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Output, Inflation and Monetary Policy

21-2. Output, Inflation,

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Output, Inflation and Monetary Policy

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    1. Chapter 21 Output, Inflation and Monetary Policy

    2. 21-2 Output, Inflation, & Monetary Policy: The Big Questions Why do inflation and output fluctuate? How do central bankers use interest rates to achieve their stabilization objectives?

    3. 21-3 Output, Inflation, & Monetary Policy: Roadmap Output and inflation in the long run Monetary policy and the quantity of real output demanded Inflation and the quantity of real output supplied Output and inflation in equilibrium

    4. 21-4 Output and Inflation in the Long Run: Potential Output What the economy is capable of producing when its resources are used at normal rates Unexpected events can push current output away from potential output, creating an output gap In the long run, current output equals potential output (Y=YP).

    5. 21-5 Output and Inflation in the Long Run: Long-Run Inflation Recall: MV = PY implies %?M + %?V = %?P + %?Y Ignoring changes in velocity, %?V=0, In the long run Y=YP, so %?Y= %?YP %?P = %?M - %?YP Inflation = Money growth – growth in potential output

    6. 21-6 Inflation refers to a sustained rise in prices that continues for a substantial period. Temporary increases in inflation represent one-time adjustments in the price-level

    7. 21-7 Dynamic Aggregate Demand Aggregate Expenditure & the Real Interest Rate: Real Interest Rate ? ? Aggregate Exp. ? Inflation, the Real Interest Rate and Monetary Policy Inflation ? ? Real Interest Rate ? Dynamic Aggregate Demand Inflation ? ? Aggregate Exp. ?

    8. 21-8 Dynamic Aggregate Demand

    9. 21-9 The Nominal and Real Federal Funds Rate

    10. 21-10 Aggregate Expenditure & the Real Interest Rate Aggregate Gov’t Net Expenditure = Consumption + Investment + Purchases + Exports Yad = C + I + G + NX When the real interest rate rises: C: reward to saving rises, C falls I : cost of financing rises, I falls NX: demand for domestic assets rises, currency appreciated, imports rise, exports fall, X-M falls

    11. 21-11 Aggregate Expenditure and the Real Interest Rate

    12. 21-12 Aggregate Expenditure and the Real Interest Rate

    13. 21-13

    14. 21-14 The Long-Run Real Interest Rates What happens to the real interest rate in the long run? Look for the real interest rate at which aggregate expenditure equals potential output.

    15. 21-15 The Long-Run Real Interest Rate

    16. 21-16 Changes in the Long-Run Real Interest Rate Long-run real interest rate changes when Aggregate expenditure shifts An increase in components of aggregate expenditure that are not sensitive to the real interest rate raises r* Potential output changes An increase in potential output lowers r*

    17. 21-17 Changes in the Long-Run Real Interest Rate

    18. 21-18 The Monetary Policy Reaction Curve High Inflation: Policymakers raise the real interest rate Current output below potential output Policymakers lower the real interest rate

    19. 21-19 The Monetary Policy Reaction Curve

    20. 21-20 The Monetary Policy Reaction Curve: Location Monetary policy reaction curve is set so current inflation equals target inflation the real interest rate equals the long-run real interest rate. ? = ?T when r = r*

    21. 21-21 The Monetary Policy Reaction Curve: Shifting the Curve Change in the inflation target Reduction in ?T shifts the MPRC to the left Change in the long-run real interest rate An increase in r* shifts the MPRC to the left

    22. 21-22 The Monetary Policy Reaction Curve: Shifting the Curve

    23. 21-23 The Monetary Policy Reaction Curve: Summary

    24. 21-24 Inflation and Output: Dynamic Aggregate Demand

    25. 21-25 Dynamic Aggregate Demand When inflation rises Policymakers raise the real interest rate along their monetary policy reaction curve Higher real interest means lower aggregate output demanded Inflation ?? Output?

    26. 21-26 Dynamic Aggregate Demand

    27. 21-27 Dynamic Aggregate Demand Curve: Shifting the Curve Changing interest insensitive components of Aggregate Expenditure Shifting the MPRC

    28. 21-28 Dynamic Aggregate Demand Curve: Shifting the Curve Changing interest insensitive components of Aggregate Expenditure Portion of C insensitive to r? ? Y ? (at all r): AD shifts right

    29. 21-29 Dynamic Aggregate Demand Curve: Shifting the Curve Shifting the MPRC Inflation Target Higher ?* means lower r at every ? Lower r means higher Y ?* ?? ? r ? (at every ?) ? Y ? AD shifts to the right

    30. 21-30 Dynamic Aggregate Demand Curve: Shifting the Curve Shifting the MPRC Inflation Target ?* ?? ? r ? (at every ?) ? Y ? AD shifts to the right Long-run Real Interest Rate Higher r* ? ? r ? (at every ?) ? Y ? AD shifts to the right

    31. 21-31 Dynamic Aggregate Demand Curve: Shifting the Curve

    32. 21-32 Dynamic Aggregate Demand Curve: Summary

    33. 21-33 When nominal interest rates are high, chances are that inflation is high, too. If you are living off interest or investment income, you can be fooled into thinking that your income is high. Spending all of the interest income causes a gradual decline in the purchasing power of your savings. To maintain real purchasing power of your income, you can only spend the real return.

    34. 21-34 Aggregate Supply Short run: SRAS Long run: LRAS

    35. 21-35 Short-Run Aggregate Supply When ? changes, what do supplier do? Input prices (wages, etc.) adjust slowly Costs fixed: higher prices ? higher profits

    36. 21-36 Short-Run Aggregate Supply

    37. 21-37 Short-Run Aggregate Supply: Shifting the Curve Deviations of Current Output from Potential Expansionary Gap ? Scare Resources Changes in Expectations of Future Inflation Higher Expected Inflation ? Increases costs Factors that Change Production Costs Higher production costs ? shifts SRAS right

    38. 21-38 Short-Run Aggregate Supply: Shifting the Curve

    39. 21-39

    40. 21-40 Long-Run Aggregate Supply What happens when adjustments finish? Where does SRAS stop shifting? When Y = YP

    41. 21-41 Long-Run Aggregate Supply

    42. 21-42 Aggregate Supply: Summary

    43. 21-43 Policymakers talk about output growth Textbooks teach about output gaps To reconcile the two realize that when %?Y ? %?YP it creates an output gap

    44. 21-44 Determination of Output & Inflation: Short-Run Equilibrium Inflation and Output are determined by intersection of AD and SRAS

    45. 21-45 Adjustment to Long-Run Equilibrium Output > Potential (Y>YP): SRAS shifts left until Y=YP Output < Potential (Y<YP): SRAS shifts right until Y=YP

    46. 21-46 Adjustment to Long-Run Equilibrium

    47. 21-47 Long-Run Equilibrium Output equals Potential Output: Y=YP Inflation equals CB target: ? = ?T Inflation equals expected: ? = ?e

    48. 21-48 Sources of Fluctuations: What Causes Recession? Shifts in Dynamic Aggregate Demand (Consumer Confidence, Business Optimism, Monetary Policy) Inflation will fall as output falls Shifts in Short-run Aggregate Supply (Oil Prices, production costs) Inflation will rise as output falls

    49. 21-49 Inflation and Recessions

    50. 21-50 What Caused AD Shifts?

    51. Chapter 21 End of Chapter

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