Monetary Policy and the Phillips Curve

Monetary Policy and the Phillips Curve Week 9 Vivaldo Mendes Dep. of Economics Instituto Universitário de Lisboa 19 November 2017 (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0236) 19 November 2014 1 / 47

Summary 1 In this chapter, we learn 2 The MP Curve: Monetary Policy and the Interest Rates 3 The Phillips Curve 4 Using the Short-Run Model 5 Microfoundations: Understanding Sticky Inflation (not covered) 6 Microfoundations: How Central Banks Control Nominal Interest Rates 7 Inside the Federal Reserve 8 Required reading (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0236) 19 November 2014 2 / 47

I In this chapter, we learn (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0236) 19 November 2014 3 / 47

In this chapter, we learn In this chapter, we learn: 1 How the central bank effectively sets the real interest rate in the short run, and how this rate shows up as the MP curve in our short-run model. 2 That the Phillips curve describes how firms set their prices over time, pinning down the inflation rate. 3 How the IS curve, the MP curve, and the Phillips curve make up our short-run model. 4 How to analyze the evolution of the macroeconomy in response to changes in policy or economic shocks. (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0236) 19 November 2014 4 / 47

In this chapter, we learn In this chapter, we learn: The federal funds rate The interest rate paid from one bank to another for overnight loans 1 The monetary policy (MP) curve 1 Describes how the central bank sets the nominal interest rate (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0236) 19 November 2014 5 / 47

In this chapter, we learn In this chapter, we learn: (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0236) 19 November 2014 6 / 47

In this chapter, we learn II The MP Curve: Monetary Policy and the Interest Rates (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0236) 19 November 2014 7 / 47

The MP Curve Central banks set the nominal interest 1 Large banks and financial institutions borrow from each other. 2 Central banks set the nominal interest rate by stating what they are willing to lend or borrow at the specified rate. 3 Banks cannot charge a higher rate: everyone would use the central bank. 4 Banks cannot charge a lower rate: they would borrow at the lower rate and lend it back to the central bank at a higher rate. 5 Thus, banks must exactly match the rate the central bank is willing to lend at (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0236) 19 November 2014 8 / 47

The MP Curve The fed funds rate since 1960 (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0236) 19 November 2014 9 / 47

The MP Curve Remember: from Nominal to Real Interest Rates 1 The relationship between the interest rates is given by the Fisher equation. Nominal interest rate Real interest rate Rate of inflation (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0236) 19 November 2014 10 / 47

The MP Curve The sticky inflation assumption 1 The rate of inflation displays inertia, or stickiness, so that it adjusts slowly over time. 2 In the very short run the rate of inflation does not respond directly to monetary policy. 3 Central banks have the ability to set the real interest rate in the short run. (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0236) 19 November 2014 11 / 47

The MP Curve Expected rate of inflation A sophisticated version of the Fisher equation replaces the inflation rate with the expected rate of inflation. Expected rate of inflation Using the expected rate of inflation gives an ex ante real interest rate: The ex ante real interest rate is relevant for investment decisions Once inflation is known, we can calculate the ex post interest rate: (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0236) 19 November 2014 12 / 47

The MP Curve The IS-MP Diagram 1 The MP curve: shows the central bank s ability to set the real interest rate 2 Central banks set the real interest rate at a particular value: the MP curve is a horizontal line. 3 See next figure 4 The economy is at potential when: 1 The real interest rate equals the MPK. 2 There are no aggregate demand shocks. 3 Short-run output = 0. (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0236) 19 November 2014 13 / 47

The MP Curve The IS-MP diagram (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0236) 19 November 2014 14 / 47

The MP Curve What happens if the central bank decides to raise the interest rate? 1 If the central bank raises the interest rate above the MPK 2 Inflation is slow to adjust. 3 The real interest rate rises. 4 Investment falls. 5 See next figure (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0236) 19 November 2014 15 / 47

The MP Curve What happens if the central bank raises the interest rate? (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0236) 19 November 2014 16 / 47

The MP Curve Example: The End of a Housing Bubble 1 Suppose housing prices had been rising, but then they fall sharply. 1 The aggregate demand parameter declines 2 The IS curve shifts left. 2 If the central bank lowers the nominal interest rate in response: 1 The real interest rate falls as well because inflation is sticky. 2 If judged correctly and without lag, the economy would not have a decline in output. (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0236) 19 November 2014 17 / 47

The MP Curve Example: The End of a Housing Bubble (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0236) 19 November 2014 18 / 47

The MP Curve III The Phillips Curve (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0236) 19 November 2014 19 / 47

The Phillips Curve The behavior of inflation Recall the inflation rate is the percent change in the overall price level. Firms set their prices on the basis of Their expectations of the economy-wide inflation rate The state of demand for their product. (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0236) 19 November 2014 20 / 47

The Phillips Curve Adaptive expectations Under adaptive expectations firms adjust their forecasts of inflation slowly.firms expect next year s inflation rate to be the same as this year s inflation rate. 1 1 Expected inflation embodies the sticky inflation assumption. (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0236) 19 November 2014 21 / 47

The Phillips Curve The Phillips curve Describes how inflation evolves over time as a function of short-run output This year s inflation Last year s inflation Short run output If output is below potential: prices rise more slowly than usual If output is above potential: prices rise more rapidly than usual Notice that This parameter measures how sensitive inflation is to demand conditions. (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0236) 19 November 2014 22 / 47

The Phillips Curve The Phillips curve (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0236) 19 November 2014 23 / 47

The Phillips Curve Price Shocks and the Phillips Curve 1 We can add shocks to the Phillips curve to account for temporary increases in the price of inflation 2 The actual rate of inflation now depends on three things: Expected rate of inflation Adjustment factor for state of economy Shock to inflation (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0236) 19 November 2014 24 / 47

The Phillips Curve The price of oil rises (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0236) 19 November 2014 25 / 47

The Phillips Curve IV Using the Short-Run Model (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0236) 19 November 2014 26 / 47

Using the Short-Run Model The Great Inflation of the 1970s and the Volcker Disinflation 1 Misinterpreting the productivity slowdown contributed to rising inflation. 2 Disinflation: sustained reduction of inflation to a stable lower rate 3 The Volcker Disinflation 1 The real interest rate must increase to induce a recession to reduce inflation 2 Reducing the level of inflation requires a sharp reduction in the rate of money growth a tight monetary policy. 4 The FED: lower money growth led to higher interest rates (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0236) 19 November 2014 27 / 47

Using the Short-Run Model The Great Inflation of the 1970s and the Volcker Disinflation (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0236) 19 November 2014 28 / 47

Using the Short-Run Model The FED increases short term nominal rates (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0236) 19 November 2014 29 / 47

Using the Short-Run Model The Effect of higher interest rates on the Phillips Curve 1 The logic is: i R Ỹ π (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0236) 19 November 2014 30 / 47

Using the Short-Run Model The Effect of higher interest rates on the Phillips Curve (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0236) 19 November 2014 31 / 47

Using the Short-Run Model The Great Inflation of the 1970s Inflation rose in the 1970s for three reasons: 1 OPEC coordinated oil price increases. 2 The U.S. monetary policy was too loose. 3 The Federal Reserve did not have perfect information (made a mistake) 1 Thought the productivity slowdown was a recession (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0236) 19 November 2014 32 / 47

Using the Short-Run Model The mistake of the FED in the 1970 s (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0236) 19 November 2014 33 / 47

Using the Short-Run Model The Short-Run Model in a Nutshell (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0236) 19 November 2014 34 / 47

Using the Short-Run Model V Microfoundations: Understanding Sticky Inflation Not covered (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0236) 19 November 2014 35 / 47

Using the Short-Run Model VI Microfoundations: How Central Banks Control Nominal Interest Rates (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0236) 19 November 2014 36 / 47

Microfoundations: How Central Banks Control Nominal Interest Rates Central Banks & short term nominal interest rates 1 The central bank controls the level of the nominal interest rate by supplying the money that is demanded at that rate. 2 The nominal interest rate: 1 Is the opportunity cost of holding money 2 Is the amount you give up by holding money instead of keeping it in a savings account 3 Is pinned down by equilibrium in the money market 3 It is determined by the equilibrium between money supply (M s ) and money demand (M d ) (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0236) 19 November 2014 37 / 47

Microfoundations: How Central Banks Control Nominal Interest Rates Money Demand and Money Supply 1 The demand for money 1 Is a decreasing function of the nominal interest rate 2 Is downward sloping 3 Higher interest rates reduce the demand for money. 2 The supply of money 1 Is a vertical line for the level of money the central bank provides (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0236) 19 November 2014 38 / 47

Microfoundations: How Central Banks Control Nominal Interest Rates The equilibrium in the money market (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0236) 19 November 2014 39 / 47

Microfoundations: How Central Banks Control Nominal Interest Rates Changing the Interest Rate: an increase in i The central bank reduces the money supply (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0236) 19 November 2014 40 / 47

Microfoundations: How Central Banks Control Nominal Interest Rates Central Banks dilemma: should they control i or Ms? 1 Nowadays Central Banks do not control the M s 2 They try to control directly (set directly) the interest rate (i) 3 Why? 4 Because Money Demand is very unstable due to many shocks 5 How does this new set look like? 6 See next figure (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0236) 19 November 2014 41 / 47

Microfoundations: How Central Banks Control Nominal Interest Rates Central Banks control i, the market determines M Central Bank position: we set the interest rate at this level (i ), and we will supply any quantity of money demanded by the market (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0236) 19 November 2014 42 / 47

Microfoundations: How Central Banks Control Nominal Interest Rates VII Inside the Federal Reserve (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0236) 19 November 2014 43 / 47

Inside the Federal Reserve Main aggregates of the FED 1 Reserves 1 Deposits held in accounts with the central bank 2 Pay no interest 2 Reserve requirements 1 Banks required to hold a certain fraction of their deposits (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0236) 19 November 2014 44 / 47

Inside the Federal Reserve Main monetary policy instruments 1 Discount rate 1 Interest rate charged by the Federal Reserve on loans made to commercial banks 2 Open-market operations 1 The central bank trades interest-bearing government bonds in exchange for currency or non-interest bearing reserves. 3 To increase the money supply, the Fed sells government bonds in exchange for currency or reserves. 1 The price at which the bond sells determines the nominal interest rate. (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0236) 19 November 2014 45 / 47

Inside the Federal Reserve VIII Required readings (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0236) 19 November 2014 46 / 47

Inside the Federal Reserve Required reading For this week you are required to read Read Chapter 12 of our adopted textbook. Charles I. Jones (2014). Macroeconomics, Third Edition, W. W. Norton & Company. (Vivaldo Mendes ISCTE-IUL ) Macroeconomics I (L0236) 19 November 2014 47 / 47