McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. Money and Banking Lecture 41

Review of the Previous Lecture Output and Inflation in the Long Run Money growth, Inflation and Aggregate Demand Monetary Policy and Real Interest Rate Aggregate Demand and Real Interest Rate Long Run Real Interest Rate

Deriving the Monetary Policy Reaction Curve To ensure that deviations of inflation from the target are only temporary, monetary policymakers respond to change in inflation by changing the real interest rate in the same direction. The monetary policy reaction curve is set so that when current inflation equals target inflation, the real interest rate equals the long-run real interest rate.

The slope of the curve depends on policymakers’ objectives; when central bankers decide how aggressively to pursue their inflation target, and how willing they are to tolerate temporary changes in inflation, they determine the slope of the curve

The Monetary Policy Reaction Curve

an economy Central bank’s

Shifting the Monetary Policy Reaction Curve Policymakers who are aggressive in keeping current inflation near target will have a steep curve, meaning that a small change in inflation will be met with a large change in the real interest rate A relatively flat curve means that central bankers are less concerned than they might be with keeping current inflation near target over the short term.

The monetary policy reaction curve is set so that when current inflation equals target inflation, the real interest rate equals the long-run real interest rate. r = r* when  =  T.

When policymakers adjust the real interest rate they are either moving along a fixed monetary policy reaction curve or shifting the curve. A movement along the curve is a reaction to a change in current inflation; a shift in the curve represents a change in the level of the real interest rate at every level of inflation

If either target inflation or the long-run real interest rate change, then the entire curve will shift With a higher inflation target, the central bank will set a lower current real interest rate at every level of current inflation, shifting the monetary policy reaction curve to the right (a reduction would have the opposite effect).

The long-run real interest rate is determined by the structure of the economy; If it were to rise as a result of an increase in government purchases (or some other component of aggregate demand that is not sensitive to the real interest rate) then the monetary policy reaction curve would shift left

Any shift in the monetary policy reaction curve can be characterized as either a change in target inflation or a shift in the long-run real interest rate

The Monetary Policy Reaction Curve

The Aggregate Demand Curve When current inflation rises Monetary policymakers raise the real interest rate, moving upward along the monetary policy reaction curve The higher real interest rate reduces consumption, investment, and net exports causing aggregate demand (output) to fall.

The Aggregate Demand Curve

Changes in current inflation move the economy along a downward-sloping aggregate demand curve This is in addition to the effect of higher inflation on real money balances noted earlier

The slope of the aggregate demand curve tells us how sensitive current output is to a given change in current inflation. The aggregate demand curve will be relatively flat if current output is very sensitive to inflation (a change in current inflation causes a large movement in current output) steep if current output is not very sensitive to inflation

The Aggregate Demand Curve

Three factors influence the sensitivity of current output to inflation: the strength of the effect of inflation on real money balances, the extent to which monetary policymakers react to a change in current inflation, the size of the response of aggregate demand to changes in the interest rate

The second factor relates to the slope of the monetary policy reaction curve If policymakers react aggressively to a movement of current inflation away from its target level with a large change in the real interest rate, the monetary policy reaction curve will be steep and the aggregate demand curve is flat If policymakers respond more cautiously, the monetary policy reaction curve is flat and the aggregate demand curve is steep

The slope of the aggregate demand curve depends in part on the preferences of the central bank; how aggressive policymakers are in responding to deviations of inflation from the target level