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

2. 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?

3. 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

4. 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).

5. 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

6. 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

7. 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. 

8. Dynamic Aggregate Demand

9. 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

10. 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

11. Aggregate Expenditure and the Real Interest Rate

12. Aggregate Expenditure and the Real Interest Rate

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

14. 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.

15. The Long-Run Real Interest Rate

16. 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*

17. Changes in the Long-Run Real Interest Rate

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

19. The Monetary Policy Reaction Curve

20. 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*

21. 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

22. The Monetary Policy Reaction Curve: Shifting the Curve

23. The Monetary Policy Reaction Curve: Summary

24. Inflation and Output: Dynamic Aggregate Demand

25. 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

26. Dynamic Aggregate Demand

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

28. 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

29. 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

30. 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

31. Dynamic Aggregate Demand Curve: Shifting the Curve

32. Dynamic Aggregate Demand Curve: Summary

33. 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.

34. Aggregate Supply
Short run: SRAS
Long run: LRAS

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

36. Short-Run Aggregate Supply

37. 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

38. Short-Run Aggregate Supply: Shifting the Curve

39. 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

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

41. Long-Run Aggregate Supply

42. Aggregate Supply: Summary

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

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

45. 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

46. Adjustment to Long-Run Equilibrium

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

48. 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

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

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

51. Chapter 21
End of Chapter