Monetary Policy and the Phillips Curve Chapter 12

12.1 Introduction
In this chapter, we learn:
How the central bank effectively sets the real interest rate in the short run, and how this rate shows up as the MP curve in our short-run model. That the Phillips curve describes how firms set their prices over time, pinning down the ination rate. How the IS curve, the MP curve, and the Phillips curve make up our short-run model. How to analyze the evolution of the macroeconomy in response to changes in policy or economic shocks.

 The monetary policy (MP) curve Describes how the central bank sets the nominal interest rate The short-run model summary: Through the MP curve the nominal interest rate determines the real interest rate Through the IS curve the real interest rate influences GDP in the short run The Phillips curve describes how booms and recessions affect the evolution of inflation

12.2 The MP Curve: Monetary Policy and the Interest Rates

Large banks and financial institutions borrow from each other. Central banks set the nominal interest rate by stating what they are willing to lend or borrow at the specified rate.

 Banks cannot charge a higher rate.

everyone would use the central bank.

Banks cannot charge a lower rate.

They would borrow at the lower rate and lend it back to the central bank at a higher rate. This is called the arbitrage opportunity.

Thus, banks must exactly match the rate the central bank is willing to lend at.

Overnight Cash Rate and Other Interest Rates

From Nominal to Real Interest Rates The relationship between the interest rates is given by the Fisher equation.

Nominal interest rate

Real interest rate

Rate of inflation

 The sticky inflation assumption

The rate of inflation displays inertia, or stickiness, so that it adjusts slowly over time. In the very short run the rate of inflation does not respond directly to monetary policy. Central banks have the ability to set the real interest rate in the short run.

Case Study: Ex Ante and Ex Post Real Interest Rates

A sophisticated version of the Fisher equation replaces the inflation rate with the expected rate of inflation.

Expected rate of inflation

 Using the expected rate of inflation gives an ex ante real interest rate:

The ex ante real interest rate is relevant for investment decisions. Once inflation is known, we can calculate the ex post interest rate:

The IS-MP Diagram

The MP curve
Illustrates the central banks ability to set the real interest rate

Central banks set the real interest rate at a particular value.

The MP curve is a horizontal line.

 The economy is at potential when

The real interest rate equals the MPK. There are no aggregate demand shocks. Short-run output = 0.

If the central bank raises the interest rate above the MPK
Inflation is slow to adjust. The real interest rate rises. Investment falls.

Exam le: The End o! a "ousing #u$$le

Suppose housing prices had been rising, but then they fall sharply.
The aggregate demand parameter declines. The IS curve shifts left.

If the central bank lowers the nominal interest rate in response:

The real interest rate falls as well because inflation is sticky. If judged correctly and without lag, the economy would not have a decline in output.

Case Study: The Term Stru%ture o! Interest Rates

The term structure of interest rates
The different period lengths for interest rates

It should be the case that interest rates on investments of different lengths of times will yield the same return.
If not, everyone would switch investment to the one with a higher return.

 Interest rates at long maturities are equal to an average of the short-term rate investors expect in the future When the Fed changes the overnight rate, interest rates at longer magnitudes change.
Financial markets expect the change will persist for some time. A change in rates today often signals information about likely changes in the future.

12.3 The Phillips Curve

Recall the inflation rate is the percent change in the overall price level.

Firms set their prices on the basis of

Their expectations of the economy-wide inflation rate The state of demand for their product.

 Expected inflation
The inflation rate firms think will prevail in the economy over the coming year.

 Firms expect next years inflation rate to be the same as this years inflation rate.

Under adaptive expectations firms adjust their forecasts of inflation slowly. Expected inflation embodies the sticky inflation assumption.

 The Phillips curve

Describes how inflation evolves over time as a function of short-run output

This years inflation

Last years inflation

Short run output

If output is below potential

Prices rise more slowly than usual

If output is above potential

Prices rise more rapidly than usual

 Using the equations:

Change in inflation

Therefore, the Phillips curve can be expressed as:

The parameter measures how sensitive inflation is to demand conditions.

Case Study: A #rie! "istory o! the Philli s Cur&e

Originally
The Phillips curve showed a relationship between the level of inflation and economic activity. Low inflation implied low output.

 Later critiques
Stimulating the economy would raise output temporarily Firms will build high inflation into their price changes Output will return to potential.

Pri%e Sho%'s and the Philli s Cur&e

We can add shocks to the Phillips curve to account for temporary increases in the price of inflation:

 The actual rate of inflation now depends on three things:

Expected rate of inflation

Adjustment factor for state of economy

Shock to inflation

Rewrite again:

 Oil price shock

The price of oil rises Results in a temporary upward shift in the Phillips curve

Cost-Push and Demand-Pull In!lation

Price shocks to an input in production
Cost-push inflation Tends to push the inflation rate up

The effect of short-run output on inflation in the Phillips curve

Demand-pull inflation Increases in aggregate demand pull up the inflation rate.

Case Study: The Philli s Cur&e and the (uantity Theory

An increase in the growth rate of real GDP would reduce inflation. The Phillips curve, however, seems to say a booming economy causes the rate of inflation to increase. Which one is correct?

 The quantity theory

Long-run model An increase in real GDP reflects an increase in the supply of goods, which lowers prices.

The Phillips curve

Part of our short-run model An increase in short-run output reflects an increase in the demand for goods.

12.4 Using the Short-Run Model

Disinflation
Sustained reduction of inflation to a stable lower rate

The Great Inflation of the 1970s

Misinterpreting the productivity slowdown contributed to rising inflation.

The )ol%'er Disin!lation

Reducing the level of inflation requires a sharp reduction in the rate of money growtha tight monetary policy.

 Because of the stickiness of inflation

The classical dichotomy is unlikely to hold exactly in the short run. Just a reduction in the rate of money growth may not slow inflation immediately.

Thus, the real interest rate must increase to induce a recession.

The recession causes inflation to become negative. As demand falls firms raise their prices less aggressively to sell more.

 Lowering the inflation rate

Can create the cost of a slumping economy High unemployment and lost output

Once inflation has declined sufficiently

Real interest rate can be raised back to MPK Allowing output to rise back to potential

The *reat In!lation o! the +,-.s

Inflation rose in the 1970s for three reasons:
1. OPEC coordinated oil price increases. Oil shock as shown in the model

2. The U.S. monetary policy was too loose.

The conventional wisdom was that reducing inflation required permanent increases in unemployment. In reality, disinflation requires only a temporary recession.

3. The Federal Reserve did not have perfect information.

Thought the productivity slowdown was a recession it was actually a change in potential output. The Fed lowered interest rates in response to what they perceived was a demand shock. which increased output above potential generated more inflation

The Short-Run Model in a Nutshell

Case Study: The /..+ Re%ession

The recession of 2001 had a jobless recovery.
Even after the return of strong GDP, employment continued to fall. This is an exception to Okuns law.

12.5 Microfoundations: Understanding Sticky Inflation

The short run model Changes in the nominal interest rate affect the real interest rate. There are bargaining costs to negotiating prices and wages. Social norms: Cause concerns about whether the nominal wage should decline as a matter of fairness in the short run: Imperfect information Costs of setting prices Contracts also set prices and wages in nominal rather than real terms.

How does inflation move?

Case Study: The 0ender o! 0ast Resort

Central banks ensure a sound, stable financial system by:
Making sure banks abide by certain rules Including the maintenance of a certain amount of reserves to be held on hand

 Central banks ensure a sound, stable financial system by:

Acting as the lender of last resort lending money when banks experience financial distress Having deposit insurance on small- and medium-sized deposits can increase risky behavior

12.6 Microfoundations: How Central Banks Control Nominal Interest Rates

The central bank controls the level of the nominal interest rate by supplying the money that is demanded at that rate. The money market clears through changes in velocity.
Which is driven by changes in the nominal interest rate

 The nominal interest rate

Is the opportunity cost of holding money Is the amount you give up by holding money instead of keeping it in a savings account Is pinned down by equilibrium in the money market

If the nominal interest rate is higher than its equilibrium level

Households hold their wealth in savings rather than currency. The nominal interest rate falls.

 The demand for money

Is a decreasing function of the nominal interest rate Is downward sloping Higher interest rates reduce the demand for money.

The supply of money

Is a vertical line for the level of money the central bank provides

Changing the Interest Rate

To raise the interest rate
The central bank reduces the money supply Creates an excess of demand over supply A higher interest rate on savings accounts reduces excess demand. The markets adjust to a new equilibrium.

1hy it instead o! Mt2

The interest rate is crucial even when central banks focus on the money supply. The money demand curve is subject to many shocks, which shift the curve.
Changes in price level Changes in output

If the money supply is constant

The nominal interest rate fluctuates Resulting in changes in output

 The money supply schedule is effectively horizontal at a targeted interest rate. An expansionary (loosening) monetary policy
Increases the money supply Lowers the nominal interest rate

A contractionary (tightening) monetary policy

Reduces the money supply Increases the nominal interest rate

12.7 Inside the Federal Reserve

Con&entional Monetary Poli%y

Reserves
Deposits held in accounts with the central bank Pay no interest

Reserve requirements
Banks required to hold a certain fraction of their deposits

Discount rate
Interest rate charged by the Federal Reserve on loans made to commercial banks

3 en-Mar'et 3 erations: "o4 the Fed Controls the Money Su ly

Open-market operations
The central bank trades interest-bearing government bonds in exchange for currency or non-interest bearing reserves.

To increase the money supply, the Fed sells government bonds in exchange for currency or reserves.
The price at which the bond sells determines the nominal interest rate.

12.8 Conclusion
Policymakers exploit the stickiness of inflation.
Changes in the nominal interest rate change the real interest rate.

Through the Phillips curve booms and recessions alter the evolution of inflation. Because inflation evolves gradually, the only way to reduce it is to slow the economy.

Summary
The short-run model
IS curve MP curve Phillips curve

Central banks set the nominal interest rate. The IS-MP diagram allows us to study the consequences of monetary policy and shocks to the economy for short-run output.

 The Phillips curve

Reflects the price-setting behavior of individual firms

Expected rate of inflation

Current demand conditions

Shocks to inflation

 The Phillips curve can also be written as:

This equation shows that in order to reduce inflation, actual output must be reduced below potential temporarily. The Volcker disinflation of the 1980s is the classic example illustrating this mechanism.

 Three important causes contributed to the Great Inflation of the 1970s:

The oil shocks of 1974 and 1979 The mistaken view that reducing inflation required a permanent reduction in output The fact that the productivity slowdown was initially interpreted as a recession

 Central banks control short-term interest rates by their willingness to supply whatever money is demanded at a particular rate. Long-term rates are an average of current and expected future short-term rates.
This structure allows changes in short-term rates to affect long-term rates.