1. INFLATION AND UNEMPLOYMENT IS-LM MODEL RATIONAL EXPECTATIONS - MONETARY POLICY IN THE SHORT-RUN
Lecture 8 Monetary policy

2. Inflation
Inflation is a significant and persistent increase in the price level
significant – more than 1 percent per year
persistent – there is difference between sustained and episodic increases in prices

3. Types of inflation by their magnitudes:
Creeping inflation –moderate inflation on the level of 1 to 3 percent per year
Hyperinflation – price increases more than 50 percent per month
for example: German hyperinflation with price index at 1.3 trillion in December 1923

4. The Causes of Inflation
1. Cost-push inflation
When unemployment is low, wages will have risen more then they otherwise would have.
Hence, wages and prices will be higher when unemployment is low and output is high.

5. lower the unemployment rate, the faster wages increase
The Short-Run
RATE OF WAGE
INCREASES
UNEMPLOYMENT

6. Phillips curve
inverse relationship between rates of unemployment and corresponding rates of inflation 
The Short-Run
Phillips Curve
RATE OF
INFLATION
UNEMPLOYMENT

7. If unemployment falls bellow a certain rate, there is ever-accelerating inflation.
The unemployment rate that is just high enough to avoid this is called the NAIRU (non-accelerating inflation rate of unemployment) or the natural unemployment rate.

8. Cost-push inflation
AS’
PRICES AS E’ p’ E p AD
REAL DEMAND AND OUTPUT

9. Reasons for cost-push inflations and supply shocks:
rising labor costs due to increased labor union power,
rising cost of raw materials (oil prices …)
increased mark-ups of prices resulting from a decline in competition,
depreciation of domestic currency which increased prices of imported goods

10. 2. Demand-pull inflation
Demand curve shifts upward, from D to D’ and prices rise.
Such shifts could be due to increase in: the average propensity to consume, the marginal efficiency of investment,government expenditures, export, and the money supply.
The aggregate demand curve also shifts upward if taxes, imports or the demand for money decrease
AD = C + I +G + (E – X)

11. Demand-pull inflation
PRICES AS E’ p’ E p
AD’ AD
REAL DEMAND AND OUTPUT

12. IS –LM model

13. IS –LM model
Only at point E, when the interest rate is i* and output is Y *, is there
equilibrium simultaneously in both the goods market (as measured
by the IS curve) and the market for money (as measured by the
LM curve).
At other points, such as A, B, C, or D, one of the two markets
is not in equilibrium, and there will be a tendency to head
toward the equilibrium, point E.

14. I - investment
C – consumption expenditure
G – government purchases
T - taxes

15. NX – net exports
Md – demand for money
Ms – money supply

16. Expansionary monetary policy
The increase in the money supply shifts the LM curve to the right from LM1 to LM2; the economy moves to point 2, where output has increased to Y2 and the interest rate has declined to i2.

17. Expansionary fiscal policy
The rise in government spending (or the decrease in taxes) shifts the IS curve to the right from IS1 to IS2; the economy moves to point 2, aggregate output increases to Y2, and the interest rate rises to i2.

18. ISLM Model in the Long Run
To see what happens in the ISLM model in the long run, we make use of the concept of the natural rate level of output (denoted by Yn ) , which is the rate of output at which the price level has no tendency to rise or fall.
When output is above the natural rate level, the booming economy will cause prices to rise; when output is below the natural rate level, the slack in the economy will cause prices to fall.

19. in the long run the price level
does change
A rise in the money supply causes the LM curve to shift rightward to LM2, and the equilibrium moves to point 2, where the interest rate falls to i2 and output rises to Y2.
Because output at Y2 is above the natural rate level Yn, the price level rises, the real money supply falls, and the LM curve shifts back to LM1; the economy has returned to the original equilibrium at point 1.

20. in the long run the price level
does change
An increase in government spending shifts the IS curve to the right to IS2, and the economy moves to point 2, at which the interest rate has risen to i2 and output has risen to Y2.
Because output at Y2 is above the natural rate level Yn, the price level begins to rise, real money balances M/P begin to fall, and the LM curve shifts to the left to LM2. The long-run equilibrium at point 2’ has an even higher interest rate at i2’, and output has returned to Yn.

21. Rational Expectations - Effects of Unanticipated and Anticipated Policy in Short Run
1. Unanticipated Policy
Expansionary monetary policy is unexpected by the public.
2. Anticipated Policy
Expansionary monetary policy is expected by the public.
Because expectations are rational, workers and firms recognize that an expansionary policy can increase the price level.
Workers will demand higher wages so that their real earnings will remain the same when the price level rises.
The aggregate supply curve will shift leftward.

22. New Classical Macroeconomic Model
1. Effects of unanticipated policy
Initially, the economy is at point 1 at the intersection of AD1 and AS1, where the realized price level is at the expected price level P1 and aggregate output is at the natural rate level Yn.
Because point 1 is also on the long-run aggregate supply curve at Yn, there is no tendency for the aggregate supply to shift.
An expansionary monetary policy shifts the aggregate demand curve to AD2, but because this is unexpected, the aggregate supply curve remains fixed at AS1.
Equilibrium now occurs at point 2’
Aggregate output has increased above the natural rate level to Y2’, and the price level has increased to P2’.

24. New Classical Macroeconomic Model
2. Effects of Anticipated Policy
The expansionary monetary policy shifts the aggregate demand curve rightward to AD2, but because this policy is expected, the aggregate supply curve shifts leftward to AS2.
The economy moves to point 2, where aggregate output is still at the natural rate level but the price level has increased to P2.
The new classical macroeconomic model demonstrates that aggregate output does not increase as a result of anticipated expansionary policy and that the economy immediately moves to a point of long-run equilibrium (point 2) where aggregate output is at the natural rate level.

26. CAN AN EXPANSIONARY POLICY LEAD TO A DECLINE IN AGGREGATE OUTPUT?
In this case, the
expansionary monetary
policy is less expansionary
than people was expected.

27. New Keynesian Model
In the new classical model, all wages and prices are completely flexible with respect to expected changes in the price level; that is, a rise in the expected price level results in an immediate and equal rise in wages and prices.
Many economists who accept rational expectations as a working hypothesis do not accept the characterization of wage and price flexibility in the new classical model.
These critics of the new classical model, called new Keynesians, object to complete wage and price flexibility and identify factors in the economy that prevent some wages and prices from rising fully with a rise in the expected price level - sticky wages, sticky prices

28. The expansionary policy that shifts aggregate demand to AD2 has a bigger effect on output when it is unanticipated than when it is anticipated.
When the expansionary policy is unanticipated, the short-run aggregate supply curve does not shift, and the economy moves to point U, so that aggregate output increases to YU and the price level rises to PU.
When the policy is anticipated, the short-run aggregate supply curve shifts to ASA (but not all the way to AS2 because rigidities prevent complete wage and price adjustment), and the economy moves to point A so that aggregate output rises to YA (which is less than YU) and the price level rises to PA (which is higher than PU).

29. 1. Effects of unanticipated policy
New Keynesian Model

30. 2. Effects of Anticipated Policy
New Keynesian Model
sticky wages, sticky prices