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Transcript
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