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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 , it11 ,....., it1 n 1 over the n periods exp(it1 it11 ..... 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 R is the change in the nominal interest rate on a i t 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