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Chapter Twenty-One

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Chapter Twenty-One

- 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.

- 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.

- 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.

- 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?

- 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.

- 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.

- 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.

- 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.

- 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.

- We can restate the equation of exchange from Chapter 20 in terms of potential output, YP.

- 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.

- 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.

- 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.

- 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.

- 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.

- 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.

- 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.

- The best way to describe aggregate expenditure is to start with the national income accounting identity from principles of economics.

- 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.

- 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.

- 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.

- 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.

- 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.

- 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.

- 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.

- 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.

- 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.

- 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.

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.

- 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.

- 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.

- 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.

- 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.

- 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.

- 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.

- 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.

- 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.

- 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.

- 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.

- There are a number of reasons why increases in inflation are associated with falling levels of aggregate output demanded.
- 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.
- Even is monetary policymakers do not change the real interest rate, the effect on M/P causes the dynamic aggregate demand curve to slope 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.

- Inflation creates risk.
- The higher the inflation, the greater the risk.
- People increase saving, lowering the level of consumption.

- Inflation makes foreign goods cheaper in relation to domestic goods.
- This drives imports up and exports down.

- In every case, higher inflation means a lower level of aggregate output demanded, causing the dynamic aggregate demand curve to slope downward.

- 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.

- In our derivation, we held constant both the aggregate expenditure curve and the monetary policy reaction curve.
- We assumed factors other than the real interest rate were fixed; and
- That the inflation target and the long run interest rate were fixed.

- Shifts in any of these will shift 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); or
- Increased net exports.

- 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.

- Changes in the long-run real interest rate 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.

- 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.

- The aggregate supply (AS) curve tells us where along the dynamic aggregate demand curve the economy ends up.
- There are short-run and long-run versions of the AS curve.
- When combined with the dynamic aggregate demand curve, the short-run AS curve tells us where the economy settles at any particular time.
- The long-run curve with dynamic aggregate demand, tells us the levels of inflation and the quantity of output that the economy is moving toward in the long term.

- The short-run AS curve is the upward-sloping relationship between current inflation and the quantity of output.
- In the short term, production costs don’t change much, so when product prices rise, firms increase supply in order to take advantage.
- In the short run, higher inflation elicits more aggregate output supplied by the firms that produce it.

- When production costs change, the short-run AS curve shifts.
- This can happen for any of three reasons:
- Deviations of current output from potential output.
- Changes in expectations of future inflation.
- Factors that drive production costs up or down.

- When current output falls below potential output, we have a recessionary output gap.
- Firms raise prices and wages by less than they did at potential output.
- Production costs will rise more slowly so inflation falls.

- When current output is above potential output, we have an expansionary gap.
- Production costs will rise more quickly so inflation increases.

- Changes in inflation expectations are analogous to changes in production costs.
- An increase in expected inflation increases production costs lowering production at every level of current inflation.
- This shifts the short-run AS curve to the left.

- Changes in the prices of raw materials, as well as other external factors that change production cists, shift the short-run AS curve:
- An increase in the price of oil, increase in labor prices from higher payroll taxes, increased health care costs, etc.

- Data show that inflation responds to the output gap.
- Figure 21.13 plots changes in the inflation rate against the output gap, lagged six quarters from 1988 to 2009.
- Inflation generally falls with a lag when there is a recessionary output gap and rises when there is an expansionary gap.

- In the long-run,
- Current output must equal potential output, and
- Inflation must be determined by monetary policy.

- That means in the long run, output and inflation are unrelated and the long-run aggregate supply curve is vertical at the point where current output equals potential output.

- The fact that the short-run AS curve is stable when there is no output gap means that the long-run AS curve is vertical at that point.
- The short-run AS curve shifts:
- When current output deviates from potential output.
- When expected inflation deviates from current inflation.

- So, at any point along the LRAS curve, current output equals potential output and current inflation equals expected inflation.

- Policymakers talk about output growth.
- Textbooks teach about output gaps.
- When monetary policymakers use the term growth, they are talking about increase in both actual and potential output.

Short Run Equilibrium

- SR equilibrium is determined by the intersection of:
- The dynamic aggregate demand curve (AD) and
- The short-run aggregate supply curve (SRAS).

- An expansionary output gap exerts upward pressure on production costs.
- This shifts the SRAS curve to the left.
- This continues until output returns to potential.

- In a recessionary output gap we have downward pressure on production costs.
- This shifts the SRAS curve to the right.
- This continues until current output returns to potential.

SRAS2

LRAS

2

SRAS

1

0

AD

YP

Y0

Current output is greater than potential output – an expansionary gap.

SRAS shifts left until reaches potential output, YP.

LRAS

SRAS

1

0

SRAS2

2

AD

YP

Y0

Current output is lower than potential output - recessionary gap.

SRAS shifts right until reaches potential output, YP.

- This example has several important implications.
- The economy has a self-correcting mechanism.
- The fact that inflation changes whenever there is an output gap reinforces our conclusion that in the long run output returns to potential output.

- Long run equilibrium is the point at which the economy comes to rest.

There are three conditions for long run equilibrium:

- Current output equals potential output: Y=YP.
- Current inflation is steady and equal to target inflation: = T, and
- Current inflation equals expected inflation: = e.

- While shifts in the dynamic AD curve or the SRAS curve can have the same effect on inflation, they have opposite effects on output.
- Shifts in AD cause output and inflation to rise and fall together, moving in the same direction.
- Shifts in the SRAS curve move output and inflation in opposite directions, one rises when the other one falls.

- Inflation in the long run will only change if policymakers have changed their inflation target.
- In the short run fluctuations can come from
- Increases in the components of AE that are not sensitive to real interest rate (shift of AD),
- A permanent easing of monetary policy (shift of monetary policy reaction curve,) or
- Increases in the costs of production (shift of SRAS).

- In the short run fluctuations can come from

- In the short run, fluctuations in output can come from:
- A decline in aggregate expenditure,
- A shift to the left in monetary policy reaction curve (policy makers could be responsible for recessions), or
- Increases in either production costs or inflation expectations drive output down.

- If demand shifts were the cause of recessions, we should see inflation decline when output falls.
- If production cost increases were the source, then we should see inflation rise as the economy weakens.
- Table 21.5 lists the dates of recessions since the mid-1950s.
- It also shows the change in inflation from the beginning to the end of the recession.

- Inflation fell in 7 of the past 9 recessions.
- The only one where inflation rose was in 1973-1975 when oil prices tripled, driving up production costs.
- It appears that three-quarters of the recessions listed can be traced to shifts in AD.
- What caused these shifts?

- Figure 21.17 shows that shortly before each recession starts, just to the left of each of the shaded bars, the interest rate tends to rise.
- This suggests that the Fed policy is at least partly to blame of the business cycle downturns over the past 50 years.
- They have done this to bring down inflation.
- The only thing the Fed could do was to raise interest rates triggering a recession.

- The recovery from the financial crisis of 2007-2009 focused the monetary policy debate on when the Fed would begin to raise the target for its policy rate from the zero percent floor.
- The U.S. Senate’s reconfirmation of Ben Bernanke as Fed chairman fueled expectation that as the economy gained steam, the Fed would resist popular pressure to keep its target rate near zero.
- Will the Fed have waited too long to prevent an unwelcome rise of inflation?

End ofChapter Twenty-One