Transcript Slides

THE CENTRAL BANK &
THE ECONOMY
Economy
Monetary Transmission Mechanism
Money Market Rates
Inventories
Interbank
Interest Rate
Trade
Balance
Investment
Consumption
Policy Feedback
• How does the central bank gauge whether the current
monetary policy is effective in guiding the economy
toward its goals?
• If it is not, how do they choose the level of the operating
target in order to guide the economy toward its goals?
Policymakers Model
of the Economy
Real Interest Rates and Demand
• Components of aggregate demand are sensitive to the
real interest rate in a negative way.
• Consumer Durables
• Residential Housing
• Corporate Investment
• High interest rates means an exchange rate appreciation
which hurts the trade balance.
Expenditure Curve
r
• Expenditure is negatively
related to the real interest rate.
AE
Y
Shifts in Aggregate Expenditure
• But other factors
like consumer or
business
confidence, fiscal
policy, or foreign
demand factors will
shift spending at
any given interest
rate.
r
AE’
AE
AE’’
Y
Monetary Policy
The central bank stabilizes inflation using the interest rate target.
• If inflation is above target, πTGT, central bank will raise interest rate
• If inflation is below target, πTGT, central bank will cut interest rate
Under Taylor Principle, inflation above target
is associated with rising real rates.
Monetary Policy Reaction Curve
rt  r  b   t  
*
r* - Neutral real interest target
b – inflation sensitivity
TGT

Monetary Policy Reaction Curve
• Real interest rate
is an increasingr
function of the
interest rate
MPR
r*
πTGT
π
• The reaction of
monetary policy to
inflation exacerbates
the effect of inflation on
AD.
Increasing π→Increasing
r → Decreasing AD
• The more sharply that
monetary policy
responds to inflation,
the more sharply
demand responds to
inflation.
Aggregate Demand Curve
π
AD
Y
Relationship between inflation and aggregate demand
depends on how sensitive MPC is to inflation
r
Sensitive
π
MPR
Insensitive
AD
Insensitive
MPR
Sensitive
AD
π
Y
Short Run Aggregate Supply Curve
• Some wages and prices will be pre-set based on price-
setters inflation expectations. When inflation is
accelerating ahead of expectations, firms will respond
with extra production (ex. McDonalds).
• Potential output is an efficient level of production when
inflation expectations match actual inflation. Associated
with an economy with flexible prices.
• The output gap is the percentage deviation between
potential real GDP and real GDP.
•
Yt  Yt P
Output Gapt 
P
Yt
Aggregate Supply
Short-run & Long Run
π
SRAS
πE
Y
YP
Rise in Household-Business Confidence\StockReal Estate Market Booms\Expansionary Fiscal
policy The AD Curve Shifts Out
• Various events may
π
AD'
shift demand out for
goods at any given
interest rate
• Household
consumption may
increase because of
optimism or wealth
effect
• Corporate investment
may increase
because of optimism
• Government Deficit
Spending
AD
Y
Expansion Short –run Demand Shifts Up
YP
π
2
1
SRAS
AD′
AD
Y
Inflationary Output Gap
Recession Short –run Demand Shifts Down
π
YP
1
SRAS
2
AD′
AD
Y
Recessionary Output Gap
Adaptive Expectations
• Adaptive Expectations: Inflation expectations adjust to
actual inflation
• Et-Et-1= [t-Et-1]
• The SRAS adjusts to self-correct the output gap.
• Eventually, inflation expectations catch up with inflation.
Inflation Expectations Shift Upward
YP
π
3
2
1
SRAS
AD′
AD
Y
Inflationary Output Gap
YP
1
π
• The more
sensitive is
monetary
policy, the
flatter is the AD
curve.
• The flatter the
AD curve, the
less that
inflation will
need to decline
to return the
economy to
potential output.
2a
2b
SRAS
AD
Sensitive
AD
Insensitive
Y
Inflation Targeting:
Inflation Sensitive Interest Rate Rule
• Under inflation targeting, central bank is sensitive
to the inflation rate in setting the interest rate,
raising interest rates in response to increasing
inflation, cutting interest rates
• A benefit of this approach is not only stable
inflation and inflation expectations, but also more
stability of output and shorter duration business
cycles in the face of demand shocks.
21
Short-term Stabilization
Japan
• When output gap is
3
2
Inflation Acceleration
1
0
-8
-6
-4
-2
0
-1
-2
-3
Output Gap
2
4
6
negative, inflation
tends to be
decelerating.
Stabilizing inflation can
also stabilize the
business cycle
Inflation Acceleration =
InflationToday  InflationLastYear
Supply Shocks
• Inflation itself may be subject to cost-push shocks such as
energy prices etc.
• A monetary policy committee which strives to maintain a
fixed inflation target with a very sensitive MPR will face a
relatively large decline in output to maintain the target.
• Central bank often adjusts the inflation target to supply
side conditions
Supply Shock
Stagflation
π
YP
SRAS′
1
2
SRAS
AD
Y
SRAS
A
YP
π
SRAS
B
AD
Sensitive
AD
Insensitive
Y
An MPR for HK
• Remember in HK, the nominal interest rate is equal to the
US$ interest rate.
• Again, assume that inflation expectations respond to
actual inflation

rt
E
t 1
  t  rt
HK
r
US
t

HK
 
i
USA
t
HK
t


HK
t

E,
HK ,t 1
• In HK, as inflation rises, real interest rate falls!
Negative Relationship between inflation and real interest
rate with fixed exchange rates
r
MPRHK
π
Under fixed exchange rate, domestic interest rate &
demand may be insensitive to domestic inflation
r
Sensitive
π
MPR
Fixed S
AD
Fixed S
MPR
Sensitive
AD
π
Y