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Monetary Policy and Inflation
Chapter 29 & 30
Monetary Policy
Channel of Monetary Policy
• When the central bank increases the monetary
base, the money supply will increase.
• Banks have excess liquidity which they use to
make more loans.
• The supply of liquidity will exceed demand and
banks must compete to attract borrowers who will
hold this liquidity only at a lower interest rate.
Dynamics of Monetary
Transmission
• Money supply expansion reduces interest
rates
• Lower interest rates implies an increase in
borrowing and affects demand for interest
sensitive goods.
• Lower interest rates increase demand for
US$ in forex market depreciating the
exchange rate.
• Aggregate demand shifts out. Given fixed
input prices this increase in demand
stimulates output.
Monetary Transmission Mechanism
ECB Web Site
Monetary Policy: Money Supply Expands
Money Supply
i
Money
Supply’
i*
1
Money Demand
i**
2
M
Expansionary Monetary Policy
P
ΔI ΔC, ΔNX
AD
AD′
Y
An Expansionary Cycle Driven by
monetary policy
2. Monetary
Policy Cuts
Interest Rate
YP
P
3
1. Economy at
LT YP.
SRAS
3. Investment
rises. The
AD curve
shifts out.
2
P*
1
AD′
AD
Output Gap
Y
4. Tight labor
markets.
SRAS
returns to
long run
equilibrium
Monetary Policy –
Short-term vs. Long Term
• In the short-run, expansionary monetary
policy can boost economic growth.
• But in the long-run, expansionary
monetary policy only leads to rising prices
(i.e. inflation).
Interest Rate Management
• In most economies around the world, the
central bank does not simply act to
maintain a fixed money supply.
• Rather, they adjust money supply to
maintain and manage interest rate
changes in response to business cycle
conditions.
Monetary Policy
• In the US (and Euroland and Japan and
most OECD economies), the central bank
sets monetary policy by picking a short-run
interest rate they would like to prevail.
• In HK, the central bank sets monetary
policy by picking a fixed exchange rate.
U.S. Central bank cuts interest
rates during recessions
Demand Driven Recession
w/ Counter-cyclical monetary policy
YP
P
SRAS
AD′
1
2. Monetary
Policy Cuts
Interest Rate
3
P*
2
AD
Gap < 0
1. Economy in
a recession.
Fed detects
deflationary
pressure
Y
3. Investment
increases
spending to
shift the AD
curve back
to long run
equilibrium
Demand Driven Expansion
w/ Counter-cyclical monetary policy
YP
P
SRAS
2
P*
1
AD′
3
AD
Gap > 0
Y
1. Economy in
expansion.
Fed detects
inflationary
pressure
2. Monetary
Policy
Raises
Interest Rate
3. Investment
decreases
spending to
shift the AD
curve back
to long run
equilibrium
Price Stability
• Counter-cyclical monetary policy stabilizes
output near potential output, YP, but also
stabilizes the price level near P*.
• Central banks may pursue price stability
as a goal and also stabilize output as well
if business cycles are caused by demand
shocks.
Policy Framework
Price Stability
• Fed Objective Humphrey Hawkins Act (1978): Fed
instructed by Congress to be “conducting the nation's
monetary policy .. in pursuit of maximum employment,
stable prices, and moderate long-term interest rates “
• ECB Objective “The primary objective of the ECB’s
monetary policy is to maintain price stability. The ECB
aims at inflation rates of below, but close to, 2% over the
medium term.”
• Japan Objective: Bank of Japan Act Article 2 Currency
and monetary control by the Bank of Japan shall be
aimed at achieving price stability, thereby contributing to
the sound development of the national economy
The Great Moderation
•The Great Moderation by Federal Reserve Bank of Dallas
Taylor Rule
•
Economist named John Taylor argues
that US target interest rate is well
represented by a function of
1. current inflation
2. Inflation GAP: current inflation vs. target
inflation
3. Output Gap: % deviation of GDP from long
run path
•
Function: Inflation Target π* = .02
TGT
t
i
 .025   t 
1
1  Output Gap

(



)

2
2
t
t
*
The Taylor Rule Download
What should be the current Fed
Funds rate? Will they be increasing
it soon?
• Step 1. Find Inflation Rate
• Step 2. Find Output Gap
• Step 3. Calculate Taylor Rule implied rate
and compare with current rate.
Answer
P_2008_2
P_2007_2
Inflation
Y
YP
Output Gap
Inflation Gap
Taylor Rule
Fed Funds Rate
121.91
120.00
0.016
11740.3
11904.0
-0.014
-0.004
0.032
0.02
Stagflation
w/ Counter-cyclical monetary policy
YP
P
SRAS
3
P**
P*
2
1
AD′
AD
Y
1. Economy
experiences
stagflation
2. Monetary
Policy Cuts
Interest Rate
3. Investment
increases
spending to
shift the AD
curve to
long run
equilibrium
with higher
prices.
Stagflation
w/ Price Stabiliztion
YP
P
1. Economy
experiences
stagflation
SRAS
2
3
P*
1
AD′
AD
Y
2. Monetary
Policy
Raises
Interest Rate
3. Investment
decreases
spending to
shift the AD
curve to
equilibrium
with lower
output.
Monetary Policy and Supply
Shocks
• In the face of demand shocks, no trade-off
between price and output stability.
• In the face of supply shocks, such a tradeoff exists.
Question: Problem with Central
Bank Stabilization
• Situation: Economy is in long-run
equilibrium, but central bank
overestimates potential output.
• Draw outcome if central bank believes that
the potential output is higher than it is.
A Bias toward Expansionary
monetary policy
1. Central Bank
repeatedly
expands the
money supply
YP
P
2. Inflation
recurs
5
4
3
P*
2
SRAS′
AD′
1
SRAS
AD
YPhantom
Y
Monetary Policy Lags
• Counter-cyclical fiscal policy beset by lags
between the time a recession is
recognized and the time the government
can form consensus to act.
• Monetary policy beset by lags between the
time policy shifts and time for private
sector to respond to lower interest rates.
Inflation
Quantity Theory
• Simplest monetary theory is the Quantity
Theory of Money.
– Purchasing power of money is equal to the
quantity of money (Mt) times the speed of
circulation (V, # of transactions)
– Purchasing power means # of goods (Yt)
multiplied by price per good (Pt)
Moneyt * Velocity = Pt * Yt
Rule of Thumb
• Rule of Thumb The growth rate of product
is approximately equal to the sum of the
growth rates of the elements of a product.
Z t  X t  Yt  g  g  g
Z
t
X
t
Y
t
Zt  Zt 1
g 
Zt 1
Z
t
Money and Inflation
• Assuming stable velocity
g  g  t
M
t
Y
t
t  g
P
t
• Inflation occurs when money growth
speeds ahead of output growth. The
unbounded creation of fiat money leads to
inflation which ultimately will make the
money worthless.
Money & Inflation: 1975-1994
Inflation & Money OECD Countries
0.2
0.18
Average Inflation Rate
0.16
0.14
0.12
0.1
0.08
0.06
0.04
0.02
0
0
0.02
0.04
0.06
0.08
0.1
0.12
Average Money Growth
0.14
0.16
0.18
Ex Ante Rate and the Fisher Effect
• Savings and investment decisions must be
made before future inflation is known so
they must be made on the basis of an ex
ante (predicted) real interest rate.
• Fisher Hypothesis: Ex ante real interest
rate is determined by forces in the
financial market. Money interest rate is just
the real ex ante rate plus the market’s
consensus forecast of inflation.
it  rt
EA

FORECAST
t 1
Great Inflation of the 1970’s
US Inflation Rates & Interest Rates
18.00
16.00
14.00
%
12.00
10.00
Interest Rates
Inflation
8.00
6.00
4.00
2.00
Mar-03
Mar-00
Mar-97
Mar-94
Mar-91
Mar-88
Mar-85
Mar-82
Mar-79
Mar-76
Mar-73
Mar-70
Mar-67
Mar-64
Mar-61
Mar-58
Mar-55
0.00
Source: St. Louis Federal Reserve http://research.stlouisfed.org/fred2/
Great Inflation Download
Fisher Effect: OECD Economies
Great Inflation of 1970’s
20
18
Interest Rates-1984
16
14
12
10
8
6
4
2
0
0
2
4
6
8
10
12
Average Inflation 1970-1984
14
16
18
Loanable Funds Market
Fisher Effect
S
i*
r*

 tE1
E
t 1
LF*
I
LF
Ex Ante vs. Ex post
• We can also examine the ex post real
return on a loan as the money interest rate
less the actual outcome for inflation.
rt
ExP
 it  
ACTUAL
t 1
• The gap between actual and forecast
inflation determines the gap between the
ex post (actual) and ex ante (forecast)
return.
ExP
ExA
FORECAST
ACTUAL
rt
 rt
  t 1
  t 1
Unexpected Inflation
Winners and Losers
– Higher than expected inflation means ex
post real rates are lower than ex ante.
Borrowers are winners/lenders are
losers.
– Lower than expected inflation means ex
post real rates are higher than ex ante.
Lenders are winners/borrowers are
losers.
Inflation Risk
• When inflation is variable, lenders will
demand some premium for inflation risk.
This will put cost on borrowers.
• High inflation rates tend to be associated
with unpredictable inflation.
Costs of Anticipated Inflation
• Shoe Leather Costs – Money is a technology for
engaging in transactions. The greater is inflation,
the greater the cost for individuals of holding
money. Individuals must make efforts as a
substitute for the convenience of holding money.
• Menu Costs – Firms must engage in costs of
changing posted prices. More generally, when
prices change rapidly over time, more time and
effort must be put into calculating relative prices.
The Inflation Tax
• Banknotes do not pay interest.
• The real interest rate on banknotes is
rt
CASH
  t 1
• If inflation is high, currency has sharply
negative returns. People will avoid holding
money leading to society losing the
convenience of money transactions.
•Zimbabwe Inflation Download
Causes of Extremely Rapid Inflation
• Government generates revenues by printing
new money (referred to as seignorage).
• Government facing borrowing constraints
may be forced to rely on inflation tax for
deficit financing and real returns to owning
money.
• Explain the link between deficits and inflation.
19
70
19
71
19
72
19
73
19
74
19
75
19
76
19
77
19
78
19
79
19
80
19
81
19
82
19
83
19
84
19
85
19
86
19
87
19
88
19
89
19
90
Israel 1970-1990
Inflation
400
350
300
250
200
150
100
50
0
Israel 1970-1990
Surplus (% of GDP)
5.00%
-5.00%
-10.00%
-15.00%
-20.00%
-25.00%
-30.00%
1990
1989
1988
1987
1986
1985
1984
1983
1982
1981
1980
1979
1978
1977
1976
1975
1974
1973
1972
1971
1970
0.00%
A Bias toward Expansionary
monetary policy
1. Central Bank
repeatedly
expands the
money supply
YP
P
2. Inflation
recurs
5
4
3
P*
SRAS′
SRAS
2
1
AD′
AD
Inflationary Gap
Y
3. After a time,
as inflation
becomes
expected it
will cease to
impact output
even in the
short run.
Features of Inflation Targeting
A medium term communication strategy
• Commitment to price stability as goal of
monetary policy.
• Clear statement of numerical target for
inflation over the medium (1-2 year) term.
• Communication with public about current
forecasts of inflation and policy actions
used to achieve target.
• Central Bankers accountable for achieving
goals.
Yield Curve
• The yield curve is the gap between the
interest rate on long-term bonds and shortterm bonds.
• When long-term interest rates are high
relative to the short-term interest rates, the
yield curve is steep.
• When short-term interest rates are
relatively high, the yield curve is flat or
inverted.
Monetary Policy and the Yield
Curve
• Central bank expands the money supply and
short-term interest rate will fall.
• Negative effect on long term real interest rate
but…
• Also likely to increase inflationary expectations
raising nominal long-term interest rates.
• Yield Curve steepens when money supply
expands and flattens when money supply
contracts.
•Yield Curve Download
9/
4/
20
07
9/
6/
20
07
9/
8/
20
07
9/
10
/2
00
9/
12 7
/2
00
9/
7
14
/2
00
9/
7
16
/2
00
9/
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18
/2
00
9/
7
20
/2
00
9/
22 7
/2
00
9/
7
24
/2
00
9/
7
26
/2
00
9/
7
28
/2
00
7
%
US Yield Curve
September 2007: Expansionary
Monetary Policy
5
4.5
4
3.5
3
2.5
2
1.5
1
0.5
0
3 month
10 Year
Yield Curve
Learning Outcome
• Calculate the impact of inflation on longterm nominal interest rates using the
theory of the Fisher effect.
• Calculate real return on debt as a function
of inflation and expected inflation.
• Calculate real return on money as a
function of inflation.