Chapter Twenty-One

1. Chapter Twenty-One

2. Introduction • An important part of economic analysis is speculation about the impact of the new data on monetary policy. • The FOMC in the U.S. and the Governing Council in the Euro area always tie their policy actions to current and expected future economic conditions. • Traders are trying to out-guess each other to make a profit by betting on what the next interest rate move will be. • The rest of us are just hoping the central bank will succeed in keeping inflation low and real growth high.

3. Introduction • The objective of this chapter is to understand fluctuations in inflation and real output and how central banks use conventional interest-rate policy to stabilize them. • We will develop a macroeconomic model of fluctuations in the business cycle in which monetary policy plays a central role.

4. Introduction • We will see that short-run movements in inflation and output can arise from two sources: • Shifts in the quantity of aggregate output demanded, or • Shifts in the quantity of aggregate output supplied. • We will develop our macroeconomic model in three steps: • A description of long-run equilibrium, • The derivation of the dynamic aggregate demand curve, and • An introduction of short-run and long-run aggregate supply.

5. Introduction • We will see how modern central banks can use their policy tools to stabilize short-run fluctuations in output and inflation. • Our ultimate objective is to understand how modern central bankers set interest rates. • When policymakers change the target interest rate, what are they reacting to and what is the impact on the economy?

6. Output and Inflation in the Long Run • The best 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.

7. Potential Output • Potential output is what the economy is capable of producing when its resources are used at normal rates. • 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 factory. • Technological improvements allow you to increase production at given levels of capital and labor.

8. 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.

9. 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.

10. What do people mean when they talk about inflation? • Inflation means a continually rising price level, a sustained rise, that continues for a substantial period. • Temporary increases in inflation represent one-time adjustments in the price-level. • A permanent change is a rise or fall in the long-run course of inflation.

11. Long-Run Inflation • We can restate the equation of exchange from Chapter 20 in terms of potential output, YP.

12. 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.

13. Monetary Policy and the Dynamic Aggregate Demand Curve • If we want to understand the role of central bankers in stabilizing the economy, we need to examine the connection between short-term interest rates and policymakers’ inflation and output targets. • This will also explain how policymakers themselves think about their role.

14. Monetary Policy and the Dynamic Aggregate Demand Curve • The goal is to understand the relationship between inflation and the quantity of aggregate output demanded by those people that use it. • We will proceed in three steps: • Examine the relationship between aggregate expenditures and the real interest rate; • Study how monetary policymakers adjust their interest-rate instrument in response to change in inflation; and • Put these two together to construct the dynamic aggregate demand curve that relates output and inflation.

15. 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.

16. Monetary Policy and the Dynamic Aggregate Demand Curve • The dynamic aggregate demand curve: • This is a downward sloping relationship between inflation and aggregate output. • 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.

17. 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 change the real interest rate.

18. Monetary Policy and the Dynamic Aggregate Demand Curve • We can see this in Figure 21.2. • This figure plots the nominal federal fund rate against a measure of the real federal funds rate using survey data on expected inflation. • The real interest rate, then, is the level through which monetary policymakers influence the real economy. • In changing real interest rates, they influence consumption, investment, and other components of aggregate expenditure.

19. The Nominal and Real Federal Funds Rate

20. Aggregate Expenditure and the Real Interest Rate • The best way to describe aggregate expenditure is to start with the national income accounting identity from principles of economics.

21. Aggregate Expenditure and the Real Interest Rate • Consumption is spending by individuals. It is 2/3 of GDP. • Investment is spending by firms for additions to physical capital. It also includes newly constructed residential homes and the change in business inventories. It is 16% of GDP. • Government purchases is spending on goods and services by federal, state, and local governments. This is 20% of GDP. • Net exports equals exports minus imports. This averages -4.5% of GDP.

22. Aggregate Expenditure and the Real Interest Rate • We can think of aggregate expenditures as having two parts: • Those that are interest rate sensitive, and • 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.

23. 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 level of business investment and • Reductions in residential investment. • For consumption, higher real interest rates mean • Higher inflation-adjusted loan payments and • Increased saving meaning less spending.

24. Aggregate Expenditure and the Real Interest Rate • For net exports, the story is similar. • When real interest rates in the U.S. rise, foreigners increase foreign demand for dollars, causing the dollar to appreciate. • The higher value of the dollar makes U.S. exports more expensive and imports cheaper. • This means lower net exports.

25. 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.

26. Aggregate Expenditure and the Real Interest Rate • We can see in Figure 21.3 that 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.

27. Aggregate Expenditure and the Real Interest Rate

28. Aggregate Expenditure and the Real Interest Rate • Table 21.1 provides a summary of the relationship between aggregate expenditure and the real interest rate. • When economic activity speeds up or slows down and current output moves above or below potential output, policymakers can adjust the real interest rate in an effort to close the expansionary or recessionary gap.

29. Aggregate Expenditure and the Real Interest Rate

30. The Long-Run Real Interest Rate • What happens to the real interest rate over the long run? • There is some level of aggregate expenditure that is consistent with the normal level of output toward which the economy moves over the long run. • The long run real interest rate equates the level of aggregate expenditure to the quantity of potential output.

31. The Long-Run Real Interest Rate

32. The Long-Run Real Interest Rate • For example, what happens when G increases? • 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 the long-run real interest rate must rise.

33. The Long-Run Real Interest Rate

34. The Long-Run Real Interest Rate • What if a change in potential output causes a change in the long-run real interest rate? • 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.

35. The Long-Run Real Interest Rate

36. The Long-Run Real Interest Rate In summary: • 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.

37. Over short periods of a quarter of a year, fluctuations in the business cycle means understanding the changes in investment. • Figure 21.6 plots the ratio of investment to GDP over the past 50 years. • The shaded bars are recessions. • Changes in investment come from: • Changes in the real interest rate and • Changes in expectations about future business conditions.

39. 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.

40. 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.

41. Deriving the Monetary Policy Reaction Curve • We introduced a version of the monetary policy reaction curve in Chapter 18. • 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 as shown in Figure 21.7.

42. Deriving the Monetary Policy Reaction Curve

43. 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. • We know the location of the curve, but what tells us the slope? • That depends on policymakers’ objectives.

44. Deriving the Monetary Policy Reaction Curve • 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.

45. 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.

46. Shifting the Monetary Policy Reaction Curve • A decrease in Tshifts the curve to the left. • The same is true for an increase in r*. • We can see this in Figure 21.8, Panel A. • A decline in the long-run real interest rate, r*, or an increase in the inflation target, T, shift the monetary policy reaction curve to the right. • We can see this in Figure 21.8, Panel B.

47. Shifting the Monetary Policy Reaction Curve

48. The Monetary Policy Reaction Curve

49. Deriving the Dynamic Aggregate Demand Curve • We will construct 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. • Using information from before, we see that when inflation rises, the quantity of aggregate output demanded falls. • The dynamic aggregate demand curve slopes downward.

50. 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. • Therefore, changes in current inflation move the economy along a downward-sloping dynamic aggregate demand curve.