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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MONETARY POLICY AND AGGREGATE DEMAND
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
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.
Condition for goods market equilibrium
Aggregate private demand
D C + I
We assume a
Balanced public budget
T = G
From (1) through (3) we then get the
Equilibrium condition for the goods market
Properties of the aggregate private demand function
Figure17.2: The real interest rate and the private sector savings surplus in Denmark, 1971-2000
In the chapter text we show that (4) may be log-linearized to give the following
Approximation of the goods market equilibrium condition
Note that the equilibrium real interest rate is determined by the condition for
Long run equilibrium in the goods market
We now wish to transform (11) into a relationship between y og . For that purpose we must study
The equilibrium condition for the money market
The money demand function
Note:iistheshort-terminterest rate which is controlled by the central bank.
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.
Money market equilibrium under the CMG rule
Assume that we have
Long run equilibrium in the previous period
Taking logarithms in (16) and (17) and using the approximations
ln(1+) andln(1+) , we get
Substitution of (18) into (19) yields
Monetary policy under the CMG 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
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
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
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
Implication: The current long rate is a simple average of the current short rate and the expected future short rates.
Further implications of (25):
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
The yield curve is flat when market participants have
Static interest rate expectations
The decoupling of short-term and long-term interest rates in the United States, 2001-2002
The ’signalling’ interest rate of the central bank and the 10-year government bond yield in Denmark
The ex post real interest rate
Investment and consumption are governed by
The ex ante real interest rate
Equations (28) and (29) imply
Inserting (21) and (30) into (11), we get
The aggregate demand curve
The AD curve shifts downwards if the central bank reduces its inflation target
Figure 17.7: The aggregate demand curve under alternative monetary policy regimes
The goods market equilibrium condition
Properties of the investment function
Properties of the consumption function
expectations and aggregate demand
Money market equilibrium
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