Transcript If you were invited to give a talk to a group of citizens in Shanghai

Capital prices & Monetary Policies
Real estate prices
Stock prices
Inflation
Monetary policies
The Model of Aggregate Demand and Aggregate Supply
P
The price
level
The model
determines the
eq’m price level
and eq’m output
(real GDP).
SRAS
P1
“Aggregate
Demand”
Y1
“ShortRun
Aggregate
Supply”
AD
Y
Real GDP, the
quantity of output
The Aggregate-Demand (AD) Curve
P
The AD curve
shows the
quantity of
all g&s
demanded
in the economy
at any given
price level.
P2
P1
AD
Y2
Y1
Y
Why the AD Curve Slopes Downward
P
Y = C + I + G + NX
Assume G fixed
by govt policy.
To understand
the slope of AD,
must determine
how a change in P
affects C, I, and NX.
P2
P1
AD
Y2
Y1
Y
The Wealth Effect (P and C )
Suppose P rises.
 The dollars people hold buy fewer g&s,
so real wealth is lower.
 People feel poorer.
Result: C falls.
The Interest-Rate Effect (P and I )
Suppose P rises.
 Buying g&s requires more dollars.
 To get these dollars, people sell bonds or other assets.
 This drives up interest rates.
Result: I falls.
(Recall, I depends negatively on interest rates.)
The Exchange-Rate Effect (P and NX )
Suppose P rises.
 U.S. interest rates rise (the interest-rate effect).
 Foreign investors desire more U.S. bonds.
 Higher demand for $ in foreign exchange market.
 U.S. exchange rate appreciates.
 U.S. exports more expensive to people abroad, imports
cheaper to U.S. residents.
Result: NX falls.
8
The Slope of the AD Curve: Summary
An increase in P
reduces the quantity
of g&s demanded
because:
P
P2
• the wealth effect
(C falls)
• the interest-rate
P1
AD
effect (I falls)
• the exchange-rate
effect (NX falls)
Y2
Y1
Y
Why the AD Curve Might Shift
Any event that changes C,
I, G, or NX
– except a change in P –
will shift the AD curve.
Example:
A stock market boom
makes households feel
wealthier, C rises,
the AD curve shifts right.
P
P1
AD2
AD1
Y1
Y2
Y
Why the AD Curve Might Shift
 Changes in C
 Stock market boom/crash
 Preferences re: consumption/saving tradeoff
 Tax hikes/cuts
 Changes in I
 Firms buy new computers, equipment, factories
 Expectations, optimism/pessimism
 Interest rates, monetary policy
 Investment Tax Credit or other tax incentives
Why the AD Curve Might Shift
 Changes in G
 Federal spending, e.g. defense
 State & local spending, e.g. roads, schools
 Changes in NX
 Booms/recessions in countries that buy our exports.
 Appreciation/depreciation resulting from international
speculation in foreign exchange market
Short Run Aggregate Supply (SRAS)
The SRAS curve
is upward sloping:
Over the period
of 1-2 years,
an increase in P
causes an
increase in the
quantity of g & s
supplied.
P
SRAS
P2
P1
Y1
Y2
Y
Why the Slope of SRAS Matters
If AS is vertical,
Phi
fluctuations in AD
do not cause
Phi
fluctuations in output
or employment.
If AS slopes up,
then shifts in AD
do affect output and
employment.
LRAS
P
SRAS
ADhi
Plo
AD1
Plo
ADlo
Ylo
Y1
Yhi
Y
The Aggregate-Supply (AS) Curves
The AS curve shows
the total quantity of
g&s firms produce and
sell at any given price
level.
P
LRAS
SRAS
AS is:
 upward-sloping
in short run
 vertical in
long run
Y
The Long-Run Aggregate-Supply Curve (LRAS)
The natural rate of
output (YN) is the
amount of output
the economy produces
when unemployment
is at its natural rate.
YN is also called
potential output
or
full-employment
output.
P
LRAS
YN
Y
Why LRAS Is Vertical
YN determined by the
P
economy’s stocks of
labor, capital, and
natural resources, and
P2
on the level of
technology.
An increase in P
does not affect
any of these,
so it does not
affect YN.
(Classical dichotomy)
LRAS
P1
YN
Y
Why the LRAS Curve Might Shift
Any event that
changes any of the
determinants of YN
will shift LRAS.
P
LRAS1 LRAS2
Example:
Immigration
increases L,
causing YN to rise.
YN
Y’
N
Y
Why the LRAS Curve Might Shift
 Changes in L or natural rate of unemployment
 Immigration
 Baby-boomers retire
 Govt policies reduce natural u-rate
 Changes in K or H
 Investment in factories, equipment
 More people get college degrees
 Factories destroyed by a hurricane
Why the LRAS Curve Might Shift
 Changes in natural resources
 discovery of new mineral deposits
 reduction in supply of imported oil
 changing weather patterns that affect agricultural
production
 Changes in technology
 productivity improvements from technological progress
Depict LR Growth and Inflation
Over the long run,
tech. progress shifts
LRAS to the right
and growth in the
money supply shifts
AD to the right.
Result:
ongoing inflation
and growth in
output.
P
LRAS1990
LRAS2000
LRAS1980
P2000
P1990
AD2000
P1980
AD1990
AD1980
Y1980
Y1990
Y2000
Y
ACTIVE LEARNING
1:
Exercise
 Draw the AD-SRAS-LRAS diagram
for the U.S. economy,
starting in a long-run equilibrium.
 A boom occurs in Canada.
Use your diagram to determine
the SR and LR effects on U.S. GDP,
the price level, and unemployment.
22
ACTIVE LEARNING
1:
Answers
Event: boom in Canada
P
1. affects NX, AD curve
LRAS
SRAS2
2. shifts AD right
3. SR eq’m at point B.
P and Y higher,
unemp lower
P3
4. Over time, PE rises,
SRAS shifts left,
until LR eq’m at C.
Y and unemp back
at initial levels.
P1
C
SRAS1
B
P2
A
AD2
AD1
YN
Y2
Y
23
What cause inflation ?
P
SRAS
SRAD
Y
The Effects of increasing the Money Supply
The Fed can decrease r by increasing the money supply.
Interest
P
MS2 MS1
rate
r2
P1
r1
AD1
MD
M
AD2
Y2
Y1
An decrease in r increase the quantity of g&s demanded.
Y
Money growth and inflation
 Equilibrium in the money market
M
 L  i, Y 
P
(1)
M-Money stock, P-Price level, i-Nominal interest rate
Y-Real income , L(.) the demand for real money balances
M
P
L(i, Y )
(2)
Money Growth and Inflation
Inflation (%)
Money supply growth (%)
Money Growth and Interest Rates
 Assume Y and r are constant at Y and r
 Prices are complete flexible
i  r 
e
M
P
e
L(r   , Y )
Fisher Identity (3)
(4)
M / P is constant, an increase in
money supply at time t 0
ln M
ln( M / P)

e
ln P
i
t0
t0
Nominal & Real money stock
Increase in ln M
Increase in 
e
Increase in
i
Decrease in ln(M / P)
Lesson: At the time when there is sudden increase in
money supply, inflation exceeds the rate of M does.
The case of incomplete price flexibility
 Liquidity effect: the negative effect of monetary
expansions on nominal rates
i
LM
1. The decline in real interest rate
exceeds the increase in expected
inflation in the short run .
2. If prices are fully flexible in
the long run, the real rate
eventually returns to the normal
following a shift to higher money
growth.
IS
Y
Expectations theory of the term structure: the
standard theory of the relationship described
above.
An Investor
 A bond with continuously compounded rates of return
exp( nitn )
 Puts the dollar into a sequence of 1-period bonds
paying continuously compound rates of return of
it1 , it11 ,....., it1 n 1 over the n periods
exp(it1  it11  .....  it1 n 1 )
Expectations theory of the term
structure
 With certainty
i  i  .....  i
i 
n
 With uncertainty
n
t
1
t
1
t 1
1
t  n 1
1
1
1
i

E
i

.....

E
i
n
t t 1
t t  n 1
it  t
 nt
n
The changes in the term structure are determined by changes
in expectations of future interest rates (rather than by changes
in the term premium).
Empirical Application: The response of the
term structure to changes in the Federal
Reserve’s Federal-Funds-Rate Target
 Cook and Hahn (1989)
 Aim of the study: investigate monetary policy’s impact
on interest rates on bonds of different maturities
 Study period: 1974-79, when the Federal Reserve was
targeting the funds rate
 Data: a record of the changes in the Federal Reserve’s
target over this period
 Data source: Federal Reserve Bank of New York and the
reports of the changes in the Wall Street Journal
Cook and Hahn (1989) Cont.
 Finding 1: the actual funds rate moves closely with the
Federal Reserve’s target
 Examine the impact of changes in the Federal
Reserve’s target on longer-term interest rates
Rti  b1i  b2i FFt  uti
Rti is the change in the nominal interest rate on a
bond of maturity i on day t
FFt is the change in the target Federal funds rate on
that day
Cook and Hahn (1989) Cont.
 Finding 2: The increase in the Federal-funds-rate
target raise nominal interest rates at all horizons
 100 basis points in FF




55 basis points in 3 month interest rate
50 basis points in 1 year interest rate
21 basis points in 5 year interest rate
10 basis points in 20 year interest rate
Cook and Hahn (1989) Cont.
 Assumption from the expectation theory of the term
structure of interest rate : Contractionary monetary
policy should immediately lower long-term nominal
interest rates
 Findings: Opposite
 Why?
C. Romer and D. Romer(2000)
C
t
F
t
 t  a  bC   bF   et
 t is actual inflation,  Ct and  tF are the commercial
and Federal reserve forecasts for  t
Finding: bF is close to one, significant; bC is near 0,
insignificant.
C. Romer and D. Romer(2000) Cont.
F
t
C
t
     Pt     t
P is the change in the Federal-funds-rate target.
 is estimated around 0.25, but not very precise.
The dynamic inconsistency of lowinflation monetary policy
 The increase in the money supply does not affect long-
term output
 However, it affects short-term output
 The government has the incentive to deviate from the
expected inflation to push output above its normal
level.
 If the game continues, people will form a new higher
expected inflation in the following periods. Then the
higher inflation will not affect the output level.
The dynamic inconsistency of lowinflation monetary policy
 In theory, if the public is aware of the difference, there
is no reason for output to behave differently under the
low-inflation policy than under the high inflation
policy.
 Kydland and Prescott(1977): the inability of
policymakers to commit themselves to such a lowinflation policy can give rise to excessive inflation
despite the absence of a long-run tradeoff.
Addressing the dynamic inconsistency
problem
 A commitment rule
 Normative problem
 Positive problem
 Reputation
 Delegation
Empirical Application: Central-bank
independence and inflation
 Finding: Independence and inflation is negative
correlated among industrialized countries
 The prediction of delegate theory: No
 Not sure whether independence is the source of the low
inflation
ACTIVE LEARNING
2:
Exercise
 Page 525
 Problems No. 10.5
 Policy rules, rational expectations, and regime changes
 Lucas 1976 , (page 612 for reference), Sargent 1983, ,
(page 621 for reference),
45