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Advanced Macroeconomics. Chapter 17 MONETARY POLICY AND AGGREGATE DEMAND. THEMES.  Keynes, the Classics and the Great Depression.  Goods market equilibrium and the determinants of aggregate demand.  Monetary policy and the formation of interest rates.

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slide1

Advanced

Macroeconomics

Chapter 17

MONETARY POLICY AND AGGREGATE DEMAND

slide2

THEMES

 Keynes, the Classics and the Great Depression

 Goods market equilibrium and the determinants of aggregate demand

 Monetary policy and the formation of interest rates

 The relationship between short-term and long-term interest rates

 Derivation of the aggregate demand curve

keynes versus the classics
KEYNES VERSUS THE CLASSICS

The classical economic orthodoxy: If only market forces are allowed to work, economic activity will quickly adjust to its natural rate determined by the supply side.

Winston Churchill, British Secretary of the Treasury 1925-1929: ”It is

the orthodox Treasury dogma, steadfastly held, that whatever might be

the political and social advantages, very little employment can, in fact,

be created by state borrowing and state expenditure”.

The Great Depression of the 1930s undermined the Classical orthodoxy

and paved the way for the Keynesian view that aggregate demand plays

an important role in the determination of economic activity.

slide4

THE GOODS MARKET

Condition for goods market equilibrium

(1)

Investment demand

(2)

Consumption demand

(3)

slide5

THE GOODS MARKET

Define

Aggregate private demand

D C + I

We assume a

Balanced public budget

T = G

slide6

THE GOODS MARKET

From (1) through (3) we then get the

Equilibrium condition for the goods market

(4)

Properties of the aggregate private demand function

(5)

(6)

slide7

Figure17.2: The real interest rate and the private sector savings surplus in Denmark, 1971-2000

slide8

THE GOODS MARKET

In the chapter text we show that (4) may be log-linearized to give the following

Approximation of the goods market equilibrium condition

(11)

Note that the equilibrium real interest rate is determined by the condition for

Long run equilibrium in the goods market

(13)

We now wish to transform (11) into a relationship between y og . For that purpose we must study

slide9

THE MONEY MARKET

The equilibrium condition for the money market

(14)

The money demand function

(15)

Note:iistheshort-terminterest rate which is controlled by the central bank.

slide10

THE MONEY MARKET

Constant money growth rule (Friedman)

lnM - lnM-1 = 

Motivation for the CMG rule: If  is close to 1 and  is close to zero, equations

(14) and (15) roughly imply that

M = kPY

A constant rate of growth of M will then ensure a stable growth in aggregate money income PY.

slide11

Interest rate policy under the CMG rule

Money market equilibrium under the CMG rule

(16)

Assume that we have

Long run equilibrium in the previous period

(17)

Taking logarithms in (16) and (17) and using the approximations

ln(1+) andln(1+)  , we get

(18)

(19)

Substitution of (18) into (19) yields

Monetary policy under the CMG rule

(20)

slide12

INTEREST RATE POLICY UNDER THE TAYLOR RULE

Note that  may be interpreted as the central bank’s target inflation rate.

Problem with the CMG rule: A stable growth in total money income cannot be

achieved if the parameters  and  change in an unpredictable way (for example through financial innovations).

As an alternative to the CMG rule John Taylor proposed the

Taylor rule

(21)

Note: It is important for economic stability that the parameter h is positive so that an increase in inflation triggers an increase in the real interest rate.

Taylor’s proposal for USA

h = 0.5 b = 0.5

slide15

FROM THE SHORT RATE TO THE LONG RATE

The problem: the central bank may control the short-term interest rate, but aggregate demand mainly depends on the long-term interest rate.

Assumption: Short-term and long-term bonds are perfect substitutes

 This implies the

Arbitrage condition

(24)

Taking logs on both sides of (24) and using the approximation ln(1+i) i, we get

The expectations theory of the term structure of interest rates

(25)

Implication: The current long rate is a simple average of the current short rate and the expected future short rates.

slide16

FROM THE SHORT RATE TO THE LONG RATE

Further implications of (25):

  • Monetary policy can only have a significant impact on long-term interest rates by influencing the expected future short-term interest rates

A change in the current short-term rate which is expected to be temporary will only have a very limited impact on the long-term interest rate

  • When the market expects a future tightening of monetary policy, the yield curve is rising
  • If the market expects a future relaxation of monetary policy, the yield curve

is falling

The yield curve is flat when market participants have

Static interest rate expectations

(26)

slide19

The ’signalling’ interest rate of the central bank and the 10-year government bond yield in Denmark

slide20

DERIVING THE AGGREGATE DEMAND CURVE

The ex post real interest rate

(27)

Investment and consumption are governed by

The ex ante real interest rate

(28)

We assume

Static expectations

(29)

Equations (28) and (29) imply

(30)

slide21

DERIVING THE AGGREGATE DEMAND CURVE

Recall that

(11)

(21)

Inserting (21) and (30) into (11), we get

The aggregate demand curve

(32)

(33)

slide22

PROPERTIES OF THE AGGREGATE DEMAND CURVE

  • The AD curve has a negative slope: higher inflation induces the central bank to raise the interest rate, causing aggregate demand to fall
  • The AD curve is flatter, the more weight the central bank attaches to stable inflation compared to output stability (see figure 17.7)
  • The AD curve shifts upwards in case of more optimistic growth expectations in the private sector or in case of a more expansionary fiscal policy

The AD curve shifts downwards if the central bank reduces its inflation target

slide24

IMPORTANT CONCEPTS AND RESULTS IN CHAPTER 17

The goods market equilibrium condition

 Properties of the investment function

 Properties of the consumption function

  • The relationship between the real interest rate, public consumption,

expectations and aggregate demand

 Money market equilibrium

slide25

IMPORTANT CONCEPTS AND RESULTS IN CHAPTER 17

 The constant-money-growth rule and its implications for interest rate policy

 The Taylor rule and its implications for interest rate policy

 The relationship between the short-term and the long-term interest rate: The expectations hypothesis and the yield curve

 The ex ante versus the ex post real interest rate

 Poperties of the AD curve, including the importance of monetary policy for the position and the slope of the curve