Transcript Chapter 21 - McGraw Hill Higher Education

Stephen G. CECCHETTI • Kermit L. SCHOENHOLTZ
Chapter Twenty-One
Output, Inflation, and Monetary Policy
McGraw-Hill/Irwin
Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
Introduction
• An important part of economic analysis is speculation
about the impact of the new data on monetary policy.
• The FOMC in the U.S. and the Governing Council in
the Euro area always tie their policy actions to current
and expected future economic conditions.
• Traders are trying to out-guess each other to make a
profit by betting on what the next interest rate move
will be.
• The rest of us are just hoping the central bank will
succeed in keeping inflation low and real growth high.
21-2
Introduction
• The objective of this chapter is to understand
fluctuations in inflation and real output and
how central banks use conventional interestrate policy to stabilize them.
• We will develop a macroeconomic model of
fluctuations in the business cycle in which
monetary policy plays a central role.
21-3
Introduction
• We will see that short-run movements in inflation and
output can arise from two sources:
• Shifts in the quantity of aggregate output demanded, or
• Shifts in the quantity of aggregate output supplied.
• We will develop our macroeconomic model in three
steps:
• A description of long-run equilibrium,
• The derivation of the dynamic aggregate demand curve, and
• An introduction of short-run and long-run aggregate supply.
21-4
Introduction
• We will see how modern central banks can use
their policy tools to stabilize short-run
fluctuations in output and inflation.
• Our ultimate objective is to understand how
modern central bankers set interest rates.
• When policymakers change the target interest
rate, what are they reacting to and what is the
impact on the economy?
21-5
Output and Inflation in the Long Run
• The best way to understand fluctuations in the
business cycle is as deviations from some
benchmark or long-run equilibrium level.
• What would the levels of inflation and output
be if nothing unexpected happened for a long
time?
• In the long run, current output equals potential
output and the inflation rate equals the level implied
by the rate of money growth.
21-6
Potential Output
• Potential output is what the economy is capable
of producing when its resources are used at
normal rates.
• In a business, conditions will change over time.
• If you think the increase or decrease in demand for
your product is permanent, you will change the
scale of your factory.
• Technological improvements allow you to increase
production at given levels of capital and labor.
21-7
Potential Output
• Your normal level of output changes over time.
• In the short run you can deviate from normal,
but in the long-run, the normal level itself
changes.
• There is a normal level of production that
defines potential output for the country as well.
• Potential output tends to rise over time.
21-8
Potential Output
• Unexpected events can push current output
away from potential output called an output
gap.
• When current output is above potential, it creates an
expansionary output gap.
• When current output falls below potential, it creates
a recessionary output gap.
• In the long run, current output equals potential
output.
21-9
• What do people mean when they talk about
inflation?
• Inflation means a continually rising price level,
a sustained rise, that continues for a substantial
period.
• Temporary increases in inflation represent onetime adjustments in the price-level.
• A permanent change is a rise or fall in the longrun course of inflation.
21-10
Long-Run Inflation
• We can restate the equation of exchange from
Chapter 20 in terms of potential output, YP.
%M  %V  %P  %Y
In the long run :
%Y  %Y
%V  0
Therefore :
P
%P  %M  %Y P
21-11
Long-Run Inflation
• In the long run, inflation equals money growth
minus growth in potential output.
• While central bankers focus primarily on
controlling short-term nominal interest rates,
they keep an eye on money growth.
• Ultimately long term money growth affects
inflation.
• But in the short-run, over periods even as long
as a few years, fluctuations in velocity weaken
this link.
21-12
Monetary Policy and the Dynamic
Aggregate Demand Curve
• If we want to understand the role of central
bankers in stabilizing the economy, we need to
examine the connection between short-term
interest rates and policymakers’ inflation and
output targets.
• This will also explain how policymakers themselves
think about their role.
21-13
Monetary Policy and the Dynamic
Aggregate Demand Curve
•
•
The goal is to understand the relationship
between inflation and the quantity of aggregate
output demanded by those people that use it.
We will proceed in three steps:
1. Examine the relationship between aggregate
expenditures and the real interest rate;
2. Study how monetary policymakers adjust their
interest-rate instrument in response to change in
inflation; and
3. Put these two together to construct the dynamic
aggregate demand curve that relates output and
inflation.
21-14
Monetary Policy and the Dynamic
Aggregate Demand Curve
1. Aggregate expenditure and the real interest
rate:
•
There is a downward sloping relationship between
the quantity of aggregate expenditure and the real
interest rate.
2. Inflation, the real interest rate, and the
monetary policy reaction curve:
•
There is an upward sloping relationship between
inflation and the real interest rate that we will call
the monetary policy reaction curve.
21-15
Monetary Policy and the Dynamic
Aggregate Demand Curve
3. The dynamic aggregate demand curve:
•
•
•
This is a downward sloping relationship between
inflation and aggregate output.
Economic decisions of households to
consume and of firms to invest depend on the
real interest rate, not the nominal interest rate.
Central banks must therefore influence the
real interest rate.
21-16
Monetary Policy and the Dynamic
Aggregate Demand Curve
• Remember that
i  r
solving for r :
e
r  i  e
• For a central bank that is effective at stabilizing
inflation and output, inflation expectations
adjust slowly
 in response to changes in
economic conditions.
• That means that changes in the nominal interest
rate change the real interest rate.
21-17
Monetary Policy and the Dynamic
Aggregate Demand Curve
• We can see this in Figure 21.2.
• This figure plots the nominal federal fund rate
against a measure of the real federal funds rate
using survey data on expected inflation.
• The real interest rate, then, is the level through
which monetary policymakers influence the
real economy.
• In changing real interest rates, they influence
consumption, investment, and other
components of aggregate expenditure.
21-18
The Nominal and Real
Federal Funds Rate
21-19
Aggregate Expenditure and the Real
Interest Rate
• The best way to describe aggregate expenditure
is to start with the national income accounting
identity from principles of economics.
Aggregate
Government
 Consumption  Investment 
 Exports  Imports 
Expenditures
Expenditures
Y  C  I  G  (X  M )
21-20
Aggregate Expenditure and the Real
Interest Rate
1. Consumption is spending by individuals. It is
2/3 of GDP.
2. Investment is spending by firms for additions
to physical capital. It also includes newly
constructed residential homes and the change
in business inventories. It is 16% of GDP.
3. Government purchases is spending on goods
and services by federal, state, and local
governments. This is 20% of GDP.
4. Net exports equals exports minus imports.
This averages -4.5% of GDP.
21-21
Aggregate Expenditure and the Real
Interest Rate
• We can think of aggregate expenditures as
having two parts:
• Those that are interest rate sensitive, and
• Those that are not.
• Three of the four components of aggregate
expenditure are sensitive to changes in the real
interest rate:
• Consumption, investment and net exports.
• Investment is the most important.
21-22
Aggregate Expenditure and the Real
Interest Rate
• Investment must be profitable for businesses.
• The higher the cost of borrowing, the less
likely that an investment will be profitable.
• Higher interest rates lead to:
• Lower level of business investment and
• Reductions in residential investment.
• For consumption, higher real interest rates
mean
• Higher inflation-adjusted loan payments and
• Increased saving meaning less spending.
21-23
Aggregate Expenditure and the Real
Interest Rate
• For net exports, the story is similar.
• When real interest rates in the U.S. rise, foreigners
increase foreign demand for dollars, causing the
dollar to appreciate.
• The higher value of the dollar makes U.S. exports
more expensive and imports cheaper.
• This means lower net exports.
21-24
Aggregate Expenditure and the Real
Interest Rate
• When real interest rates rise:
• Consumption falls because the reward to saving and
the cost of financing purchases are now higher.
• Investment falls because the cost of financing has
gone up.
• Net exports fall because the domestic currency has
appreciated, making imports cheaper and exports
more expensive.
21-25
Aggregate Expenditure and the Real
Interest Rate
• We can see in Figure 21.3 that a rise in the real
interest rate reduces the level of aggregate
expenditure.
• This leads to a downward sloping aggregate
expenditure (AE) curve.
• However, the AE curve can also shift if things
change that are unrelated to the real interest
rate.
21-26
Aggregate Expenditure and the Real
Interest Rate
21-27
Aggregate Expenditure and the Real
Interest Rate
• Table 21.1 provides a summary of the
relationship between aggregate expenditure and
the real interest rate.
• When economic activity speeds up or slows
down and current output moves above or below
potential output, policymakers can adjust the
real interest rate in an effort to close the
expansionary or recessionary gap.
21-28
Aggregate Expenditure and the Real
Interest Rate
21-29
The Long-Run Real Interest Rate
• What happens to the real interest rate over the
long run?
• There is some level of aggregate expenditure
that is consistent with the normal level of
output toward which the economy moves over
the long run.
• The long run real interest rate equates the level
of aggregate expenditure to the quantity of
potential output.
21-30
The Long-Run Real Interest Rate
21-31
The Long-Run Real Interest Rate
• For example, what happens when G increases?
• The level of aggregate expenditure increases at
every real interest rate.
• This shifts aggregate expenditure curve to the right.
• For the level of aggregate expenditure to remain
equal to potential output, the interest-sensitive
components of aggregate expenditure must fall.
• That means the long-run real interest rate must rise.
21-32
The Long-Run Real Interest Rate
21-33
The Long-Run Real Interest Rate
• What if a change in potential output causes a
change in the long-run real interest rate?
• When the quantity of potential output rises, the
level of aggregate expenditure must rise with it.
• This requires a decline in the real interest rate.
21-34
The Long-Run Real Interest Rate
21-35
The Long-Run Real Interest Rate
In summary:
• When components of aggregate expenditure
that are not sensitive to the real interest rate
rise, the long-run real interest rate rises with
them.
• When potential output rises, the long-run real
interest rate falls.
21-36
• Over short periods of a quarter of a year,
fluctuations in the business cycle means
understanding the changes in investment.
• Figure 21.6 plots the ratio of investment to
GDP over the past 50 years.
• The shaded bars are recessions.
• Changes in investment come from:
• Changes in the real interest rate and
• Changes in expectations about future business
conditions.
21-37
21-38
Inflation, the Real Interest Rate, and
the Monetary Policy Reaction Curve
• When current inflation is high or current output
is running above potential output, central
bankers will set a relatively high policy interest
rate.
• When current inflation is low or current output
is well below potential, they will set a low
policy interest rate.
• While they state their policies in terms of
nominal interest rates, they do so knowing that
changes in the nominal interest rate will
translate into a change in the real interest rate.
21-39
Inflation, the Real Interest Rate, and
the Monetary Policy Reaction Curve
• These changes in the real interest rate influence
the economic decisions of firms and
households.
• We can summarize all of this in the form of a
monetary policy reaction curve that
approximates the behavior of central bankers.
21-40
Deriving the Monetary Policy
Reaction Curve
• We introduced a version of the monetary
policy reaction curve in Chapter 18.
• Higher current inflation requires a policy response
that raises the real interest rate, and
• Lower current inflation requires a policy response
that lowers the real interest rate.
• This mean that the monetary policy reaction
curve slopes upward as shown in Figure 21.7.
21-41
Deriving the Monetary Policy
Reaction Curve
21-42
Deriving the Monetary Policy
Reaction Curve
• The monetary policy reaction curve is set so
that when current inflation equals target
inflation (T), the real interest rate equals the
long-run real interest rate.
r  r * when   
T
• We know the location of the curve, but what
tells us the slope?

• That depends on policymakers’ objectives.
21-43
Deriving the Monetary Policy
Reaction Curve
• Policymakers who are aggressive in keeping
current inflation near the target will have a
steep monetary policy reaction curve.
• Those who are less concerned will have a
relatively flat monetary policy reaction curve.
21-44
Shifting the Monetary Policy Reaction
Curve
• A movement along the curve is a reaction to a
change in current inflation.
• A shift in the curve represents a change in the
level of the real interest rate at every level of
inflation.
• What shifts the curve are those things we held
constant when we drew the curve:
• Target inflation and long-run real interest rate.
21-45
Shifting the Monetary Policy Reaction
Curve
• A decrease in T shifts the curve to the left.
• The same is true for an increase in r*.
• We can see this in Figure 21.8, Panel A.
• A decline in the long-run real interest rate, r*,
or an increase in the inflation target, T, shift
the monetary policy reaction curve to the right.
• We can see this in Figure 21.8, Panel B.
21-46
Shifting the Monetary Policy Reaction
Curve
21-47
The Monetary Policy Reaction Curve
21-48
Deriving the Dynamic Aggregate
Demand Curve
• We will construct the dynamic aggregate
demand curve:
• This relates inflation and the level of output,
accounting for the fact that monetary policymakers
respond to changes in current inflation by changing
the interest rate.
• Using information from before, we see that
when inflation rises, the quantity of aggregate
output demanded falls.
• The dynamic aggregate demand curve slopes
downward.
21-49
Deriving the Dynamic Aggregate
Demand Curve
• When current inflation rises:
• Monetary policymakers raise the real interest rate,
moving the economy upward along the monetary
policy reaction curve.
• The higher real interest rate reduces the interestsensitive components of aggregate expenditure.
• This causes a fall in the quantity of aggregate output
demanded.
• Therefore, changes in current inflation move
the economy along a downward-sloping
dynamic aggregate demand curve.
21-50
Deriving the Dynamic Aggregate
Demand Curve
21-51
Why the Dynamic Aggregate Demand
Curve Slopes Down
•
There are a number of reasons why increases
in inflation are associated with falling levels
of aggregate output demanded.
1. The higher the rate of inflation for a given
rate of money growth, the lower the level of
real money balances in the economy.
•
•
When P grows faster than M, M/P falls.
Even is monetary policymakers do not change the
real interest rate, the effect on M/P causes the
dynamic aggregate demand curve to slope down.
21-52
Why the Dynamic Aggregate Demand
Curve Slopes Down
2. Higher inflation reduces wealth, which lowers
consumption.
•
•
Inflation means money declines in value.
Inflation is also bad for the stock market.
3. Inflation affects the poor disproportionately
more than the wealthy.
•
The redistribution lowers consumption in the
economy as a whole, reducing the quantity of
aggregate output demanded.
21-53
Why the Dynamic Aggregate Demand
Curve Slopes Down
4. Inflation creates risk.
•
•
The higher the inflation, the greater the risk.
People increase saving, lowering the level of
consumption.
5. Inflation makes foreign goods cheaper in
relation to domestic goods.
•
•
This drives imports up and exports down.
In every case, higher inflation means a lower
level of aggregate output demanded, causing
the dynamic aggregate demand curve to slope
downward.
21-54
• When nominal interest rates are high, chances
are that inflation is high, too.
• If you are living off interest or investment
income, you can be fooled into thinking that
your income is high.
• Spending all of the interest income causes a
gradual decline in the purchasing power of
your savings.
• To maintain real purchasing power of your
income, you can only spend the real return.
21-55
Shifting the Dynamic Aggregate
Demand Curve
• In our derivation, we held constant both the
aggregate expenditure curve and the monetary
policy reaction curve.
• We assumed factors other than the real interest rate
were fixed; and
• That the inflation target and the long run interest
rate were fixed.
• Shifts in any of these will shift the dynamic
aggregate demand curve.
21-56
Shifting the Dynamic Aggregate
Demand Curve
• Any change in the components of aggregate
expenditure will shift the dynamic aggregate
demand curve.
• All of the following increase aggregate
expenditure, there by shifting the dynamic
aggregate demand curve to the right:
• Increased consumer confidence;
• Increased optimism about future business prospects;
• Increased government spending (or decreased
taxes); or
• Increased net exports.
21-57
Shifting the Dynamic Aggregate
Demand Curve
• Whenever the monetary policy reaction curve
shifts, the dynamic aggregate demand curve
shifts, too.
• Consider an increase in the central bank’s
inflation target.
• The monetary policy reaction curve shifts right.
• The real interest rate that policymakers set at every
level of inflation falls.
• The lower real interest rate increases the quantity of
aggregate output demanded at every level of
inflation.
• The dynamic aggregate demand curve shifts right.
21-58
Shifting the Dynamic Aggregate
Demand Curve
21-59
Shifting the Dynamic Aggregate
Demand Curve
• Changes in the long-run real interest rate shift
the dynamic aggregate demand curve.
• Suppose the level of potential output increases.
• The long-run real interest rate must fall.
• This drives up the interest-rate-sensitive
components of aggregate expenditure.
• This shifts the curve to the right, reducing the real
interest rate policymakers set at every level of
inflation.
• This shifts the dynamic aggregate demand curve
right.
21-60
Shifting the Dynamic Aggregate
Demand Curve
• Any shift in the monetary policy reaction curve
shifts the dynamic aggregate demand curve in
the same direction.
• Expansionary monetary policy shifts the dynamic
aggregate demand curve to the right.
• Contractionary monetary policy shifts the dynamic
aggregate demand curve to the left.
21-61
Dynamic Aggregate Demand Curve:
Summary
21-62
Aggregate Supply
• The aggregate supply (AS) curve tells us where along
the dynamic aggregate demand curve the economy
ends up.
• There are short-run and long-run versions of the AS
curve.
• When combined with the dynamic aggregate demand
curve, the short-run AS curve tells us where the
economy settles at any particular time.
• The long-run curve with dynamic aggregate demand,
tells us the levels of inflation and the quantity of output
that the economy is moving toward in the long term.
21-63
Short-Run Aggregate Supply
• The short-run AS curve is the upward-sloping
relationship between current inflation and the
quantity of output.
• In the short term, production costs don’t
change much, so when product prices rise,
firms increase supply in order to take
advantage.
• In the short run, higher inflation elicits more
aggregate output supplied by the firms that
produce it.
21-64
Short-Run Aggregate Supply
21-65
Shifts in the Short Run Aggregate
Supply Curve
•
•
When production costs change, the short-run
AS curve shifts.
This can happen for any of three reasons:
1. Deviations of current output from potential output.
2. Changes in expectations of future inflation.
3. Factors that drive production costs up or down.
21-66
Shifts in the Short Run Aggregate
Supply Curve
• When current output falls below potential
output, we have a recessionary output gap.
• Firms raise prices and wages by less than they did
at potential output.
• Production costs will rise more slowly so inflation
falls.
• When current output is above potential output,
we have an expansionary gap.
• Production costs will rise more quickly so inflation
increases.
21-67
Shifts in the Short Run Aggregate
Supply Curve
• Changes in inflation expectations are
analogous to changes in production costs.
• An increase in expected inflation increases
production costs lowering production at every level
of current inflation.
• This shifts the short-run AS curve to the left.
• Changes in the prices of raw materials, as well
as other external factors that change production
cists, shift the short-run AS curve:
• An increase in the price of oil, increase in labor
prices from higher payroll taxes, increased health
care costs, etc.
21-68
Shifts in the Short Run Aggregate
Supply Curve
21-69
Shifts in the Short Run Aggregate
Supply Curve
21-70
• Data show that inflation responds to the output
gap.
• Figure 21.13 plots changes in the inflation rate
against the output gap, lagged six quarters from
1988 to 2009.
• Inflation generally falls with a lag when there
is a recessionary output gap and rises when
there is an expansionary gap.
21-71
21-72
The Long-Run Aggregate Supply
Curve
• In the long-run,
• Current output must equal potential output, and
• Inflation must be determined by monetary policy.
• That means in the long run, output and
inflation are unrelated and the long-run
aggregate supply curve is vertical at the point
where current output equals potential output.
21-73
The Long-Run Aggregate Supply
Curve
• The fact that the short-run AS curve is stable
when there is no output gap means that the
long-run AS curve is vertical at that point.
• The short-run AS curve shifts:
• When current output deviates from potential output.
• When expected inflation deviates from current
inflation.
• So, at any point along the LRAS curve, current
output equals potential output and current
inflation equals expected inflation.
21-74
Long-Run Aggregate Supply
21-75
Aggregate Supply: Summary
21-76
• Policymakers talk about output growth.
• Textbooks teach about output gaps.
• When monetary policymakers use the term
growth, they are talking about increase in both
actual and potential output.
21-77
Equilibrium and the Determination of
Output and Inflation
Short Run Equilibrium
• SR equilibrium is
determined by the
intersection of:
• The dynamic aggregate
demand curve (AD) and
• The short-run aggregate
supply curve (SRAS).
21-78
Adjustment to Long-Run Equilibrium
• An expansionary output gap exerts upward
pressure on production costs.
• This shifts the SRAS curve to the left.
• This continues until output returns to potential.
• In a recessionary output gap we have
downward pressure on production costs.
• This shifts the SRAS curve to the right.
• This continues until current output returns to
potential.
21-79
Adjustment to Long-Run Equilibrium

SRAS2
LRAS
2
SRAS
1
0
Current output is greater than
potential output – an
expansionary gap.
SRAS shifts left until reaches
potential output, YP.
AD
YP
Y0
21-80
Adjustment to Long-Run Equilibrium

LRAS
SRAS
0
1
SRAS2
Current output is lower than
potential output - recessionary
gap.
SRAS shifts right until reaches
potential output, YP.
2
AD
Y0
YP
21-81
Adjustment to Long-Run Equilibrium
•
This example has several important
implications.
1. The economy has a self-correcting mechanism.
2. The fact that inflation changes whenever there is
an output gap reinforces our conclusion that in the
long run output returns to potential output.
•
Long run equilibrium is the point at which the
economy comes to rest.
21-82
Adjustment to Long-Run Equilibrium
There are three conditions for long run
equilibrium:
1. Current output equals potential output: Y=YP.
2. Current inflation is steady and equal to target
inflation:  = T, and
3. Current inflation equals expected inflation:
 = e.
21-83
The Sources of Fluctuations in Output
and Inflation
•
While shifts in the dynamic AD curve or the
SRAS curve can have the same effect on
inflation, they have opposite effects on
output.
1. Shifts in AD cause output and inflation to rise and
fall together, moving in the same direction.
2. Shifts in the SRAS curve move output and
inflation in opposite directions, one rises when the
other one falls.
21-84
The Sources of Fluctuations in Output
and Inflation
• Inflation in the long run will only change if
policymakers have changed their inflation
target.
• In the short run fluctuations can come from
• Increases in the components of AE that are not
sensitive to real interest rate (shift of AD),
• A permanent easing of monetary policy (shift of
monetary policy reaction curve,) or
• Increases in the costs of production (shift of
SRAS).
21-85
The Sources of Fluctuations in Output
and Inflation
• In the short run, fluctuations in output can
come from:
• A decline in aggregate expenditure,
• A shift to the left in monetary policy reaction curve
(policy makers could be responsible for recessions),
or
• Increases in either production costs or inflation
expectations drive output down.
21-86
What Causes Recessions?
• If demand shifts were the cause of recessions,
we should see inflation decline when output
falls.
• If production cost increases were the source,
then we should see inflation rise as the
economy weakens.
• Table 21.5 lists the dates of recessions since
the mid-1950s.
• It also shows the change in inflation from the
beginning to the end of the recession.
21-87
What Causes Recessions?
• Inflation fell in 7 of the past 9 recessions.
• The only one where inflation rose was in 19731975 when oil prices tripled, driving up
production costs.
• It appears that three-quarters of the recessions
listed can be traced to shifts in AD.
• What caused these shifts?
21-88
What Causes Recessions?
21-89
What Causes Recessions?
• Figure 21.17 shows that shortly before each
recession starts, just to the left of each of the
shaded bars, the interest rate tends to rise.
• This suggests that the Fed policy is at least
partly to blame of the business cycle downturns
over the past 50 years.
• They have done this to bring down inflation.
• The only thing the Fed could do was to raise
interest rates triggering a recession.
21-90
What Causes Recessions?
21-91
• The recovery from the financial crisis of 20072009 focused the monetary policy debate on
when the Fed would begin to raise the target
for its policy rate from the zero percent floor.
• The U.S. Senate’s reconfirmation of Ben
Bernanke as Fed chairman fueled expectation
that as the economy gained steam, the Fed
would resist popular pressure to keep its target
rate near zero.
• Will the Fed have waited too long to prevent an
unwelcome rise of inflation?
21-92
Stephen G. CECCHETTI • Kermit L. SCHOENHOLTZ
End of
Chapter Twenty-One
Output, Inflation, and Monetary Policy
McGraw-Hill/Irwin
Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.