Output, Inflation and Monetary Policy Chapter 21 Output, Inflation and Monetary Policy

Output, Inflation, & Monetary Policy: The Big Questions Why do inflation and output fluctuate? How do central bankers use interest rates to achieve their stabilization objectives?

Output, Inflation, & Monetary Policy: Roadmap Output and inflation in the long run Monetary policy and the quantity of real output demanded Inflation and the quantity of real output supplied Output and inflation in equilibrium

Output and Inflation in the Long Run: Potential Output What the economy is capable of producing when its resources are used at normal rates Unexpected events can push current output away from potential output, creating an output gap In the long run, current output equals potential output (Y=YP).

Output and Inflation in the Long Run: Long-Run Inflation Recall: MV = PY implies %M + %V = %P + %Y Ignoring changes in velocity, %V=0, In the long run Y=YP, so %Y= %YP %P = %M - %YP Inflation = Money growth – growth in potential output

Inflation refers to a sustained rise in prices that continues for a substantial period. Temporary increases in inflation represent one-time adjustments in the price-level

Dynamic Aggregate Demand Aggregate Expenditure & the Real Interest Rate: Real Interest Rate   Aggregate Exp.  Inflation, the Real Interest Rate and Monetary Policy Inflation   Real Interest Rate  Dynamic Aggregate Demand Inflation   Aggregate Exp. 

Dynamic Aggregate Demand

The Nominal and Real Federal Funds Rate Economic decisions depend on real interest rates. In the short-run, changes in the nominal interest rate change the real interest rate

Aggregate Expenditure & the Real Interest Rate Aggregate Gov’t Net Expenditure = Consumption + Investment + Purchases + Exports Yad = C + I + G + NX When the real interest rate rises: C: reward to saving rises, C falls I : cost of financing rises, I falls NX: demand for domestic assets rises, currency appreciated, imports rise, exports fall, X-M falls

Aggregate Expenditure and the Real Interest Rate

Aggregate Expenditure and the Real Interest Rate

Fluctuations in investment are one of the most important sources of changes in aggregate expenditure.

The Long-Run Real Interest Rates What happens to the real interest rate in the long run? Look for the real interest rate at which aggregate expenditure equals potential output.

The Long-Run Real Interest Rate

Changes in the Long-Run Real Interest Rate Long-run real interest rate changes when Aggregate expenditure shifts An increase in components of aggregate expenditure that are not sensitive to the real interest rate raises r* Potential output changes An increase in potential output lowers r*

Changes in the Long-Run Real Interest Rate

The Monetary Policy Reaction Curve High Inflation: Policymakers raise the real interest rate Current output below potential output Policymakers lower the real interest rate

The Monetary Policy Reaction Curve

The Monetary Policy Reaction Curve: Location Monetary policy reaction curve is set so current inflation equals target inflation the real interest rate equals the long-run real interest rate.  = T when r = r*

The Monetary Policy Reaction Curve: Shifting the Curve Change in the inflation target Reduction in T shifts the MPRC to the left Change in the long-run real interest rate An increase in r* shifts the MPRC to the left

The Monetary Policy Reaction Curve: Shifting the Curve

The Monetary Policy Reaction Curve: Summary

Inflation and Output: Dynamic Aggregate Demand

Dynamic Aggregate Demand When inflation rises Policymakers raise the real interest rate along their monetary policy reaction curve Higher real interest means lower aggregate output demanded Inflation  Output

Dynamic Aggregate Demand

Dynamic Aggregate Demand Curve: Shifting the Curve Changing interest insensitive components of Aggregate Expenditure Shifting the MPRC

Dynamic Aggregate Demand Curve: Shifting the Curve Changing interest insensitive components of Aggregate Expenditure Portion of C insensitive to r  Y  (at all r): AD shifts right

Dynamic Aggregate Demand Curve: Shifting the Curve Shifting the MPRC Inflation Target Higher * means lower r at every  Lower r means higher Y *   r  (at every )  Y  AD shifts to the right

Dynamic Aggregate Demand Curve: Shifting the Curve Shifting the MPRC Inflation Target *   r  (at every )  Y  AD shifts to the right Long-run Real Interest Rate Higher r*   r  (at every )  Y  AD shifts to the right

Dynamic Aggregate Demand Curve: Shifting the Curve

Dynamic Aggregate Demand Curve: Summary

When nominal interest rates are high, chances are that inflation is high, too. If you are living off interest or investment income, you can be fooled into thinking that your income is high. Spending all of the interest income causes a gradual decline in the purchasing power of your savings. To maintain real purchasing power of your income, you can only spend the real return.

Aggregate Supply Short run: SRAS Long run: LRAS

Short-Run Aggregate Supply When  changes, what do supplier do? Input prices (wages, etc.) adjust slowly Costs fixed: higher prices  higher profits

Short-Run Aggregate Supply

Short-Run Aggregate Supply: Shifting the Curve Deviations of Current Output from Potential Expansionary Gap  Scare Resources Changes in Expectations of Future Inflation Higher Expected Inflation  Increases costs Factors that Change Production Costs Higher production costs  shifts SRAS right

Short-Run Aggregate Supply: Shifting the Curve

A 1 percentage point recessionary output gap drives inflation down 0 A 1 percentage point recessionary output gap drives inflation down 0.2 percentage points 18 months later

Long-Run Aggregate Supply What happens when adjustments finish? Where does SRAS stop shifting? When Y = YP

Long-Run Aggregate Supply

Aggregate Supply: Summary

Policymakers talk about output growth Textbooks teach about output gaps To reconcile the two realize that when %Y  %YP it creates an output gap

Determination of Output & Inflation: Short-Run Equilibrium Inflation and Output are determined by intersection of AD and SRAS

Adjustment to Long-Run Equilibrium Output > Potential (Y>YP): SRAS shifts left until Y=YP Output < Potential (Y<YP): SRAS shifts right until Y=YP

Adjustment to Long-Run Equilibrium

Long-Run Equilibrium Output equals Potential Output: Y=YP Inflation equals CB target:  = T Inflation equals expected:  = e

Sources of Fluctuations: What Causes Recession? Shifts in Dynamic Aggregate Demand (Consumer Confidence, Business Optimism, Monetary Policy) Inflation will fall as output falls Shifts in Short-run Aggregate Supply (Oil Prices, production costs) Inflation will rise as output falls

Inflation and Recessions With one exception, inflation and output move in the same direction. Conclude it is AD shifts.

What Caused AD Shifts? Appears that AD shifted because policymakers raised interest rates. Likely that they did this to reduce inflation.

Chapter 21 End of Chapter