13.2 Monetary Policy Rules and Aggregate Demand Introduction 6/24/2014. Stabilization Policy and the AS/AD Framework.

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1 Introduction In this chapter, we learn: With systematic monetary policy, we can combine the IS curve and the MP curve to get an aggregate demand () curve.

1 Chapter 13 Stabilization Policy and the / Framework By Charles I. Jones 13.2 Monetary Policy Rules and Aggregate Demand The short-run model consists of three basic equations: Media Slides Created By Dave Brown Penn State University 13.1 Introduction In this chapter, we learn: With systematic monetary policy, we can combine the IS curve and the MP curve to get an aggregate demand () curve. That the Phillips curve can be reinterpreted as an aggregate supply () curve. How the and curves represent an intuitive version of the short-run model that describes the evolution of the economy in a single graph. The modern theories that underlie monetary policy. The model implies that high short-run output leads to an increase in inflation. The central bank chooses how to make this trade-off by choosing the interest rate. A monetary policy rule A set of instructions that determines the stance of monetary policy for a given situation that might occur in the economy. Question for this chapter: If we could formulate a systematic policy in response to the various kinds of shocks that can possibly hit the economy, what would the policy look like? The rule we consider is that the stance of monetary policy depends on Current inflation Inflation target If inflation is above the target The real interest rate should be high If inflation is below the target The real interest rate should be low 1

2 Simple Monetary Policy Rule Real interest rate Long run interest rate Current inflation Inflation target The curve Describes how the central bank chooses short-run output based on the rate of inflation. Is fundamentally different than market demand Governs how aggressively monetary policy responds to inflation If inflation is above target The central bank raises the interest rate to lower output below potential. The Curve We can substitute the monetary policy rule into the IS curve. The resulting equation is the aggregate demand () curve. Says short-run output is a function of the rate of inflation Moving along the Curve A change in inflation A movement along the curve Changes in Alter the slope of the curve 2

3 Shifts of the Curve curve shifts caused by: Changes in the parameter Changes in the target rate of inflation The point in the graph where short-run output equals zero is equal to the inflation rate in the previous period. The curve will shift due to The inflation rate changing over time Change in the inflation shock parameter 13.3 The Aggregate Supply Curve The aggregate supply () curve is The price-setting equation used by firms The Phillips curve with a new name Equation: Current inflation Inflation in last time period 13.4 The / Framework Combining the and curve Two equations Two unknowns Parameters 3

4 The Steady State In the steady state the endogenous variables are constant over time no shocks to the economy. the inflation rate must be constant and short-run output is equal to zero. Steady state implies: 13.5 Macroeconomic Events in the / Framework The / curves allow us to analyze the dynamics of inflation and output. The / Graph The curve slopes upward implication of price-setting behavior of firms embodied in the Phillips curve The curve slopes downward Due to the response of policymakers to inflation. The vertical axis represents inflation The horizontal axis represents short-run output. Event #1: An Inflation Shock The economy begins in steady state and is hit with a lasting increase in the price of oil. Thus, the parameter Is positive for one period This inflation shock raises the price level permanently. The curve will shift up as a result. Stagflation The stagnation of economic activity accompanied by inflation. 4

5 Note that in period 2: returns to normal The curve does not shift back because Inflation is now In steady state we started with inflation in the previous period equaling the target rate: High inflation created by the oil shock Raises expected inflation Slows the adjustment of the curve back to its initial position Movement of the curve follows the principle of transition dynamics. Transition Dynamics: Movement back to the steady state is fastest when the economy is furthest from its steady state. Inflation slowly falls. Eventually the model will return to its original steady state. In summary, the impact of a price shock It raises inflation directly. Even a single period shock raises expected inflation. Inflation remains higher for a longer period of time. It takes a prolonged slump to get expectations back to normal. The economy suffers stagflation. 5

6 But we are still not yet back to the steady state, so the whole process repeats itself, with shifting slowly The same logic applies: even with no oil shock this period, and with output below potential pulling inflation down, inflation will still remain above its long run level, with gradual steps back toward steady state The steps get smaller and smaller as the economy nears steady state... Sound familiar? This is like the Solow Model An oil shock takes a while to dissipate! Event 1: Second look: Suppose the price of oil spikes up and produces an inflation shock The math of this is that the parameter in increases from zero: What happens to? It shifts upward: at every level of output, inflation is now higher The economy immediately jumps to a new temporary equilibrium at a lower level of short-run output and a higher level of inflation It turns out that s only the short-run effect; what happens next? Let s review the time path of output and inflation after this oil price shock time, t time, t Before the oil price shock hits, inflation is stable and output is growing at potential When the oil shock hits, Aggregate Supply shifts up, immediately raising inflation and lowering short-run output below potential Since output is below potential, firms set their prices lower, reducing inflation; Aggregate Supply slowly shifts down, increasing shortrun output back to zero After the oil shock subsides, inflation expectations update slowly, and will slowly shift back We can see from the Aggregate Supply curve that inflation stays high because it was high last period, even though the shock subsides and decreased output pulls it down: Now higher Now zero Now negative (lower) So next, shifts down but not all the way Inflation falls a little while output increases Another perspective: Event #2: Disinflation Suppose the economy begins in steady state and policymakers decide to lower the target rate of inflation. The curve Shifts down The new rule calls for An increase in interest rates 6

7 The change in the rate of inflation causes the curve to shift during the following period. Firms adjust their expectation for inflation to account for the new lower inflation rate. The curve shifts down. The economy must now move to its new steady state. When actual output equals potential output, the new steady state is at the new target rate of inflation. The inflation rate is still above the target. The central bank keeps actual output below potential. The inflation rate falls further. Eventually, the economy will rest in its new steady state. Note that if the classical dichotomy holds in the short run, the and curves would reach the new steady state immediately. If there is sticky inflation, a recession is needed to adjust expectations down. 7

8 Even 2. Second look: The Volcker Disinflation, a permanent shock to Suppose the Fed wants a lower long-run rate of inflation than is currently prevailing, and it will use monetary policy to achieve it The Fed s monetary policy affects Aggregate Demand, and not Aggregate Supply The Fed chooses a lower inflation target, Aggregate Demand shifts inward because But the Fed actually aims for a short-term intersection above the final level of inflation! The time path of output and inflation after the Volcker Disinflation, a permanent shift in : time, t time, t Before the Fed switches targets, inflation is stable but high and output is growing at potential The Fed chooses a lower inflation target and raises interest rates, shifting back and immediately lowering inflation and short-run output Since output is below potential, firms set their prices lower, reducing inflation; Aggregate Supply slowly shifts down, increasing shortrun output back to zero Just like before, we re not done - also shifts! When the Fed starts the disinflation by lowering Aggregate Demand, inflation falls A fall in inflation shifts Aggregate Supply downward. Why? It s because firms see the disinflation and set their prices accordingly: Since inflation has fallen, πt 1 is lower, so the intercept term has fallen, causing a downward or outward shift in the curve But doesn t fall all the way immediately! Event #3: A Positive Shock Suppose there is a temporary increase in the aggregate demand parameter The curve will shift out. Prices increase. And just like before, Aggregate Supply slowly adjusts The Curve keeps falling as long as short-run output is below zero, because firms set next period s prices that way: Ultimately, the curve reaches the new steady state at zero short-run output (in other words, output is at potential) and lower long-run inflation, 8

9 As inflation has increased, firms expect higher inflation in the future. Thus, the curve shifts upward over time. The inflation rate associated with zero shortrun output rises. The curve shifts until the economy has higher inflation and zero short-run output. The aggregate demand shock implies that booms are matched by recessions. The economy benefits from a boom but inflation rises. The way to reduce inflation is by a recession. The costs of inflation: The economy would have been better staying at its original steady state than going through this cycle. Event #3: Second look: A temporary positive shock to Aggregate Demand through exports Suppose there is a boom in Europe, and they demand more U.S. exports temporarily Aggregate Demand shifts out immediately, and the economy jumps to the new intersection But we re not done... Aggregate Supply reacts to increased inflation by shifting upward, reducing shortrun output, because firms adjust their prices: 9

10 As before, Aggregate Supply adjusts slowly because firms are setting their prices Aggregate Supply shifts upward as firms set prices higher and increase inflation, and the process stops when the new and the new intersect at But now: yet another twist! We re still not done. Why? The Aggregate Demand shock was only temporary Ultimately, will shift back to where it was initially! Further Thoughts on Aggregate Demand Shocks In theory, monetary policy can be used to insulate an economy from aggregate demand shocks. The monetary policy rule we specified here responds only to inflation and not output changes. The Aggregate Demand shock eventually dies out, and shifts back to where it was Now, Aggregate Supply will adjust by shifting downward, because short-run output is negative, below potential! This process returns us slowly to the original equilibrium! Why? The Aggregate Demand shock, of Europeans buying more U.S. exports, is only temporary Things happen in the interim, but in the long run it wears off Case Study: Real Business Cycle Models and the New Economy Variations in total factor productivity (TFP) can produce realistic fluctuations in the economy. Real business cycles Fluctuations in the economy that are driven by real forces in the economy The time path of output and inflation after the temporary Aggregate Demand shock through exports time, t time, t Before the export shock hits, inflation is stable and output is growing at potential Europeans demand more U.S. exports, and shifts out, raising output and inflation immediately Aggregate Supply slowly shifts up, increasing inflation and lowering shortrun output back to When the export shock stops, shifts back, immediately lowering output and inflation Aggregate Supply slowly shifts down, lowering inflation and raising output An unresolved issue is whether fluctuations in GDP are due mostly to either Fluctuations in potential output Fluctuations in actual output Which described the new economy? A technological shock that changed potential output An aggregate demand shock that would increase inflation Greenspan attributed most gains in output to technological change. 1

11 13.6 Empirical Evidence Question: What are the empirical predictions of the short-run model when monetary policy is dictated by an inflation-based policy rule? Inflation-Output Loops When plotting inflation on the vertical axis and output on the horizontal axis: The economy will follow counterclockwise loops to shocks in the economy. Positive short-run output leads to rising inflation. A rise in inflation leads policymakers to reduce output. Predicting the Fed Funds Rate The Fisher equation Monetary policy rule in terms of the nominal interest rate: Nominal interest rate The Taylor rule suggests picking parameter values that are functions of 2. 11

12 Case Study: Forecasting and the Business Cycle To conduct forecasts, economists study a large number of variables of leading economic indicators. The fed funds rate The term structure for interest rates Claims for unemployment insurance The number of new houses Forecasts have a difficult time predicting turning points. More Sophisticated Monetary Policy Rules Richer monetary policy rules that use short-run output create results similar to the simpler model. The simple policy rule we used implicitly weights short-run output Modern Monetary Policy The short-run model captures many features of monetary policy. Central banks are now more explicit about policies and targets. Inflation rates in industrialized countries have been well behaved for the last 25 years. Rules versus Discretion Is there any benefit to creating a systematic policy? The time consistency problem Even though an agent supports a particular policy, once the future comes, they have incentives to renege on their promises. 12

13 Firms and workers form expectations about inflation and build them into pricing decisions. Under adaptive expectations, we assume Central bankers have incentives to pursue an expansionary policy. Firms and workers anticipate the policy and build that anticipation into resulting in no benefit to output. Expected inflation Last year s inflation Also assume the equation doesn t change with policy rule changes. Our motivation for this assumption was the stickiness of inflation. Policymakers need to commit to not exploit inflation expectations in order to keep a low rate of inflation. Rational expectations People use all information at their disposal to make their best forecast of the rate of inflation. This information may include the costs resulting in sticky inflation but may also add the target rate of inflation. The Paradox of Policy and Rational Expectations The goal of macroeconomic policy Full employment Output at potential Low, stable inflation The presence of a policymaker willing to generate a large recession to fight inflation makes policy use less likely. The central bank s willingness to fight inflation is a key determinant of expected inflation. If firms know the bank will fight aggressively to keep inflation low They are less likely to raise prices after an inflation shock. 13

14 Managing Expectations in the / Model We can drop the assumption of adaptive expectations and rewrite the curve in terms of the expected rate of inflation: Expected rate of inflation Case Study: Rational Expectations and the Lucas Critique The Lucas critique It is inappropriate to build a macroeconomic model based on equations in which expectations are not consistent with the statistical properties of the economy. Models should incorporate the theory of rational expectations. If the Federal Reserve lowers the inflation target The curve shifts down. If expectations adjust immediately and people use all information, the curve shifts down immediately to the new target. If the central bank can control expectations of inflation Inflation can be kept low without recessions. Inflation Targeting In many countries, central banks have an explicit target rate of inflation that they seek to apply over the medium horizon. Explicit inflation targets Anchor inflation expectations May make it easier for central banks to stimulate output Constrained discretion A central bank has the flexibility to respond to shocks in the short-run. The bank is committed to particular rate of inflation in the long run. 14

Second look:rules versus discretion in monetary policy To review: rules are set-in-stone reactions, like the rule we specified for the Federal Reserve.

15 Second look:rules versus discretion in monetary policy To review: rules are set-in-stone reactions, like the rule we specified for the Federal Reserve. Discretion refers to the Fed s choice whether and when to act Why talk about this distinction? Three reasons: Mechanically, we need a rule to simplify the short run model from IS-MP- PC to the Aggregate Supply and Demand model Recent economic history suggests that the specific rule we chose is consistent with the Fed s actual behavior (this is in section 12.6 in the text, if you are interested) Nobel prizewinning research has revealed why discretionary monetary policy can actually be bad for the macroeconomy How could discretionary policy be bad if policymakers have good intentions? Specifying a policy rule is a way of tying yourself to the mast, so you can t be tempted The rule does not have to ignore output, like our original rule did, but it does have to convince the public that you will fight inflation. The more convincing you are in promising to fight inflation the more tightly you tie yourself to the mast, promising not to raise short-run output even though you really, really badly want to the more adaptive Aggregate Supply will be, and the shorter recessions will last Why? If your commitment to a particular inflation target is credible, then inflation expectations will be equal to that target, and not necessarily equal to recent inflation: How does this look in the / graph? Why is discretionary policy dangerous? Suppose the Fed has garnered credibility and announces a lower inflation target that people believe People know how the short-run model works, and they know that policymakers also know how the short-run model works Why is this knowledge dangerous? First of all: everyone, including policymakers, likes to have low inflation and high output at the same time What does the IS-MP diagram tell us about the Fed and interest rates? By lowering interest rates, the Fed can stimulate investment and push output above potential, raising What does the Phillips Curve (PC) tell us about output above potential? When, the change in inflation is positive inflation will rise If we know the Fed likes output, we might expect inflation to rise, and it will, in a self-fulfilling prophecy, because π e is high: : As in Example #2, the Fed chooses a new target Aggregate demand will fall because the Fed adopts this new target, since is But if the Fed announces this change and has built up its credibility so that firms believe it, will simultaneously jump down as firms price in exactly The result? Less inflation with no recession! How can the Fed avoid this trap? Odysseus (a.k.a. the Fed) really badly wanted to get back home from the Trojan War (think of this as having low inflation) But he also really badly wanted to hear the song of the sirens (think: high output) The problem: he knew that if he and his men listened to the sirens, sure it would be fun, but they d run their ship aground and die(think: high inflation) So he plugged the ears of his men and tied himself to the mast (think: commit to rule) Is this for real? Lower inflation without a recession? This sounds almost too good to be true, right? We don t like inflation, and we don t like recessions, so doesn t this kind of policy fit the bill exactly? Yes it does, and this reasoning is behind the use of inflation targeting by central banks in many countries today: UK, Australia, Brazil, Canada, Mexico, New Zealand, and Sweden But this isn t a free lunch credibility is required but not free! The only way to make firms believe in your inflation target is to stick to it, which means raising interest rates and causing a recession when oil price shocks hit, among other things The bottom line: we would still have recessions under fully credible inflation targeting, and we still believe that flexibility the occasional use of discretion is an important tool to keep in the toolbox 15

16 Case Study: Choosing a Good Federal Reserve Chair The Romer and Romer study argues that policymakers views about how the economy works play a crucial role in making a good chair. Knowledge of macroeconomics is essential to successful Fed chairs. Combining a monetary policy rule with the IS curve leads to an aggregate demand () curve curve Describes how the central bank chooses the level of short-run output based on the current rate of inflation The aggregate supply () curve, another name for the Phillips curve Tells us that the current rate of inflation depends positively on short-run output The equation for the curve is: Conclusion A credible, transparent commitment to a low rate of inflation is one of the key factors in taming inflation. Anchors inflation expectations so that shocks are deflected quickly Stabilizes economy The period after the recession The Great Moderation Relative stability of the macroeconomy In the / framework, we assume expected inflation adjusts slowly, or is sticky. We have adaptive expectations, so that The / framework allows us to study shocks to the economy and changes in the inflation target. The graph shows how inflation and short-run output evolve over time. The economy moves gradually back to its steady state after a shock. Summary Monetary policy often follows a systematic approach that can be characterized as a monetary policy rule: The central bank increases the real interest rate whenever inflation exceeds a particular target. This rule describes monetary policy in the U.S. economy over the last few decades reasonably well. Modern monetary policy recognizes that managing inflation expectations is an important key to stabilizing the economy. The theory of rational expectations In order to determine future inflation, people analyze all information that is available to them. 16

17 Systematic monetary policy, reputation, and inflation targets are tools that central banks use to help them manage inflation expectations. By anchoring inflation expectations, central banks can achieve low inflation and stable output in the least costly fashion. This concludes the Lecture Slide Set for Chapter 13 Macroeconomics Second Edition by Charles I. Jones W. W. Norton & Company Independent Publishers Since

Stabilization Policy and the AS/AD

Stabilization Policy and the AS/AD Week 10 Vivaldo Mendes Dep. of Economics Instituto Universitário de Lisboa 25 November 2017 (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0271) 25 November 2014 1 /