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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 * t Central bank’s target inflation rate t Demand shock t Supply shock • 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 * t 1.0 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