long.”

The Taylor rule would have raised rates to higher levels sooner than the Fed actually did.

Low federal funds rates may have helped encourage the housing boom and consequent bubble.

Research shows countries that deviated from the nominal interest rate suggested by the Taylor rule experienced worse housing bubbles.

Chairman of the FOMC, Alan Greenspan, stressed his concerns about deflation during the recovery from the 2001 recession.

Current Chairman, Ben Bernanke, has argued a global savings glut was the cause of low interest rates.

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The Taylor rule and the real interest rate

The Taylor rule applies to the short-term nominal interest rate.

By assuming the central bank has an inflation target of 2%, we can write:

The Fed should increase the nominal interest rate by 1.5 percentage points for each 1 percentage point increase in inflation.

Higher inflation results in higher real interest rates using the Taylor rule.

Higher real rates reduce consumption, investment, and net exports.

Reduced GDP would lead to downward pressure on inflation rates.

By following the monetary policy rule, monetary policy helps keep the inflation rate stable.

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The case for discretion

Some events are new and unexpected.

Policymakers should not have their hands tied by rigid rules.

Historically, the Fed has changed interest rates when unexpected events occur.

Example: Stock market crash of 1987: inflation was near the target rate, and real GDP was near potential.

Rules often assume key economic values are constant.

Money multiplier has changed due to financial innovation.

Strictly adhering to Friedman’s money growth rule may be destabilizing.

Equilibrium real interest rates have changed over time.

Strictly adhering to the Taylor rule may be destabilizing.

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The case for rules

Policymakers have an incentive to promise to achieve low inflation to reduce expected inflation.

Lower expected inflation results in lower actual inflation.

After pricing decisions are set, the central bank has an incentive to exploit the trade-off between inflation and unemployment.

The central bank can apparently fool households and firms to stimulate the economy.

The fact that a central bank might do this is a time-inconsistency problem:

Time-inconsistency problem The tendency of policymakers to announce one policy in advance in order to change the expectations of households and firms and then to follow a second policy after households and firms have made economic decisions based on the first policy.

As households and firms understand the central bank’s motivations, they expect the central bank to break their promise, leaving actual inflation high.

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Other central banks try inflation targeting

In 1989 the Reserve Bank of New Zealand adopted an explicit inflation target.

In all, 26 central banks had explicit inflation targets in April 2011.

Four key elements for the central bank:

An explicit mandate to pursue price stability as primary or sole objective.

An explicit inflation target usually between 1% and 3%.

Accountability for meeting the target rate.

Emphasis on the inflation rate over the next several years.

These key elements constrain discretion and provide credibility.

Evidence on effectiveness of explicit targeting is mixed.

Inflation has been shown to decrease after central banks adopted explicit targets, but at about the same rate as other countries.

The 2007 surge in oil prices caused a smaller increase in inflation in countries who had explicit targets relative to those who did not.

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Making the Connection

Answering the key question

“Did discretionary monetary policy kill the Great Moderation?”

The Great Moderation ended with the collapse of the housing bubble and the 2007-2009 recession.

Discretionary policy can lead to poor decisions by the central bank.

The federal funds rate was below the rate suggested by the Taylor rule at the time the housing market was developing in the U.S.

The extent of housing bubbles in other countries appears to be related to how far central banks deviated from rules like the Taylor rule.

This evidence is suggestive that discretionary monetary policy in the 2001-2006 period contributed to the housing bubble and the financial crisis that ended the Great Moderation.

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