1. THE CENTRAL BANK & THE ECONOMY Policymakers Model of the Economy

2. Monetary Transmission Mechanism Economy Inventories Trade Balance Investment Consumption Money Market Rates Interbank Interest Rate LT Interest Rates Stock Prices F/X Rates Financial Markets

3. Output Gap Disequilibrium in labor market (caused by wage stickiness and job-search frictions) causes swings in unemployment. Potential output is the hypothetical level of output when labor markets are in equilibrium. The output gap is the percentage deviation between potential real GDP and real GDP.

4. AS-AD Model Inflation and the output gap are jointly determined by the intersection of aggregate expenditure and production decisions. Negative relationship between inflation and expenditure on goods and services. High inflation reduces competitiveness of exports High inflation reduces spending power of nominal assets (money) (Temporary) positive relationship between inflation and producers willing to provide goods. Wages tend to be locked in by inflation expectations. When inflation is ahead of expectation, firms will hire more workers.

5. AD Curve Negative relationship between inflation stems from Accelerating inflation makes exports less competitive and imports more. Inflation reduces spending power of nominal assets (like money) Policy response of central bank (more later) AD curve may shift due to external shocks, fiscal policy, exchange rates, asset prices, interest rates and but importantly confidence about the future.

6. Short Run Aggregate Supply Curve Some wages and prices will be pre-set based on price- setters inflation expectations. When inflation is accelerating ahead of expectations, firms will respond with extra production (ex. McDonalds). Potential output is an efficient level of production when inflation expectations match actual inflation. Associated with an economy with flexible prices and wages. Over time, inflation expectations will adjust to actual market outcomes.

7. AS-AD Model Y* π π*π* Y AS AD πEπE Inflation sets to clear supply equal to demand.  When inflation equals inflation expectations, output is equal to potential and Gap is zero.  YPYP Gap

8. Recessionary Cycle Gap* π π*π* Y AS AD πEπE   AS’  Self-correction process occurs through the adjustment of expectations YPYP  Economy begins in equilibrium. Demand contracts for some reason.  Economy finds new equilibrium with slowing inflation and a negative output gap. Inflation expectations ratchet downwards in response to low inflation and supply shifts out as wage demands moderate  In new equilibrium, inflation continues to fall but output gap falls

9. Monetary Policy Transmission Mechanism

10. Monetary Policy has no long-term effect on output gap Gap* π Y AS AD πEπE   AS’  Central bank engages in expansionary monetary policy Aggregate Demand shifts out.  Temporary business cycle expansion with higher inflation Inflation expectations accelerate until they catch up with actual inflation πEπE Aggregate Supply Shifts up  New long- term equilibrium with zero gap and higher inflation YPYP

11. Simple Macroeconomics Monetary policy primarily affects the demand through various channels. Cutting interest rates shifts demand out; raising interest rates shifts demand inward. In the face of an unstable demand curve (driven by external shocks or animal spirits) counter-cyclical monetary policy can simultaneously stabilize both inflation and output. In the face of an unstable supply curve (driven by cost or productivity shocks), the central bank faces a trade-off between unstable inflation or unstable

12. Recession with Counter-cyclical policy Gap* π π*π* Y AS AD πEπE   RECESSIONARY DEMAND SHOCK CUT POLICY RATE  INFLATION AND OUTPUT GAP STABILIZED YPYP

13. Trade-off w/ Supply Shocks π Gap AS AD πEπE  AS SUPPLY SHOCK RAISES COSTS AND INFLATION  MONETARY POLICY CHOICE: A. RAISE POLICY RATE AD  INFLATION STABILIZES BUT OUTPUT GAP IS DEEPER B. CUT POLICY RATES OUTPUT STABILIZES BUT INFLATION RISES AD  YPYP

14. Difficult Dynamics A number of factors related to the fact that the economy is evolving over time make monetary policy more difficult. 1. Long and variable lags – Interest rate changes affect economic decisions but inertia among firms and consumers means this does not occur right away. Today’s monetary policy must be set for future economic conditions. Central bank must forecast the future and take that into account.

15. Lags Data Lag – Measurement of the economy Recognition Lag – Time for data to cohere into actionabl pattern. Legislative Lag Implementation Lag – Time for policymakers to take action. Effectiveness Lag – Time for changes in policy to affect economic outcome. Most important for monetary policy.

16. Difficult Dynamics pt. II 2. Asset prices and LT interest rates depend on market expectations of future interest rates and strength of impact on monetary policy. Central bank controls only the overnight rate directly. Central bank influences most rates and asset prices through market expectations. The central bank must communicate direction of policy with markets to enhance effect on economy. Further, credibility of central bank stabilization policies reduces financial market uncertainty being a source of shocks to demand curve.

17. Asset Prices are function of the future path of interest rates. Assets entitle the owner to a stream of future payments, Present value of stream of payments is sum of payments discounted by the interest rate. Asset prices anchored by fundamental value

18. Difficult Dynamics Part III 3. Current demand driven by consumers’ and firms’ expectations of future economic conditions. Expectations channel an important part of economic stabilization. Uncertainty about central bank commitment to future stabilization policies could be a source of demand shocks. Long-term credibility of monetary policy framework as important to stabilization as current decisions.

19. Real Interest Rates and Demand Components of aggregate demand are sensitive to the real interest rate in a negative way. Consumer Durables Residential Housing Corporate Investment

20. 20 Real interest rate impacts demand for goods. Real interest rate is r t = i t - E[π t+1 ] When E[π t+1 ] rises, central bank should increase i t more than 1-for-1 to raise real interest rate, limit demand and limit inflation. When E[π t+1 ] falls, central bank should reduce i t more than 1-for-1 to drop real interest rate, raise demand and avoid deflation. Example of the Policy Mechanism Taylor Principle

21. Forward Looking Aggregate Demand Equation Current theories of aggregate demand suggest that spending is determined as a trade-off with future spending with the real interest rate determining the balance of the trade-off New Keynesian Aggregate Demand

22. Forward Looking Demand Current demand is determined by the path of future real interest rates

23. Difficult Dynamics pt. 4 4. Worker’s wage demands driven by inflation expectations. Unstable inflation expectations can be a source of instability in supply curve and may be responsible for a wage price spiral. “Thirty years ago, the public's expectations of inflation were not well anchored. With little confidence that the Fed would keep inflation low and stable, the public at that time reacted to the oil price increases by anticipating that inflation would rise still further. A destabilizing wage-price spiral ensued as firms and workers competed to "keep up" with inflation. … The episode highlights the crucial importance of keeping inflation expectations low and stable, which can be done only if inflation itself is low and stable.” Bernanke, 2006

24. Wage Price Spiral π Leads to stagflation AD πEπE Workers inflation expectations rise Wage demands and firms costs rise  AS  If central bank tries to close output gap, they need to ratify inflation expecta tions. AD  YPYP

25. Implications Avoid monetary policy surprises since they can destabilize the aggregate demand curve. Further, instability of expectations of future monetary policy path can destabilize financial markets and aggregate demand. Monetary policymakers need to communicate policy path in order to have full effect on demand. Communication policy should indicate future policy should move in a stabilizing direction. Monetary policy must have credible commitment to a stable, future inflation path.