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## Chapter 21

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**Chapter 21**Output, Inflation and Monetary Policy**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?**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**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).**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**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**Dynamic Aggregate Demand**• Aggregate Expenditure & the Real Interest Rate:Real Interest Rate Aggregate Exp. • Inflation, the Real Interest Rate and Monetary PolicyInflation Real Interest Rate • Dynamic Aggregate DemandInflation Aggregate Exp. **The Nominal and Real Federal Funds Rate**Economic decisions depend on real interest rates. In the short-run, changes in the nominal interest rate change the real interest rate**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**Fluctuations in investment are one of the most important**sources of changes in aggregate expenditure.**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.**Changes in the Long-Run Real Interest Rate**• Long-run real interest rate changes when • Aggregate expenditure shiftsAn 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***The Monetary Policy Reaction Curve**• High Inflation:Policymakers raise the real interest rate • Current output below potential outputPolicymakers lower the real interest rate**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. = Twhenr = r***The Monetary Policy Reaction Curve:Shifting the Curve**• Change in the inflation target Reduction in Tshifts the MPRC to the left • Change in the long-run real interest rate An increase in r*shifts the MPRC to the left**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**Dynamic Aggregate Demand Curve:Shifting the Curve**• Changing interest insensitive components of Aggregate Expenditure • Shifting the MPRC**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**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**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**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.**Aggregate Supply**• Short run: SRAS • Long run: LRAS**Short-Run Aggregate Supply**When changes, what do supplier do?Input prices (wages, etc.) adjust slowlyCosts fixed: higher prices higher profits**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**A 1 percentage point recessionary output gap drives**inflation down 0.2 percentage points 18 months later**Long-Run Aggregate Supply**• What happens when adjustments finish? • Where does SRAS stop shifting? • When Y = YP**Policymakers talk about output growth**• Textbooks teach about output gaps • To reconcile the two realize that when %Y %YP it creates an output gap**Determination of Output & Inflation:Short-Run Equilibrium**Inflation and Output are determined by intersection of AD and SRAS**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**Long-Run Equilibrium**• Output equals Potential Output: Y=YP • Inflation equals CB target: = T • Inflation equals expected: = e**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**Inflation and Recessions**With one exception, inflation and output move in the same direction.Conclude it is AD shifts.**What Caused AD Shifts?**Appears that AD shifted because policymakers raised interest rates. Likely that they did this to reduce inflation.