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## Advanced Macroeconomics

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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

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.

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

Equilibrium condition for the goods market

(4)

Properties of the aggregate private demand function

(5)

(6)

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

(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

The equilibrium condition for the money market

(14)

The money demand function

(15)

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.

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)

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

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.

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)

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

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)

DERIVING THE AGGREGATE DEMAND CURVE

Recall that

(11)

(21)

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

The aggregate demand curve

(32)

(33)

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

Figure 17.7: The aggregate demand curve under alternative monetary policy regimes

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

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

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