MONEY AND BONDS NOVEMBER 4, 20 Inroducion IS MONETARY POLICY NEUTRAL? An enduring quesion in macroeconomics: does moneary policy have any imporan effecs on he real (i.e, real GDP, consumpion, ec) economy? Definiion: Money (and hence moneary policy) is neural if changes in he money supply (i.e., changes in moneary policy) have no effec on he real economy Moneary policy is non-neural if i does have effecs on he real economy New Keynesian view: money is non-neural (ecause prices are rigid/sicky, someimes for long periods of ime) RBC view: money is neural (ecause prices are no rigid/sicky in any imporan way) To seriously consider neuraliy issue, need o finally explicily hink aou money and moneary policy I s only een in he ackground of he analysis so far Novemer 4, 20 2
Macro Fundamenals THE ROLES OF MONEY The roles played y money Medium of exchange Eases doule-coincidence of wans prolem Uni of accoun A common language for all prices o e quoed in Sore of value Bananas will perish in shor amoun of ime, dollar ills won Novemer 4, 20 3 Macro Fundamenals THE ROLES OF MONEY The roles played y money Medium of exchange Eases doule-coincidence of wans prolem Uni of accoun A common language for all prices o e quoed in Sore of value Bananas will perish in shor amoun of ime, dollar ills won How o concepually model money a surprisingly hard prolem Much more difficul han, e.g., consumpion-leisure framework or consumpion-savings framework How o formally (mahemaically) represen hese roles of money? A shorcu: suppose money direcly yields uiliy Period- uiliy funcion M u c, P Money-in-he-uiliy-funcion (MIU) formulaion IMPORTANT: I s no M in he uiliy funcion, u raher M /P Novemer 4, 20 4 2
Macro Fundamenals REAL MONEY BALANCES M /P a key variale for macroeconomic analysis Uni Analysis (i.e., analyze algeraic unis of variales) Unis(M ) $ Unis(P ) $/uni of consumpion Unis(M /P ) $ uni of consumpion $ $ $ uni of consumpion uni of consumpion Novemer 4, 20 5 Macro Fundamenals REAL MONEY BALANCES M /P a key variale for macroeconomic analysis Uni Analysis (i.e., analyze algeraic unis of variales) Unis(M ) $ Unis(P ) $/uni of consumpion Unis(M /P ) $ uni of consumpion $ $ $ uni of consumpion uni of consumpion Uiliy (composie of medium of exchange, uni of accoun, sore of value) depends on real money (M/P), no nominal money (M) Measures he purchasing power of (nominal) money holdings which is presumaly wha people mos care aou M and P can poenially grow a differen raes In which case real money alances flucuae from one period o he nex Novemer 4, 20 6 3
Macro Fundamenals MONEY MARKETS AND BOND MARKETS A prerequisie for analyzing moneary policy: undersanding onds and ond markes Bond markes and money markes ighly linked o each oher Wha is a ond? Novemer 4, 20 7 Macro Fundamenals MONEY MARKETS AND BOND MARKETS A prerequisie for analyzing moneary policy: undersanding onds and ond markes Bond markes and money markes ighly linked o each oher Wha is a ond? Simply pu, a de oligaion (i.e., orrow funds oday, repay a some fuure dae wih ineres) Types of onds Convenional 30-day, 60-day, 90-day Federal governmen onds moneary policy -year Federal governmen onds operaes 2-year Federal governmen onds hrough shorerm onds 5-year Federal governmen onds 0-year Federal governmen onds 30-year Federal governmen onds Foreign sovereign governmen onds of various mauriies Sae and local governmen onds of various mauriies Corporae onds of various mauriies Coupon onds pay somehing ack ( coupon paymens ) every so ofen unil he final dae of mauriy Zero-coupon onds only pay ack a final dae of mauriy Novemer 4, 20 8 4
Macro Fundamenals BOND MARKETS A prerequisie for analyzing moneary policy: undersanding onds and ond markes Bond markes and money markes ighly linked o each oher Wha is a ond? Simply pu, a de oligaion (i.e., orrow funds oday, repay a some fuure dae wih ineres) Simplify y supposing ha all onds are one-period zero-coupon governmen onds i.e., shor-erm onds Tradiional simplificaion for analysis of moneary policy Undersanding how shor-erm ond is priced Asse-pricing lurking in he Key o undersanding how all onds are priced ackground Key o undersanding how all sors of financial asses are priced again Also sheds ligh on he pricing kernel (recall from Chaper 8) Sock prices linked o ond prices Novemer 4, 20 9 Macro Fundamenals BOND MARKETS In normal imes. Decoupling amids severe recession? A prerequisie for analyzing moneary policy: undersanding onds and ond markes Bond markes and money markes ighly linked o each oher Wha is a ond? Simply pu, a de oligaion (i.e., orrow funds oday, repay a some fuure dae wih ineres) Simplify y supposing ha all onds are one-period zero-coupon governmen onds i.e., shor-erm onds Tradiional simplificaion for analysis of moneary policy Undersanding how shor-erm ond is priced Key o undersanding how all onds are priced Key o undersanding how all sors of financial asses are priced Shor-erm governmen ond a riskless de insrumen U.S. governmen has never defauled on (nominal ) ond paymen Bu excess inflaion a ackdoor way of defauling (Imporan concep(s) for financial acceleraor framework laer.) Novemer 4, 20 0 5
Macro Fundamenals BOND MARKETS Bonds priced according o presen-value of fuure payoff Key relaionship eween price of a ond and nominal ineres rae FV + P + i Noaion P : nominal price of a one-period ond i : nominal ineres rae eween period and period + FV + : face-value of ond (i.e., how much will e repaid in +) In realiy, many differen values of FV ($00, $000, $0,000, ec ) Novemer 4, 20 Macro Fundamenals BOND MARKETS Bonds priced according o presen-value of fuure payoff Key relaionship eween price of a ond and nominal ineres rae P i + i P IMPORTANT: inverse relaionship eween P and i Noaion P : nominal price of a one-period ond i : nominal ineres rae eween period and period + FV + : face-value of ond (i.e., how much will e repaid in +) In realiy, many differen values of FV ($00, $000, $0,000, ec ) Simplify and assume FV (will ge main ideas across) Inverse relaionship eween price of a ond and nominal ineres rae criical Shor-erm ond markes are/have een he convenional channel hrough which Federal Reserve conducs moneary policy Novemer 4, 20 2 6
Convenional Moneary Policy MONEY MARKETS AND BOND MARKETS Shor-erm ond markes and money markes ighly linked o each oher P S (ulimaely a reflecion of fiscal policy ) i S (conrolled y Fed) CRUCIAL LINK P /(+i) D D BOND MARKET onds MONEY MARKET money i can e hough of in wo (mirror-image) ways The ineres payoff of a ond Opporuniy cos of holding money Each uni of wealh held as a dollar is a uni of wealh no held as a ond, which enails he loss of chance o earn ineres (i.e., opporuniy cos) i is inerpreed as he price of money Novemer 4, 20 3 Convenional Moneary Policy MONEY MARKETS AND BOND MARKETS Shor-erm ond markes and money markes ighly linked o each oher P S (ulimaely a reflecion of fiscal policy u Fed can influence oo) i S (conrolled y Fed) CRUCIAL LINK P /(+i) D D BOND MARKET onds MONEY MARKET money i can e hough of in wo (mirror-image) ways The ineres payoff of a ond Opporuniy cos of holding money Each uni of wealh held as a dollar is a uni of wealh no held as a ond, which enails he loss of chance o earn ineres (i.e., opporuniy cos) i is inerpreed as he price of money Convenional moneary policy Basic macro: Fed open-marke operaions conduced via shor-erm ond markes, so Fed operaions do affec ond supply Novemer 4, 20 4 7
Convenional Moneary Policy MONEY MARKETS AND BOND MARKETS Basic macro: open-marke operaions conduced via shor-erm ond markes P S of open marke Toal S wha Congress acually ses i S (conrolled y Fed) CRUCIAL LINK P /(+i) D D onds OPEN MARKET FOR BONDS MONEY MARKET money Expansionary moneary policy y Fed Fed uys shor onds from financial secor, reducing open-marke supply y prining new money, increasing is supply in money marke which causes shor-erm i o decrease Novemer 4, 20 5 Convenional Moneary Policy MONEY MARKETS AND BOND MARKETS Basic macro: open-marke operaions conduced via shor-erm ond markes P S of open marke Toal S wha Congress acually ses i S (conrolled y Fed) Review from inro macro noes or Chaper -2 in macro refresher D CRUCIAL LINK P /(+i) D onds OPEN MARKET FOR BONDS MONEY MARKET money Expansionary moneary policy y Fed Fed uys shor onds from financial secor, reducing open-marke supply y prining new money, increasing is supply in money marke which causes shor-erm i o decrease Conracionary moneary policy y Fed Fed sells shor onds o financial secor, increasing open-marke supply in exchange for money, decreasing is supply in money marke which causes shor-erm i o increase Novemer 4, 20 6 8
Beyond Convenional Moneary Policy AMORE EXPANSIVE VIEW OF MONETARY POLICY? Convenional moneary policy: ineres-rae argeing via open-marke operaions Wha else is moneary policy and how else can i e conduced? Unconvenional policy measures an imporan issue he pas few years Allow Fed o purchase oher asses, no jus shor-erm U.S Treasuries i.e., le i conduc oher marke operaions esides only convenional shor-ond open-marke operaions Allow Fed o issue is own onds (legal issues unclear) Novemer 4, 20 7 Beyond Convenional Moneary Policy AMORE EXPANSIVE VIEW OF MONETARY POLICY? Convenional moneary policy: ineres-rae argeing via open-marke operaions Wha else is moneary policy and how else can i e conduced? Unconvenional policy measures an imporan issue he pas few years Allow Fed o purchase oher asses, no jus shor-erm U.S Treasuries i.e., le i conduc oher marke operaions esides only convenional shor-ond open-marke operaions Allow Fed o issue is own onds (legal issues unclear) Bail ou/lend o anks and firms in imes of disress ( lender of las resor ) Communicae wih he pulic and markes aou how he economy is doing A confidence-managemen role Bernanke has given quarerly press riefings since April Curren focus on quaniaive easing/credi easing is here a QE3 coming? Purchase asses no convenionally used in policy implemenaion (erm derives from Friedman s quaniy of money heories) Novemer 4, 20 8 9
MONETARY POLICY IN THE INFINITE-PERIOD ECONOMY NOVEMBER 4, 20 Inroducion BASICS Exend our infinie-period framework Inroduce money and onds ino he Chaper 8 framework So now hree ypes of asses (socks, shor-erm onds, money) for represenaive consumer o use for savings purposes Will allow us o hink furher aou wha he pricing kernel is Will allow us o hink aou connecion eween ond prices and sock prices Will allow us o hink aou issue of moneary neuraliy (he main issue in he RBC vs. New Keynesian deae) i.e., does money (and hus moneary policy) have imporan consequences for real (i.e., consumpion and real GDP) variales? Index ime periods y arirary indexes, +, +2, ec. Imporan: all of our analysis will e conduced from he perspecive of he very eginning of period Sequenial Lagrangian analysis (wih money in he uiliy funcion) Novemer 4, 20 20 0
Inroducion BASICS Timeline of evens Now hree ypes of asses consumers can use for savings purposes Noaion c : consumpion in period P : nominal price of consumpion in period Y : nominal income in period ( falls from he sky ) a - : real sock holdings a eginning of period /end of period - M - : nominal money holdings a eginning of period /end of period - B - : nominal ond holdings a eginning of period /end of period - Novemer 4, 20 2 Inroducion BASICS Timeline of evens Now hree ypes of asses consumers can use for savings purposes Noaion c : consumpion in period P : nominal price of consumpion in period Y : nominal income in period ( falls from he sky ) a - : real sock holdings a eginning of period /end of period - M - : nominal money holdings a eginning of period /end of period - B - : nominal ond holdings a eginning of period /end of period - S : nominal price of a uni of sock in period D : nominal dividend paid in period y each uni of sock held a he sar of P : nominal price of a ond in period i : nominal ineres rae on a ond purchased in and which pays off in + π + : ne inflaion rae eween period and period + y : real income in period ( Y /P ) Novemer 4, 20 22
Inroducion BASICS Timeline of evens Now hree ypes of asses consumers can use for savings purposes Noaion c + : consumpion in period + P + : nominal price of consumpion in period + Y + : nominal income in period + ( falls from he sky ) a : real sock holdings a eginning of period +/end of period M : nominal money holdings a eginning of period +/end of period B : nominal ond holdings a eginning of period +/end of period S + : nominal price of a uni of sock in period + D + : nominal dividend paid in + y each uni of sock held a he sar of + P +: nominal price of a ond in period + i + : nominal ineres rae on a ond purchased in + and which pays off in +2 π +2 : ne inflaion rae eween period + and period +2 y + : real income in period ( Y + /P + ) Novemer 4, 20 23 Inroducion BASICS Timeline of evens Noaion And so on for period +2, +3, ec Novemer 4, 20 24 2
Model Srucure BUDGET CONSTRAINT(S) Exend udge consrains from Chaper 8 sock-pricing framework o now include hree disinc ypes of asses: socks, money, and shor-erm onds Need infinie udge consrains o descrie economic opporuniies and possiiliies One for each period In period Pc + PB+ M + S a Y + M + B + S a + D a Toal oulays in period : period- consumpion + socks o carry ino period + + money o carry ino period + + ond purchases Toal income in period : period-y+ income from sockholdings carried ino period (has value S and pays dividend D ) + money-holdings carried ino period + ond-holdings carried ino period (each uni repays FV ) Novemer 4, 20 25 Model Srucure BUDGET CONSTRAINT(S) Exend udge consrains from Chaper 8 sock-pricing framework o now include hree disinc ypes of asses: socks, money, and shor-erm onds Need infinie udge consrains o descrie economic opporuniies and possiiliies One for each period In period Pc + PB+ M + S a Y + M + B + S a + D a Toal oulays in period : period- consumpion + socks o carry ino period + + money o carry ino period + + ond purchases Toal income in period : period-y+ income from sockholdings carried ino period (has value S and pays dividend D ) + money-holdings carried ino period + ond-holdings carried ino period (each uni repays FV ) In period + P c + P B + M + S a Y + M + B + S a + D a + + + + + + + + + + Toal oulays in period +: period-+ consumpion + socks o carry ino period +2 + money o carry ino period +2 + ond purchases Toal income in period +: period-+ Y + income from sockholdings carried ino period + (has value S + and pays dividend D + ) + money-holdings carried ino period + + ondholdings carried ino period + (each uni repays FV ) And idenical-looking udge consrains in period +2, +3, +4, ec. Novemer 4, 20 26 3
Infinie-Period Model: Sequenial Formulaion LAGRANGE ANALYSIS: SEQUENTIAL APPROACH Sep : Consruc Lagrange funcion (saring from ) 2 uc (, M / P) + βuc ( +, M+ / P+ ) + β uc ( + 2, M+ 2 / P+ 2) +... + λ Y + ( S + D) a + M + B Pc Sa M P B + βλ + Y+ + ( S+ + D+ ) a + M + B P+ c+ S+ a+ M+ P+ B + 2 + βλ+ 2 Y+ 2 + ( S+ 2 + D+ 2) a+ + M+ + B+ P+ 2c+ 2 S+ 2a+ 2 M+ 2 P 2B + + 2 3 + βλ + 3 Y+ 3 + ( S+ 3 + D+ 3) a+ 2 + M+ 2 + B+ 2 P+ 3c+ 3 S+ 3a+ 3 M+ 3 P+ 3B + 3... + Infinie numer of erms Firs he lifeime uiliy funcion.(no differen han Chaper 8, excep now wih MIU) hen he period consrain hen he period + consrain hen he period +2 consrain hen he period +3 consrain Novemer 4, 20 27 Infinie-Period Model: Sequenial Formulaion LAGRANGE ANALYSIS: SEQUENTIAL APPROACH Sep : Consruc Lagrange funcion (saring from ) 2 uc (, M / P) + βuc ( +, M+ / P+ ) + β uc ( + 2, M+ 2 / P+ 2) +... + λ Y + ( S + D) a + M + B Pc Sa M P B + βλ Y + ( S + D ) a + M + B P c S a M P B + βλ + + + 2 2 2 2 2 2 2 + βλ + + + + +... hen he period + consrain + + + + + + + + + + + 2 + 2 Y+ 2 ( S+ 2 D+ 2) a+ M+ + B+ P+ c+ S+ a+ M+ P B hen he period +2 + + consrain 3 + 3 Y+ 3 ( S+ 3 D+ 3) a+ 2 M+ 2 B+ 2 P+ 3c+ 3 S+ 3a+ 3 M+ 3 P+ 3B hen he period +3 + 3 consrain Sep 2: Compue FOCs wih respec o c, a, B, M, Firs he lifeime uiliy funcion.(no differen han Chaper 8, excep now wih MIU) Infinie numer of erms hen he period consrain wih respec o c : Equaion wih respec o a : wih respec o B : Equaion 2 Equaion 3 wih respec o M : Equaion 4 (need chain rule of calculus o compue his) Novemer 4, 20 28 4
Finance Fundamenals ASSET PRICING REVISITED Equaion 2 Period- sock price u (, / ) 0 c M P λp Equaion λs + βλ + ( S + + D + ) 0 Equaion 2 λp + βλ + 0 Equaion 3 u2( c, M / P) λ + βλ + 0 Equaion 4 P S βλ ( S D ) + + + STOCK-PRICING EQUATION + λ Pricing kernel Fuure reurn Much of finance heory concerned wih pricing kernel Theoreical properies Empirical models of kernels x Pricing kernel where macro heory and finance heory inersec Lagrange mulipliers where macro and finance inersec an idea ha will e imporan in he financial acceleraor framework Novemer 4, 20 29 Finance Fundamenals ASSET PRICING REVISITED Equaion 2 Equaion 3 Period- sock price u (, / ) 0 c M P λp Equaion λs + βλ + ( S + + D + ) 0 Equaion 2 λp + βλ + 0 Equaion 3 u2( c, M / P) λ + βλ + 0 Equaion 4 P S βλ S D + ( + + + ) STOCK-PRICING EQUATION λ P Pricing kernel βλ x Fuure reurn + BOND-PRICING EQUATION λ Terminology: riskless asse Price of shor-erm ond is he pricing kernel Sock prices and ond prices are conneced Mos (all?) asse prices fundamenally conneced o shor ond prices Finance: pricing kernel reflecs he price/reurn of he leas risky asse in he economy U.S. Treasury shor-erm onds Novemer 4, 20 30 5
Finance Fundamenals ASSET PRICING REVISITED Equaion 2 Equaion 3 Recall Period- sock price S βλ S D can express pricing kernel as u (, / ) 0 c M P λp Equaion λs + βλ + ( S + + D + ) 0 Equaion 2 λp + βλ + 0 Equaion 3 u2( c, M / P) λ + βλ + 0 Equaion 4 P + ( + + + ) STOCK-PRICING EQUATION λ P Pricing kernel βλ x Fuure reurn + BOND-PRICING EQUATION λ P + i βλ λ + + i Novemer 4, 20 3 Macro Fundamenals FISHER EQUATION u ( c, / ) 0 M P λp Equaion λs + βλ + ( S + + D + ) 0 Equaion 2 λp + βλ + 0 Equaion 3 u2( c, M / P) λ + βλ + 0 P Equaion 4 Comining sock-pricing equaion wih ond-pricing equaion + i + r + FISHER EQUATION π + Fisher equaion a relaionship eween reurns on nominal onds and reurns on sock (finance heory: no-arirage condiion) (See derivaion in Chaper 4) Bonds: riskless asse Sock: risky asse Fisher equaion was a uilding lock of wo-period model Recall approximae form: r i - π Novemer 4, 20 32 6
Money Demand CONSUMPTION-MONEY OPTIMALITY CONDITION Begin wih equaion 4: u2( c, M / P) λ βλ + P Use βλ + λ P from equaion 3 u (, / ) 2 c M P λ λp P Divide hrough y λ u (, / ) 2 c M P P λ P u ( c, M / P) 2 u ( c, M / P ) P Use λ P u from equaion Use P /(+i ) CONSUMPTION-MONEY OPTIMALITY CONDITION u2( c, M / P) i u ( c, M / P) + i MRS (eween consumpion and real money holdings) price raio (eween consumpion and money) Novemer 4, 20 33 Money Demand MONEY DEMAND Consumpion-money opimaliy condiion he foundaion of money demand funcion M M Example: suppose u c, lnc + ln P P M M Thus, u c, and u 2 c, (no chain rule his ime ) P c P M / P Novemer 4, 20 34 7
Money Demand MONEY DEMAND Consumpion-money opimaliy condiion he foundaion of money demand funcion M M Example: suppose u c, lnc + ln P P M M Thus, u c, and u 2 c, (no chain rule his ime ) P c P M / P Consumpion-money opimaliy condiion (for his uiliy funcion ) is Pc i M + i Isolae he M /P erm M + i c P i REAL MONEY DEMAND FUNCTION: depends posiively on c and negaively on i (i is he opporuniy cos of money) Will use his money demand funcion o analyze The moneary neuraliy deae The long-run (aka seady-sae) connecion eween moneary policy and inflaion Novemer 4, 20 35 MONETARY POLICY IN THE INFINITE-PERIOD ECONOMY: SHORT-RUN EFFECTS NOVEMBER 4, 20 8
Moneary Policy Analysis: Shor-Run Effecs IS MONETARY POLICY NEUTRAL? An enduring quesion in macroeconomics: does moneary policy have any imporan effecs on he real (i.e, real GDP, consumpion, ec) economy? Definiion: Money (and hence moneary policy) is neural if changes in he money supply (i.e., changes in moneary policy) have no effec on he real economy Moneary policy is non-neural if i does have effecs on he real economy New Keynesian view: money is non-neural (ecause prices are rigid/sicky, someimes for long periods of ime) RBC view: money is neural (ecause prices are no rigid/sicky in any imporan way) MIU framework allows us o consider how/why moneary policy is or is no neural Novemer 4, 20 37 Moneary Policy Analysis: Shor-Run Effecs MONEY DEMAND CONSUMPTION-MONEY OPTIMALITY CONDITION u2( c, M / P) i u ( c, M / P) + i NOTE: consumpion-money opimaliy condiion and money demand funcion are he same hing, jus viewed from differen poins of view MRS (eween consumpion and real money holdings) price raio (eween consumpion and money) M M Using uiliy funcion u c, lnc + ln, P P generae money demand funcion REAL MONEY DEMAND FUNCTION: depends posiively on c and negaively on i (i is he opporuniy cos of money) M + i c P i Use money demand funcion o illusrae effecs of money (moneary policy) shocks Ges a core of neuraliy deae Le s e even more precise aou he iming of evens Novemer 4, 20 38 9
Moneary Policy Analysis: Shor-Run Effecs MONETARY NEUTRALITY DEBATE Precise iming of evens wihin period Fed ses acual M afer consumers makes heir choices of c and planned M (and oher choices, oo ) If acual M differs from planned M, money shock has occurred Novemer 4, 20 39 Moneary Policy Analysis: Shor-Run Effecs MONETARY NEUTRALITY DEBATE Precise iming of evens wihin period Fed ses acual M afer consumers makes heir choices of c and planned M (and oher choices, oo ) If acual M differs from planned M, money shock has occurred Quesion: which adjuss (P or c ) o ensure consumpion-money opimaliy condiion holds? (simplify y assuming i doesn adjus) M + i c P i Novemer 4, 20 40 20
Moneary Policy Analysis: Shor-Run Effecs MONETARY NEUTRALITY DEBATE Quesion: which adjuss (P or c ) o ensure consumpion-money opimaliy condiion holds? (simplify y assuming i doesn adjus) M + i c P i Keynesian/New Keynesian view P canno adjus ecause prices are sicky (Prices will adjus laer (i.e, in period + or laer), jus no in period ) A posiive (negaive) money shock leads o a rise (fall) in c Money (and hence moneary policy) is no neural Novemer 4, 20 4 Moneary Policy Analysis: Shor-Run Effecs MONETARY NEUTRALITY DEBATE Quesion: which adjuss (P or c ) o ensure consumpion-money opimaliy condiion holds? (simplify y assuming i doesn adjus) M + i c P i Keynesian/New Keynesian view P canno adjus ecause prices are sicky (Prices will adjus laer (i.e, in period + or laer), jus no in period ) A posiive (negaive) money shock leads o a rise (fall) in c Money (and hence moneary policy) is no neural RBC view P can adjus ecause prices are no sicky No reason for c o adjus (hey do reflec opimal choices, afer all...) A posiive (negaive) money shock leads o no change (no change) in c Money (and hence moneary policy) is neural Empirical evidence for how sicky are prices is very mixed Novemer 4, 20 42 2
Moneary Policy Analysis: Shor-Run Effecs MONETARY NEUTRALITY DEBATE: EXAMPLE Assume i 0.25 is fixed Consumers planned choices are c 2 and M 80 This plan was made wih P 0 in mind Fed ses acual M 270 (a posiive money shock ecause acual M greaer han planned M ) Keynesian/New Keynesian view P 0 won change (sicky prices) c will rise (o c 3) o make consumpion-money opimaliy condiion hold Moneary policy is non-neural M + i c P i RBC view Consumers plan of c 2 is wha he economy really wans P can fully and quickly adjus o accommodae his P 5 Moneary policy is neural; only effec of moneary policy is on inflaion Novemer 4, 20 43 Moneary Policy Analysis: Shor-Run Effecs MONETARY NEUTRALITY DEBATE P AD P Expansionary moneary policy shifs AD Period- goods marke GDP Novemer 4, 20 44 22
Moneary Policy Analysis: Shor-Run Effecs MONETARY NEUTRALITY DEBATE P AS (if prices adjus insanly ) AD The crucial issue: how quickly do nominal prices adjus? P AS (if prices very sicky in adjusing) Expansionary moneary policy shifs AD GDP Period- goods marke Novemer 4, 20 45 The Three Macro Markes THE THREE MACRO (AGGREGATE) MARKETS Goods Markes Demand derived from C-L framework (Shape of AS funcion?...depends how quickly nominal prices adjus) P S D Laor Markes Supply derived from C-L framework Demand derived from firm heory in C-S framework wage S goods D Capial/Savings/Funds/Asse Markes (aka Financial Markes) Supply derived from C-S framework Demand derived from firm heory in C-S framework real ineres rae Novemer 4, 20 46 S D laor savings/in vesmen 23
MONETARY POLICY IN THE INFINITE-PERIOD ECONOMY: LONG-RUN EFFECTS NOVEMBER 4, 20 Moneary Policy Analysis: Long-Run Effecs MONEY AND INFLATION IN THE LONG-RUN Quesion: wha deermines inflaion in he long run (i.e., in seady-sae)? Use oh period-(-) and period- money demand funcions o analyze Money demand funcion in - M P + i c i Money demand funcion in M + i c P i M / P c + i i M / P c i + i Divide period money demand y period - money demand Novemer 4, 20 48 24
Moneary Policy Analysis: Long-Run Effecs MONEY AND INFLATION IN THE LONG-RUN Quesion: wha deermines inflaion in he long run (i.e., in seady-sae)? Use oh period-(-) and period- money demand funcions o analyze Money demand funcion in - M P + i c i Money demand funcion in M + i c P i Divide period money demand y period - money demand Recall definiion of inflaion M / P c + i i M / P c i + i P π P + μ c + i i + π c i + i And now define he money growh rae in an analogous way: M μ M Impose seady sae i.e., c - c c, i - i i, π π, and μ μ + μ c + i i + π c i + i μ π IN LONG RUN, RATE OF MONEY GROWTH RATE OF INFLATION Novemer 4, 20 49 Moneary Policy Analysis: Money and Inflaion MONETARISM μ π IN LONG RUN, RATE OF MONEY GROWTH RATE OF INFLATION In seady sae, inflaion deermined solely y how quickly cenral ank (Fed) expands (or shrinks) he nominal money supply This relaionship he asis for he monearis school of hough Milon Friedman s famous dicum: Inflaion is always and everywhere a moneary phenomenon Policy ranslaion: A cenral ank should no worry aou/ry o conrol anyhing oher han how quickly he money supply in he economy is growing. Keeping money growh under conrol will keep inflaion under conrol. Novemer 4, 20 50 25
Moneary Policy Analysis: Money and Inflaion MONETARISM μ π IN LONG RUN, RATE OF MONEY GROWTH RATE OF INFLATION In seady sae, inflaion deermined solely y how quickly cenral ank (Fed) expands (or shrinks) he nominal money supply This relaionship he asis for he monearis school of hough Milon Friedman s famous dicum: Inflaion is always and everywhere a moneary phenomenon Policy ranslaion: A cenral ank should no worry aou/ry o conrol anyhing oher han how quickly he money supply in he economy is growing. Keeping money growh under conrol will keep inflaion under conrol. Rose o prominence in mid- and lae 970 s (during macro crises) Larges policy influence in U.K., shor-lived policy influence in U.S. Largely died ou as asis for serious policy advice y mid-980 s Neverheless sill viewed as fundamenal law of macroeconomics A concern oday: Fed s easy moneary policy (read: Fed has increased money supply very rapidly) will generae a urs of inflaion Novemer 4, 20 5 Moneary Policy: Wrapup MONETARY POLICY In shor-run, do changes in moneary policy have effecs on consumpion and real GDP? Keynesian/New Keynesian view: yes ecause prices are sicky RBC view: no ecause prices are no sicky In long-run, changes in money growh rae Only have effecs on inflaion Have no effecs on consumpion and real GDP Novemer 4, 20 52 26
Moneary Policy: Wrapup MONETARY POLICY In shor-run, do changes in moneary policy have effecs on consumpion and real GDP? Keynesian/New Keynesian view: yes ecause prices are sicky RBC view: no ecause prices are no sicky In long-run, changes in money growh rae Only have effecs on inflaion Have no effecs on consumpion and real GDP Compeing principles/heories influence policy-makers decisions Basic models are guideposs for policy deaes Acual policy-making quie messy Requires lo of judgmen Requires hope/elief ha asic models are a leas somewha useful guides o hinking Nex: ineracions eween moneary policy and fiscal policy (Chaper 5) Novemer 4, 20 53 27