5.9 financial markets and central bank online test
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L17ECON3507.pptxOutput, Inflation, and Monetary Policy
Chapter 21
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Learning Objectives
Describe the determinants of output and inflation in the long run.
Show the role of monetary policy in the dynamic aggregate demand curve.
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Output and Inflation in the Long Run
A useful way to understand fluctuations in the business cycle is as deviations from some benchmark or long-run equilibrium level.
What would the levels of inflation and output be if nothing unexpected happened for a long time?
In the long run, current output equals potential output and the inflation rate equals the level implied by the rate of money growth.
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Potential Output
Potential output is the level of output given existing technology and the normal use of resources.
In a business, conditions will change over time.
If you think the increase or decrease in demand for your product is permanent, you will change the scale of your business.
Technological improvements allow you to increase production at given levels of capital and labor.
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Potential Output
Your “normal” level of output changes over time.
In the short run you can deviate from normal, but in the long-run, the normal level itself changes.
There is a normal level of production that defines potential output for the country as well.
Potential output tends to rise over time.
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Potential Output
Unexpected events can push current output away from potential output called an output gap.
When current output is above potential, it creates an expansionary output gap.
When current output falls below potential, it creates a recessionary output gap.
In the long run, current output equals potential output.
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Inflation means a continually rising price level, a sustained rise, that continues for a substantial period.
Temporary increases in inflation represent one-time adjustment in the price-level that does not change the trend of inflation.
A permanent change is a rise or fall in the trend.
Deflation is a sustained decline in the price-level, a one-time drop in prices has no impact on the trend
Disinflation means a slowdown of in the pace of inflation, not a decline in prices.
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Long-Run Inflation
The other key to long-run equilibrium is inflation
Money growth plus the change in the velocity of money equals inflation plus real growth
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Long-Run Inflation
In the long run, inflation equals money growth minus growth in potential output.
While central bankers focus primarily on controlling short-term nominal interest rates, they keep an eye on money growth.
Ultimately long term money growth affects inflation.
But in the short-run, over periods even as long as a few years, fluctuations in velocity weaken this link.
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Monetary Policy and the Dynamic Aggregate Demand Curve
Aggregate expenditure and the real interest rate:
There is a downward sloping relationship between the quantity of aggregate expenditure and the real interest rate.
Inflation, the real interest rate, and the monetary policy reaction curve:
There is an upward sloping relationship between inflation and the real interest rate that we will call the monetary policy reaction curve.
The dynamic aggregate demand curve:
This is a downward sloping relationship between inflation and aggregate output.
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Monetary Policy and the Dynamic Aggregate Demand Curve
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Monetary Policy and the Dynamic Aggregate Demand Curve
Economic decisions of households to consume and of firms to invest depend on the real interest rate, not the nominal interest rate.
Central banks must therefore influence the real interest rate.
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Monetary Policy and the Dynamic Aggregate Demand Curve
Remember that
For a central bank that is effective at stabilizing inflation and output, inflation expectations adjust slowly in response to changes in economic conditions.
That means that changes in the nominal interest rate alter the real interest rate.
In changing real interest rates, they influence consumption, investment, and other components of aggregate expenditure.
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The Nominal and Real Federal Funds Rate
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Aggregate Expenditure and the Real Interest Rate
The components of aggregate expenditure:
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Aggregate Expenditure and the Real Interest Rate
Consumption (C) is spending by individuals. About 68% of GDP.
Investment (I) is spending by firms for additions to physical capital, newly constructed residential homes, and the change in business inventories. Averaged 17% of GDP since 2000.
Government purchases (G) is spending on goods and services by federal, state, and local governments. About 19% of GDP.
Net exports equals exports minus imports (X - M). Since 2000 this has averaged -4% of GDP.
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Aggregate Expenditure and the Real Interest Rate
We can think of aggregate expenditures as having two parts:
Those that are interest rate sensitive
Those that are not.
Three of the four components of aggregate expenditure are sensitive to changes in the real interest rate:
Consumption, investment and net exports.
Investment is the most important.
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Aggregate Expenditure and the Real Interest Rate
Investment must be profitable for businesses.
The higher the cost of borrowing, the less likely that an investment will be profitable.
Higher interest rates lead to:
Lower levels of business
Reductions in residential investment
For consumption, higher real interest rates mean
Higher inflation-adjusted loan payments
Increased saving -- less spending.
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Aggregate Expenditure and the Real Interest Rate
When real interest rates rise:
Consumption falls because the reward to saving and the cost of financing purchases are now higher.
Investment falls because the cost of financing has gone up.
Net exports fall because the domestic currency has appreciated, making imports cheaper and exports more expensive.
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Aggregate Expenditure and the Real Interest Rate
A rise in the real interest rate reduces the level of aggregate expenditure.
This leads to a downward sloping aggregate expenditure (AE) curve.
However, the AE curve can also shift if things change that are unrelated to the real interest rate.
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Aggregate Expenditure and the Real Interest Rate
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Aggregate Expenditure and the Real Interest Rate
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The Long-Run Real Interest Rate
The long run real interest rate, r*, equates the level of aggregate expenditure to the quantity of potential output.
Two possible reasons why r* can change:
Shifts in the aggregate expenditure curve
Changes in the level of potential output
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The Long-Run Real Interest Rate
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The Long-Run Real Interest Rate
When there is a rise in government purchases:
The level of aggregate expenditure increases at every real interest rate.
This shifts aggregate expenditure curve to the right.
For the level of aggregate expenditure to remain equal to potential output, the interest-sensitive components of aggregate expenditure must fall.
That means r* must rise.
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The Long-Run Real Interest Rate
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The Long-Run Real Interest Rate
What if a change in potential output causes a change in r*?
When the quantity of potential output rises, the level of aggregate expenditure must rise with it.
This requires a decline in the real interest rate.
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The Long-Run Real Interest Rate
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The Long-Run Real Interest Rate
When components of aggregate expenditure that are not sensitive to the real interest rate rise, the long-run real interest rate rises with them.
When potential output rises, the long-run real interest rate falls.
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Inflation, the Real Interest Rate, and the Monetary Policy Reaction Curve
When current inflation is high or current output is running above potential output, central bankers will set a relatively high policy interest rate.
When current inflation is low or current output is well below potential, they will set a low policy interest rate.
While they state their policies in terms of nominal interest rates, they do so knowing that changes in the nominal interest rate will translate into a change in the real interest rate.
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Inflation, the Real Interest Rate, and the Monetary Policy Reaction Curve
These changes in the real interest rate influence the economic decisions of firms and households.
We can summarize all of this in the form of a monetary policy reaction curve that approximates the behavior of central bankers.
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Deriving the Monetary Policy Reaction Curve
Higher current inflation requires a policy response that raises the real interest rate, and lower current inflation requires a policy response that lowers the real interest rate.
This mean that the monetary policy reaction curve slopes upward
The location depends on where policymakers would like the economy to end up in the long run
For the real interest rate, the economy moves toward the long-run real interest rate that equates aggregate expenditure with potential output
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Deriving the Monetary Policy Reaction Curve
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Deriving the Monetary Policy Reaction Curve
The monetary policy reaction curve is set so that when current inflation equals target inflation (T), the real interest rate equals the long-run real interest rate.
Policymakers who are aggressive in keeping current inflation near the target will have a steep monetary policy reaction curve.
Those who are less concerned will have a relatively flat monetary policy reaction curve.
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Shifting the Monetary Policy Reaction Curve
A movement along the curve is a reaction to a change in current inflation.
A shift in the curve represents a change in the level of the real interest rate at every level of inflation.
What shifts the curve are those things we held constant when we drew the curve:
Target inflation and long-run real interest rate.
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Shifting the Monetary Policy Reaction Curve
A decrease in T shifts the curve to the left.
The same is true for an increase in r*.
A decline in the long-run real interest rate, r*, or an increase in the inflation target, T, shifts the monetary policy reaction curve to the right.
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Shifting the Monetary Policy Reaction Curve
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The Monetary Policy Reaction Curve
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Deriving the Dynamic Aggregate Demand Curve
The final step is constructing the dynamic aggregate demand curve:
This relates inflation and the level of output, accounting for the fact that monetary policymakers respond to changes in current inflation by changing the interest rate.
When inflation rises, the quantity of aggregate output demanded falls.
The dynamic aggregate demand curve slopes downward.
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Deriving the Dynamic Aggregate Demand Curve
When current inflation rises:
Monetary policymakers raise the real interest rate, moving the economy upward along the monetary policy reaction curve.
The higher real interest rate reduces the interest-sensitive components of aggregate expenditure.
This causes a fall in the quantity of aggregate output demanded.
Changes in current inflation move the economy along a downward-sloping dynamic aggregate demand curve.
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Deriving the Dynamic Aggregate Demand Curve
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Why the Dynamic Aggregate Demand Curve Slopes Down
Increases in inflation are associated with falling levels of aggregate output demanded.
Higher current inflation induces policymakers to raise the real interest rate, depressing various components of aggregate expenditure.
The higher the rate of inflation for a given rate of money growth, the lower the level of real money balances in the economy.
When P grows faster than M, M/P falls.
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Why the Dynamic Aggregate Demand Curve Slopes Down
Higher inflation reduces wealth, which lowers consumption.
Inflation means money declines in value.
Inflation is also bad for the stock market.
Inflation affects the poor disproportionately more than the wealthy.
The redistribution lowers consumption in the economy as a whole, reducing the quantity of aggregate output demanded.
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Why the Dynamic Aggregate Demand Curve Slopes Down
Inflation creates risk.
The higher the inflation, the greater the risk.
People increase saving, lowering the level of consumption.
Rising inflation makes foreign goods cheaper in relation to domestic goods.
This drives imports up and exports down.
Higher inflation means a lower level of aggregate output demanded, causing the dynamic aggregate demand curve to slope downward.
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Shifting the Dynamic Aggregate Demand Curve
Any change in the components of aggregate expenditure will shift the dynamic aggregate demand curve.
All of the following increase aggregate expenditure, there by shifting the dynamic aggregate demand curve to the right:
Increased consumer confidence
Increased optimism about future business prospects
Increased government spending (or decreased taxes)
Increased net exports
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Shifting the Dynamic Aggregate Demand Curve
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Shifting the Dynamic Aggregate Demand Curve
Whenever the monetary policy reaction curve shifts, the dynamic aggregate demand curve shifts, too.
Consider an increase in the central bank’s inflation target.
The monetary policy reaction curve shifts right.
The real interest rate that policymakers set at every level of inflation falls.
The lower real interest rate increases the quantity of aggregate output demanded at every level of inflation.
The dynamic aggregate demand curve shifts right.
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Shifting the Dynamic Aggregate Demand Curve
Changes in r* shift the dynamic aggregate demand curve.
Suppose the level of potential output increases.
The long-run real interest rate must fall.
This drives up the interest-rate-sensitive components of aggregate expenditure.
This shifts the curve to the right, reducing the real interest rate policymakers set at every level of inflation.
This shifts the dynamic aggregate demand curve right.
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Shifting the Dynamic Aggregate Demand Curve
Any shift in the monetary policy reaction curve shifts the dynamic aggregate demand curve in the same direction.
Expansionary monetary policy shifts the dynamic aggregate demand curve to the right.
Contractionary monetary policy shifts the dynamic aggregate demand curve to the left.
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Dynamic Aggregate Demand Curve: Summary
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