© The McGraw-Hill Companies, 2005 Advanced Macroeconomics Chapter 17 MONETARY POLICY AND AGGREGATE DEMAND

© The McGraw-Hill Companies, 2005 THEMES  Keynes, the Classics and the Great Depression  Goods market equilibrium and the determinants of aggregate demand  Monetary policy and the formation of interest rates  The relationship between short-term and long-term interest rates  Derivation of the aggregate demand curve

© The McGraw-Hill Companies, 2005 KEYNES VERSUS THE CLASSICS The classical economic orthodoxy: If only market forces are allowed to work, economic activity will quickly adjust to its natural rate determined by the supply side. Winston Churchill, British Secretary of the Treasury : ”It is the orthodox Treasury dogma, steadfastly held, that whatever might be the political and social advantages, very little employment can, in fact, be created by state borrowing and state expenditure”. The Great Depression of the 1930s undermined the Classical orthodoxy and paved the way for the Keynesian view that aggregate demand plays an important role in the determination of economic activity.

© The McGraw-Hill Companies, 2005 THE GOODS MARKET Condition for goods market equilibrium (1) Investment demand (2) Consumption demand (3)

© The McGraw-Hill Companies, 2005 THE GOODS MARKET Define Aggregate private demand D  C + I We assume a Balanced public budget T = G

© The McGraw-Hill Companies, 2005 From (1) through (3) we then get the Properties of the aggregate private demand function (4) (5) (6) THE GOODS MARKET Equilibrium condition for the goods market

© The McGraw-Hill Companies, 2005 Figure 17.2: The real interest rate and the private sector savings surplus in Denmark,

© The McGraw-Hill Companies, 2005 THE GOODS MARKET In the chapter text we show that (4) may be log-linearized to give the following Approximation of the goods market equilibrium condition (11) Note that the equilibrium real interest rate is determined by the condition for Long run equilibrium in the goods market (13) We now wish to transform (11) into a relationship between y og . For that purpose we must study

© The McGraw-Hill Companies, 2005 THE MONEY MARKET The equilibrium condition for the money market (14) The money demand function (15) Note: i is the short-term interest rate which is controlled by the central bank.

© The McGraw-Hill Companies, 2005 THE MONEY MARKET Constant money growth rule (Friedman) lnM - lnM -1 =  Motivation for the CMG rule: If  is close to 1 and  is close to zero, equations (14) and (15) roughly imply that M = kPY A constant rate of growth of M will then ensure a stable growth in aggregate money income PY.

© The McGraw-Hill Companies, 2005 Interest rate policy under the CMG rule Money market equilibrium under the CMG rule (16) Assume that we have Long run equilibrium in the previous period (17) Taking logarithms in (16) and (17) and using the approximations ln(1+  )   and ln(1+  )  , we get (18) (19) Substitution of (18) into (19) yields Monetary policy under the CMG rule (20)

© The McGraw-Hill Companies, 2005 INTEREST RATE POLICY UNDER THE TAYLOR RULE Note that  may be interpreted as the central bank’s target inflation rate. Problem with the CMG rule: A stable growth in total money income cannot be achieved if the parameters  and  change in an unpredictable way (for example through financial innovations). As an alternative to the CMG rule John Taylor proposed the Taylor rule (21) Note: It is important for economic stability that the parameter h is positive so that an increase in inflation triggers an increase in the real interest rate. Taylor’s proposal for USA h = 0.5 b = 0.5

© The McGraw-Hill Companies, 2005 Estimated interest rate reaction functions of four central banks

© The McGraw-Hill Companies, 2005 Three-month interest rate and the estimated Taylor rate in the euro area

© The McGraw-Hill Companies, 2005 FROM THE SHORT RATE TO THE LONG RATE The problem: the central bank may control the short-term interest rate, but aggregate demand mainly depends on the long-term interest rate. Assumption: Short-term and long-term bonds are perfect substitutes This implies the Arbitrage condition (24) Taking logs on both sides of (24) and using the approximation ln(1+i)  i, we get The expectations theory of the term structure of interest rates (25) Implication: The current long rate is a simple average of the current short rate and the expected future short rates.

© The McGraw-Hill Companies, 2005 FROM THE SHORT RATE TO THE LONG RATE Further implications of (25):  Monetary policy can only have a significant impact on long-term interest rates by influencing the expected future short-term interest rates  A change in the current short-term rate which is expected to be temporary will only have a very limited impact on the long-term interest rate  When the market expects a future tightening of monetary policy, the yield curve is rising  If the market expects a future relaxation of monetary policy, the yield curve is falling  The yield curve is flat when market participants have Static interest rate expectations (26)

© The McGraw-Hill Companies, 2005 The term structure of interest rates in Denmark

© The McGraw-Hill Companies, 2005 The decoupling of short-term and long-term interest rates in the United States,

© The McGraw-Hill Companies, 2005 The ’signalling’ interest rate of the central bank and the 10-year government bond yield in Denmark

© The McGraw-Hill Companies, 2005 DERIVING THE AGGREGATE DEMAND CURVE The ex post real interest rate (27) Investment and consumption are governed by The ex ante real interest rate (28) We assume Static expectations (29) Equations (28) and (29) imply (30)

© The McGraw-Hill Companies, 2005 DERIVING THE AGGREGATE DEMAND CURVE Recall that (11) (21) Inserting (21) and (30) into (11), we get The aggregate demand curve (32) (33)

© The McGraw-Hill Companies, 2005 PROPERTIES OF THE AGGREGATE DEMAND CURVE  The AD curve has a negative slope: higher inflation induces the central bank to raise the interest rate, causing aggregate demand to fall  The AD curve is flatter, the more weight the central bank attaches to stable inflation compared to output stability (see figure 17.7)  The AD curve shifts upwards in case of more optimistic growth expectations in the private sector or in case of a more expansionary fiscal policy  The AD curve shifts downwards if the central bank reduces its inflation target

© The McGraw-Hill Companies, 2005 Figure 17.7: The aggregate demand curve under alternative monetary policy regimes

© The McGraw-Hill Companies, 2005 IMPORTANT CONCEPTS AND RESULTS IN CHAPTER 17  Properties of the investment function  Properties of the consumption function  The relationship between the real interest rate, public consumption, expectations and aggregate demand  Money market equilibrium  The goods market equilibrium condition

© The McGraw-Hill Companies, 2005 IMPORTANT CONCEPTS AND RESULTS IN CHAPTER 17  The constant-money-growth rule and its implications for interest rate policy  The Taylor rule and its implications for interest rate policy  The relationship between the short-term and the long-term interest rate: The expectations hypothesis and the yield curve  The ex ante versus the ex post real interest rate  Poperties of the AD curve, including the importance of monetary policy for the position and the slope of the curve