Transcript (MP) and Phillips Curve

 From Goods Market (IS) to Asset Market (MP):
 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.
 that the Phillips curve describes how firms set their prices over time, pinning
down the inflation rate.
 how the IS curve, the MP curve, and the Phillips curve make up our short-run
model.
 how to analyze the evolution of the macroeconomy—output, inflation, and
interest rates—in response to changes in policy or economic shocks.
 The federal funds rate is the interest rate paid by one bank to another for overnight
loans.
 The monetary policy (MP) curve describes how the central bank sets the nominal
interest rate and exploits the fact that the real and the nominal interest rates move
closely together in the short run when inflation is “sticky”
The short-run model is summarized as follows:
•Through the MP curve, the nominal interest rate set by the central bank determines
the real interest rate in the economy.
•Through the IS curve, the real interest rate influences GDP in the short-run.
•The Phillips curve describes how booms and recessions affect the evolution of
inflation.
The MP Curve: Monetary Policy and the Interest Rates
 Banks and financial institutions borrow from each other from one business day to
the next on the interbank federal funds market.
 Large banks that are willing to take risks tend to borrow from risk averse small banks
 Banks borrow and lend their deposits at the Fed – reserves/fed funds – to each other
 Conceptually, a central bank sets the nominal interest rate on overnight loans by
stating that it is willing to borrow or lend any amount at the specified rate.
 In practice, the open market desk at the Federal Reserve Bank of New York buys and
sells securities to adjust the supply of reserves in the banking system.
 On average, these open market operations get the overnight rate on interbank loans to
hit the FOMC’s target federal funds rate.
 When the Fed buys a security and pays for it, it injects reserves into the banking
system and eases credit conditions.
 When the Fed sells a security and is paid it, it removes reserves from the banking
system and tightens credit conditions.
BEST (Buy Ease, Sell Tighten)
From Nominal to Real Interest Rates
 The relationship between the nominal interest rate and the real interest rate is given
by the Fisher equation.
 Changes in the nominal interest rate lead to changes in the real interest rate as long as
they are not offset by corresponding changes to expected inflation.
 We assume that the rate of inflation adjusts slowly over time.
 In the very short run (6 months or so), we assume the rate of inflation does not respond
directly to monetary policy.
 If the rate of inflation is sticky, it is reasonable for people to expect inflation to remain
at its recent rate.
 When inflation is sticky, central banks can set the real interest rate in the short run.
 Because borrowing is done before the rate of inflation is known, it is the expected rate
of inflation that affects the decision to borrow and invest in new capital stock.
 The ex ante real interest rate is relevant for investment decisions.
 The MP curve illustrates the central bank’s
ability to set the real interest rate.
 Central banks set the real interest rate at a
particular value and the MP curve is a
horizontal line.
 The IS-MP diagram is a graph of the IS and
the MP curves.
 The economy is at potential when the real
interest rate equals the MPK and when there
are no aggregate demand shocks.


short-run output = 0
 If the central bank raises the interest rate
above the MPK, inflation is slow to adjust so
the real interest rate rises and investment falls.
Example: The End of a Housing Bubble
 Suppose housing prices had been
rising, but they fall sharply.
 This episode implies that the aggregate
demand parameter declines and the IS
curve shifts left.
 If the central bank lowers the nominal
interest rate in response, the real
interest rate falls as well because
inflation is sticky.
 If judged correctly and without lag,
output would not decline
The Term Structure of Interest Rates:
Long-term Real Rates Matter!
•
 In reality, policymakers are unsure of
the severity of shocks and it takes 6 to
18 months for changes in the interest
The yield on a long-term bond and the expected yield on shortterm bonds turned over for the same duration will be equal …
rate to impact the economy.
or else everyone would switch to the one with a higher return
 Thus, the Fed can control long-term
real interest rates by adjusting the
nominal overnight fed funds rate and
managing expectations about future
adjustments.
 Interest rates at long maturities equal an average of the
short-term rates investors expect in the future.
When the Fed changes the overnight rate, interest rates at longer
magnitudes change because:
•Financial markets expect the change will persist for some time.
•A change in rates today often signals information about likely
changes in the future.
The Phillips Curve Redux
 Workers and employers negotiate wages
and firms set prices based on expectations
of the economy-wide inflation rate and the
state of demand for their labor and product.
 Assume adaptive expectations:
 workers and firms expect the inflation
rate in the coming year to equal the rate
of inflation that prevailed during the
last year.
 The Phillips curve describes how inflation evolves
over time as a function of short-run output.
 We can add shocks to the Phillips curve to account
for temporary increases in the price of inflation:
 The actual rate of inflation now depends on three things:
 The expected rate of inflation, which equals the inflation rate from last year by
adaptive expectations:
 An adjustment factor for the state of the
economy:
 A shock to inflation:
An oil price shock, when the price of oil rises, will result in a temporary upward shift
in the Phillips curve.
•Price shocks to an input in production
(wages, energy costs) cost-push inflation
they push the inflation rate up.
•The effect of short-run output on is
demand-pull inflation
increases in aggregate demand pull
the inflation rate up.
Summary
1. The IS curve describes how output in the short run depends
on the real interest rate and on shocks to the aggregate
economy.
2. When the real interest rate rises, the cost of borrowing
faced by firms and households increases, leading them to
delay their purchases of new equipment, factories, and
housing. These delays reduce the level of investment,
which in turn lowers output below potential. Therefore, the
IS curve shows a negative relationship between output and
the real interest rate.
CHAPTER 10 The IS Curve
3. Shocks to aggregate demand can shift the IS curve.
These shocks include (a) changes in consumption
relative to potential output, (b) technological
improvements that stimulate investment demand
given the current interest rate, (c) changes in
government purchases relative to potential output,
and (d) interactions between the domestic and foreign
economies that affect exports and imports.
4. The life-cycle/permanent-income hypothesis says
that individual consumption depends on average
income over time rather than current income. This
serves as the underlying justification for why we
assume consumption depends on potential output.
CHAPTER 10 The IS Curve
5. The permanent-income theory does not seem to hold
exactly, however, and consumption responds to
temporary movements in income as well. When we
include this effect in our IS curve, a multiplier term
appears. That is, a shock that reduces the aggregate
demand parameter by 1 percentage point may have
an even larger effect on short-run output because the
initial reduction in output causes consumption to fall,
which further reduces output.
CHAPTER 10 The IS Curve
6. A consideration of the microfoundations of the
equations that underlie the IS curve reveals important
subtleties. The most important are associated with
the no-free-lunch principle imposed by the
government’s budget constraint. The direct effect of
changes in government purchases is to change
.
However, depending on how these purchases are
financed, they can also affect consumption and
investment, partially mitigating the effects of fiscal
policy on short-run output
CHAPTER 10 The IS Curve