Transcript Diploma Macro Paper 2 - Robinson College, Cambridge

Diploma Macro Paper 2
Monetary Macroeconomics
Lecture 7
Policy effectiveness and inflation targeting
Mark Hayes
1
Unemployment rate
Mistakes forecasting the 1982 US recession
2
Chart C GDP outturns and projection in the May 2011
Inflation Report
3
The Cycle and Automatic Stabilizers
Y
Surplus
Boom
Economy with
no automatic
stabilizers
Y
Economy with
automatic
stabilizers
Recession
Deficit
t0
t1 t 2
time
t3
4
E
E=Y
E1
E0
E1
E0
A
t 0
t 0
t 0
t 0
A
1  c1 (1  t )
Y0
Y2
Y1
A
1  c1
income
output, Y
5
The Cycle and Automatic Stabilizers
Y
Surplus
Boom
Economy with
no automatic
stabilizers
Y
Economy with
automatic
stabilizers
Recession
Deficit
t0
t1 t 2
time
t3
6
Exogenous: M, G, T, i*, πe
Goods market
KX and IS
(Y, C, I)
Phillips Curve
(,u)
Labour market
(P, Y)
AS
AD-AS
(P, i, Y, C, I)
Money
market (LM)
(i, Y)
Foreign exchange
market
(NX, e)
IS-LM
(i, Y, C, I)
AD
IS*-LM*
(e, Y, C, NX)
AD*
AD*-AS
(P, e, Y, C, NX)
7
Short-run equilibrium in the DAD-DAS model
π
Yt
DASt
πt
A
In each period, the
intersection of DAD and
DAS determines the shortrun equilibrium values of
inflation and output.
In the equilibrium
shown here at A,
output is below its
natural level.
DADt
Yt
Y
The DAD-DAS Equations
Yt  Yt    (rt   )   t
Demand Equation
rt  it  Et t 1
Fisher Equation
 t  Et 1 t    Yt  Yt   t Phillips Curve
Et t 1   t
Adaptive Expectations


it   t       t    Y  Yt  Yt 
*
t
Monetary Policy Rule
The model’s variables and parameters
• Endogenous variables:
Yt  Output
t 
Inflation
rt  Real interest rate
it  Nominal interest rate
Et  t 1  Expected inflation
The model’s variables and parameters
• Exogenous variables:
Yt  Natural level of output
 
Central bank’s target inflation rate
t 
Demand shock
t 
Supply shock
*
t
• Predetermined variable:
 t 1 
Previous period’s inflation
The model’s variables and parameters
• Parameters:
  Responsiveness of demand to
the real interest rate
  Natural rate of interest
  Responsiveness of inflation to
output in the Phillips Curve
 
Y 
Responsiveness of i to inflation
in the monetary-policy rule
Responsiveness of i to output
in the monetary-policy rule
Output:
The Demand for Goods and Services
Yt  Yt   (rt   )   t
output
natural
level of
output
real
interest
rate
  0,   0
Assumption: There is a negative relation between
output (Yt) and interest rate (rt). The justification is the
same as for the IS curve of Ch. 10.
Output:
The Demand for Goods and Services
Yt  Yt   (rt   )   t
measures the
interest-rate
sensitivity of
demand
“natural rate of
interest”
This is the long-run real
interest rate we had
calculated in Ch. 3
Note that in the absence of demand shocks,
Yt  Yt when rt  
demand
shock,
random and
zero on
average
The demand shock is
positive when C0, I0, or G
is higher than usual or T
is lower than usual.
The Real Interest Rate: The Fisher Equation
ex ante
(i.e. expected)
real interest
rate
rt  it  Et  t 1
nominal
interest
rate
expected
inflation rate
Assumption: The real interest rate is the inflation-adjusted
interest rate. To adjust the nominal interest rate for inflation, one
must simply subtract the expected inflation rate during the
duration of the loan.
The Real Interest Rate: The Fisher Equation
ex ante
(i.e. expected)
real interest
rate
 t 1 
rt  it  Et  t 1
nominal
interest
rate
expected
inflation rate
increase in price level from period t to t +1,
not known in period t
Et  t 1  expectation, formed in period t,
of inflation from t to t +1
We saw this before in Ch. 4
Inflation: The Phillips Curve
 t  Et 1  t   (Yt  Yt )   t
current
inflation
previously
expected
inflation
  0 indicates how much
inflation responds when
output fluctuates around
its natural level
supply
shock,
random and
zero on
average
Expected Inflation: Adaptive Expectations
Et  t 1   t
Assumption: people expect
prices to continue rising at the
current inflation rate.
Examples: E2000π2001 = π2000; E2010π2011 = π2010; etc.
Monetary Policy Rule
Current
inflation
rate
Parameter that
measures how
strongly the
central bank
responds to the
inflation gap

Parameter that
measures how
strongly the
central bank
responds to
the GDP gap

it   t       t    Y  Yt  Yt 
Nominal
interest
rate, set
each period
by the
central bank
Natural real
interest rate
*
t
Inflation Gap: The
excess of current
inflation over the
central bank’s
inflation target
GDP Gap: The
excess of current
GDP over natural
GDP
CASE STUDY
10
9
8
Percent
7
The Taylor Rule
actual
Federal
Funds rate
6
5
4
3
2
1
Taylor’s
rule
0
1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009
Short-run equilibrium in the DAD-DAS model
π
Yt
DASt
πt
A
In each period, the
intersection of DAD and
DAS determines the shortrun equilibrium values of
inflation and output.
In the equilibrium
shown here at A,
output is below its
natural level.
DADt
Yt
Y
A Series of Aggregate Demand Shocks
• Suppose the economy is at the long-run
equilibrium
• Then a positive aggregate demand shock (ε>0)
hits the economy for five successive periods,
and then stops (ε = 0)
• How will the economy be affected in the short
run?
• How will the economy adjust over time?
A shock to aggregate demand
π
πt + 5
G
πt
πt – 1
Yt + 5
Period t – 1: initial
equilibrium at A
Period t: Positive demand
DASt +5
shock (ε
shifts AD
to the
Period
t +>1:0)Higher
inflation
Y
right;
output
and inflation
DASt +4
in
t raised
Periods
t +inflation
2 to t + 4:
rise.
forint +previous
1,
Higher inflation
DASt +3 expectations
F
shifting
DAS up.
Inflation
period
raises
inflation
DASt +2 rises more, output falls.
expectations, shifts DAS up.
E
Period t +rises,
5: DAS
is higher
output
falls.
DASt + 1 Inflation
D
due to higher inflation in
C
DASt -1,t preceding period, but
demand shock ends and
B
DADPeriods
returnstto
initial
+ 6itsand
higher:
position.
Equilibrium
at G.
DAS gradually
shifts
DADt ,t+1,…,t+4 down as inflation and
A
inflation expectations
DADt -1, t+5
fall. The economy
Y
gradually recovers and
Yt –1
Yt
returns to long run
equilibrium at A.
Parameter values for simulations
Yt  100
  2.0
  1.0
*
t
  2.0
  0.25
  0.5
Y  0.5
The central bank’s inflation target is 2 percent.
A 1-percentage-point increase in the real interest
rate reduces output demand by 1 percent of its
natural level.
The natural rate of interest is 2 percent.
When output is 1 percent above its natural level,
inflation rises by 0.25 percentage point.
These values are from the Taylor Rule, which
approximates the actual behavior of the Federal
Reserve.
The dynamic response to a demand shock
t
Yt
The demand
shock raises
output for five
periods.
When the
shock ends,
output falls
below its
natural level,
and recovers
gradually.
The dynamic response to a demand shock
t
t
The
demand shock
causes
inflation
to rise.
When the
shock ends,
inflation
gradually falls
toward its
initial level.
The dynamic response to a demand shock
t
it
The central
bank raises the
money interest
rate in
response.
After the
shock ends,
the money
interest
rate falls, first
sharply, then
gradually
returns to its
initial level.
The dynamic response to a demand shock
t
rt
The real
interest rate is
the resultant
of the money
interest rate
and inflation.
APPLICATION:
Output variability vs. inflation variability
CASE 1: θπ is large, θY is small
π
A supply shock
shifts DAS up.
DASt
DASt – 1
πt
In this case, a small
change in inflation has
a large effect on
output, so DAD
is relatively flat.
πt –1
DADt – 1, t
Yt
Yt –1
Y
The shock has a large
effect on output, but a
small effect on
inflation.
APPLICATION:
Output variability vs. inflation variability
CASE 2: θπ is small, θY is large
π
DASt
πt
DASt – 1
In this case, a large
change in inflation has
only a small effect on
output, so DAD is
relatively steep.
πt –1
DADt – 1, t
Yt Yt –1
Y
Now, the shock has
only a small effect on
output, but a big effect
on inflation.
APPLICATION:
Output variability vs. inflation variability
CASE 2: θπ is small, θY is large
π
DASt
πt
DASt – 1
In this case, a large
change in inflation has
only a small effect on
output, so DAD is
relatively steep.
πt –1
DADt – 1, t
Yt Yt –1
Y
Now, the shock has
only a small effect on
output, but a big effect
on inflation.
APPLICATION:
Output variability vs. inflation variability
CASE 1: θπ is large, θY is small
π
DASt
DASt – 1
πt
πt –1
DADt – 1, t
Yt
Yt –1
Y
Inflation
bias
DADT
πR
DASR
C
DAS
DAD
B
π*
A
Y
Y
YT
Hysteresis
π
Yt Yt+2
Yt+1
Yt-1
DASt + 3
DASt + 2
E
DASt + 1
D
C
DASt-1, t
B
A
DADt -1
DADt, t+1, … t+3
Y
Next time
 Origins of the North Atlantic and Euro crises
35