Macroeconomic equilibrium in the short run: the Money market
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1 Macroeconomc equlbrum n the short run: the Money market 2013
2 1. The bg pcture Overvew Prevous lecture How can we explan short run fluctuatons n GDP? Key assumpton: stcky prces Equlbrum of the goods market IS curve Today Equlbrum of the Money market TR-curve Macroeconomc equlbrum IS-TR
3 Introducton The bg pcture IS-TR Model TR curve IS-TR today IS-TR wth captal flows: Wednesday S: next Monday Ch 12 S-D: lecture notes (+ parts of Ch 13)
4 Outlne 1. Recall: IS curve 2. Dervng the TR curve 1. Money demand 2. Money supply 3. Taylor Rule 4. The slope of the TR curve 5. Shfts of the TR curve 3. Macroeconomc equlbrum 1. Demand shocks 2. Change n monetary polcy 3. Polcy mx
5 1. IS curve IS curve: equlbrum on the goods market IS-curve graphs all combnatons of and that result n goods market equlbrum Goods market equlbrum ggregate supply of domestc goods and servces = aggregate demand ggregate supply: ggregate demand (desred demand DD): C + G + I + PC *,,,, C T I q G PC Supply adjusts to demand Keynesan Cross If nvestment (DD )
6 Desred demand Interest rate 1. IS curve From DD to IS Equlbrum on the goods market: = desred demand *,,,, C T I q G PC IS curve derved by fndng s for all s that lead to = DD =DD IS DD DD B DD ( ) DD() B
7 Interest rate 1. IS curve IS curve: equlbrum on the goods market IS-curve graphs all combnatons of and that result n goods market equlbrum actual output = planned expendture (desred demand: DD) If nvestment (DD ) downward slopng Rght of IS: excess supply Left of IS: excess demand ll combnatons of and for whch total supply of goods equals total demand of goods (for a gven prce level) IS
8 Desred demand Interest rate 1. IS curve Shft n the IS curve IS curve: *,,,, C T I q G PC IS curve shfts, when any of the exogenous parameters change: Ω, T, q, G, *, σ ( More rght, Less left, except: T + σ) =DD DD DD B DD( G, ) DD( G, ) IS IS B
9 2. Dervng the TR curve Money market equlbrum TR curve represents the equlbrum n the money market.e. the combnatons of the nterest rate and the ncome level where money demand equals money supply Prces are fxed Upward slopng CB sets the nterest rate money supply endogenous Interest rate set accordng to the Taylor rule to ensure prce stablty (nflaton targetng)
10 Nomnal nterest rate 2.1. Money demand Dervng the TR curve money demand Money demand = k()p People are nterested n the purchasng power of money Real money demand wth fxed prces: k()p k() If output ncreases from to : money demand ncreases from k() to k() k() k() Real money stock
11 2.2. Money supply Interbank rate Dervng the TR curve money supply (M s ) real money supply = M/P If P constant M/P constant controlled by the central bank (M0) CB can choose any pont on the money demand curve Inflaton targetng: CB fxes the nterest rate must provde as much M0 s as s demanded at that rate Real money M/P
12 2.2. Money supply Nomnal nterest rate TR curve and money market equlbrum k() M/P k() M/P M/P* Real Money : ncreases money demand from k() to k() t nterest rate, money market equlbrum holds f the CB supples (M/P)* CB rases the nterest rate from to n reacton to the output ncrease The hgher nterest rate reduces money demand. New money market equlbrum: at (M/P) and How does the CB decdes on?
13 2.3. Taylor Rule The Taylor rule Taylor rule : trend GDP : nflaton target Prce stablty a( ) : natural nomnal nterest rate, the rate CB would want f both π and are at ther trend values. a and b: weghts of the respectve objectves b stablty Short run: prces are fxed, nflaton = 0 b If (above trend GDP) If (below trend GDP)
14 2.4. The slope of the TR curve Nomnal nterest rate The Slope of the TR Curve: TR 0 The slope of TR depends on b: b Scenaro 1: b= 0 TR 0 : CB holds nterest rate constant k() k() > Hgher output ncreases money demand. But: TR 0 mples a totally elastc money supply curve M S 0. (slope of zero) D M S 0 D TR 0 M/P M/P Real money
15 2.4. The slope of the TR curve Nomnal nterest rate The Slope of the TR Curve: TR 1 Scenaro 2: central bank responds to output ncrease by rasng nterest rates moderately. b > 0 TR 1 k() k() b Hgher output ncreases money demand. TR 1 mples a postve slope of money supply curve M S 1. C M S 1 TR C M/P M/P Real money
16 2.4. The slope of the TR curve Nomnal nterest rate The Slope of the TR Curve: TR 2 Scenaro 3: central bank responds to output ncrease by rasng nterest rates strongly. b 0 TR 2 : CB keeps money supply fxed. 2 k() k() M S 2 B TR 2 mples a totally nelastc money supply curve MS 2. 2 B TR 2 > M/P Real money
17 Nomnal nterest rate Nomnal nterest rate 2.4. The slope of the TR curve Summary of the TR curve TR always goes through. The slope of TR depends on the weght b the central bank puts on the output gap. F M S 2 M S 1 B C D M S 0 k() b F B C D TR 3 TR 2 (LM) TR 1 TR 0 k() M/P Real money supply
18 2.4. The slope of the TR curve Example of the Taylor rule schedule Example: Inflaton = 0 nflaton target =0 Natural nterest rate = 3% gap = 4% b 1. scenaro: CB reacts only lttle to a change n : b= 0.4 = *0.04=0.046 (ex.: Curve TR 1 n prevous slde) 2. scenaro: CB reacts stronger to a change n : b=0.5 = *0.04= 0.05 Money supply ncreases less than n scenaro 1
19 Nomnal nterest rate 2.5. Shfts of the TR curve Shfts of the TR curve TR curve: a( ) b For the TR curve to shft: If change n the target for or for π or the natural nterest rate or change n π (Ch. 13) B TR TR Ex: Change n monetary polcy: CB ncreases the natural nterest rate to TR shfts up (left)
20 2. Dervng the TR curve Summary of the TR curve TR curve represents the equlbrum n the money market.e. the combnatons of the nterest rate and the ncome level where money demand equals money supply Upward slopng Slope depends on b, shfts due to exogenous changes n monetary polcy Central bank: nflaton targetng CB can choose any nterest rate t wants, but has to provde the amount of money demanded at that nterest rate If Taylor rule s followed: once the CB has decded on a, b and the nflaton target, s determned by ths equaton Money market always n equlbrum
21 3. Macroeconomc equlbrum Macroeconomc equlbrum In the IS-TR framework, the macroeconomc equlbrum occurs when both the goods and the money market are n equlbrum no excess demand/supply ether for goods or for money (general equlbrum) IS-TR We wll consder three polcy experments: Exogenous ncrease n demand Exogenous change n monetary polcy Polcy mx
22 Interest rate 3. Macroeconomc equlbrum IS-TR equlbrum IS TR
23 Nomnal nterest rate 3.1. Demand shocks n the macroeconomc equlbrum IS-TR equlbrum: demand shock Postve demand shock: ncrease n demand IS shfts to the rght TR B In response to output expanson, the central bank rases the nterest rate. New equlbrum: pont B IS IS
24 3.1. Demand shocks n the macroeconomc equlbrum Nomnal nterest rate Nomnal nterest rate IS-TR equlbrum TR curve wth a slope >0 Outward Shft of IS,, M/P M s Exogenous ncrease n demand TR B C S B C D D IS IS Real money supply
25 3.1. Demand shocks n the macroeconomc equlbrum The economcs behnd IS-TR Example: IS curve shfts because of an ncrease n G Goods market (Keynesan cross): Desred demand(c+i+g+pc) ncreases supply of goods wll follow Total producton rses and thus ncome rses also: Multpler effect: -C (the new equlbrum would be C) Money market: Increase n leads to a hgher money demand for a gven Taylor rule tells CB how to set the nterest rate n case that s above the trend value (here the case!) expansonary monetary polcy CB wll ncrease money supply and (dependng on b) ( B)
26 3.1. Demand shocks n the macroeconomc equlbrum The economcs behnd IS-TR The acton of the CB has agan an mpact on the real economy: Goods market: Hgher reduces nvestment planned nvestement, DD Ths drop n nvestment partally offsets the postve effect of the ncrease n G on. (C-B) New equlbrum: pont B hgher, hgher, but lower then predcted by the Keynesan cross. That s because of the nteracton wth the money market! No money neutralty here!
27 Nomnal nterest rate 3.1. Demand shocks n the macroeconomc equlbrum IS-TR equlbrum: demand shock Negatve demand shock: decrease n demand IS shfts to the left TR C IS IS In response to output contracton, the central bank lowers the nterest rate. Queston: Can you fnd what happens n the money market? Queston: How does the money market nfluences the goods market?
28 Nomnal nterest rate 3.2. Monetary polcy changes the macroeconomc equlbrum IS-TR equlbrum: TR shocks Expansonary monetary polcy shock: decrease n the natural nterest rate TR shfts to the rght TR TR NOTE: ccordng to the Taylor rule monetary polcy s automatcally expansonary f < (contractonary f > ) D IS Shft of TR-curve only f decrease/ncrease n for LL levels of (also ) change n one of the parameters of the TR!
29 Interest rate 3.2. Monetary polcy changes the macroeconomc equlbrum IS-TR equlbrum Polcy mx: new equlbrum n D same, M/P, IS IS TR TR Combnaton of exogenous changes n demand and monetary polcy D
30 3.2. Monetary polcy changes the macroeconomc equlbrum Short-Term Interest Rates,
31 Nomnal nterest rate Nomnal nterest rate Fnd the mstake! M H B F D C S D H C B F TR TR IS IS Real money supply
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