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Fed’s primary policy tool is very short-term nominal interest rates, i.

Chapter 21: MP Curve and AD Curve. Fed’s primary policy tool is very short-term nominal interest rates, i. (controlled by adding and draining reserves from banking system) Recall Fisher Equation r = i – ( D P/P) e t+1 Where r affects NX and I.

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Fed’s primary policy tool is very short-term nominal interest rates, i.

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  1. Chapter 21: MP Curve and AD Curve Fed’s primary policy tool is very short-term nominal interest rates, i. (controlled by adding and draining reserves from banking system) Recall Fisher Equation r = i – (DP/P)et+1 Where r affects NX and I. Assume (DP/P) and (DP/P)et+1 are constant in the short-run (sticky prices). (there is a long lag time between D (DM/M) and D (DP/P) ). r = i – (DP/P)et+1 by changing i, the Fed controls r in the short run.

  2. MP Curve MP (monetary policy) curve – Indicates the relationship between r the Fed sets and the DP/P. r = r + l (DP/P)et+1 r = autonomous component, set by the FOMC, not related to DP/P. l = parameter showing responsiveness of r to DP/P. Automatic/endogenous/normal Fed response to higher DP/P. Movement along curve. MP Curve has an upward slope which is explained by the Taylor Principle Assume Fed’s goal is for stable DP/P. The FOMC will increase i more than any increase in (DP/P)et+1 => increase in r r = i – (DP/P)et+1 The Taylor Principle will prevent the following feedback loop.  DP/P =>  r =>  Y => DP/P =>  r =>  Y => DP/P 0.5% 1.5% 1.0%

  3. AD Curve AD (aggregate demand) Curve – Indicates the relationship between DP/P and Y when the G/S market is in equilibrium. Movement along curve explained by the following:  DP/P => FOMC  r =>  NX,  I =>  planned spending =>  Y Factors that shift AD curve. • All the factors that shift the IS curve (C, I, G, NX, f, T) • The factor that shifts the MP curve, r, autonomous tightening or easing of MP.

  4. AD Curve (substitute MP Curve into IS Curve) Y = [C + I + G + NX – d f – MPC T] * 1 – (d + x) * [r + l (DP/P)et+1 ] 1 - [mpc(1-t)] 1 - [mpc(1-t)]

  5. Shift AD Curve • Assume 2% DP/P and 2% r •  G (at any given interest rate) => multi  Y DP/P A 2.0% B AD Curve Y MP Curve r = r + l (DP/P)et+1 r % r % A 2.0% 2.0% B A IS Curve Y 2% DP/P $14 T $15 T

  6. Shift AD Curve (due to D r ) • Assume 2% DP/P • The debt crisis => Fed’s “Financial Repression” => r falls from 1 to -2. (autonomous easing of MP) => r falls from 2 to -1 =>  I,  NX, =>  Y, at every given DP/P . DP/P 2.0% B A AD Curve Y MP Curve r = r + l (DP/P)et+1 r % r % IS Curve 2 = 1 + 0.5(2) 2.0% A 2.0% A -1 = -2 + 0.5(2) 2% $15 T $14 T Y DP/P -1.0% -1.0% B B

  7. Econ 330 Chapter 21 HomeworkDue Friday, May 2 Chapter 21 Questions & Applied Problems 3, 4, 6, 21, 23, 25

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