Chapter 12 - Monetary Policy

Chapter 12: Monetary Policy
Ryan W. Herzog
Spring 2021
Ryan W. Herzog (GU) Monetary Policy Spring 2021 1 / 43

1 Introduction
2 The MP Curve: Monetary Policy and Interest Rates
3 Phillips Curve
4 Using the Short-Run Model
5 Microfoundations: How Central Banks Control Nominal Interest Rates
6 How the Central Bank Sets the Nominal Interest Rate
7 Inside the Federal Reserve

Introduction
Learning Objectives
How the central bank effectively sets the real interest rate in the short
run, and how this rate shows up as the MP curve in our short-run
model.
That the Phillips curve describes how firms set their prices over time,
pinning down the inflation rate.
How the IS curve, the MP curve, and the Phillips curve make up our
short-run model.
How to analyze the evolution of the macroeconomy in response to
changes in policy or economic shocks.

Introduction
The federal funds rate - The interest rate paid from one bank to
another for overnight loans
The monetary policy (MP) curve - Describes how the central bank
sets the nominal interest rate

Introduction
A Summary
Through the MP curve
the nominal interest rate determines the real interest rate
Through the IS curve
the real interest rate influences GDP in the short run
The Phillips curve
describes how booms and recessions affect the evolution of inflation

Introduction
Structure of the Short-Run Model

The MP Curve
The MP Curve: Monetary Policy and the Interest Rates
Large banks and financial institutions borrow from each other.
Central banks set the nominal interest rate by stating what they are
willing to lend or borrow at the specified rate.
Banks cannot charge a higher rate, everyone would use the central
bank.
Banks cannot charge a lower rate.They would borrow at the lower
rate and lend it back to the central bank at a higher rate.
This is called the arbitrage opportunity.
Thus, banks must exactly match the rate the central bank is willing
to lend at

The MP Curve
The Federal Funds Rate

The MP Curve
Nominal to Real Interest Rates
The relationship between the interest rates is given by the Fisher
equation.
it = Rt + πt (1)
Rt = it − πt (2)

The MP Curve
Sticky Inflation Assumption
The rate of inflation displays inertia, or stickiness, so that it adjusts
slowly over time.
In the very short run the rate of inflation does not respond directly to
monetary policy.
Central banks have the ability to set the real interest rate in the short
run.

The MP Curve
The MP curve: illustrates the central bankÕs ability to set the real
interest rate
Central banks set the real interest rate at a particular value.
The MP curve is a horizontal line.

The MP Curve
The MP Curve

The MP Curve
The economy is at potential when
The real interest rate equals the MPK.
There are no aggregate demand shocks.
Short-run output = 0.
If the central bank raises the interest rate above the MPK
Inflation is slow to adjust.
The real interest rate rises.
Investment falls.

The MP Curve
Raising the Interest Rate

The MP Curve
The End of a Housing Bubble
Suppose housing prices had been rising, but then they fall sharply.
The aggregate demand parameter declines.
The IS curve shifts left.
If the central bank lowers the nominal interest rate in response:
The real interest rate falls as well because inflation is sticky.
If judged correctly and without lag, the economy would not have a
decline in output.

The MP Curve
Stabilizing the Economy

Phillips Curve
Phillips Curve
Firms set their prices on the basis of
Their expectations of the economy-wide inflation rate
The state of demand for their product.
Expected inflation: The inflation rate firms think will prevail in the
economy over the coming year.
πt = πe
t
|{z}
expected Inflation
+ vỸt
|{z}
demand conditions
(3)
where:
πe
t = πt−1 (4)
Under adaptive expectations firms adjust their forecasts of inflation
slowly (sticky inflation assumption).

Phillips Curve
Phillips Curve
Describes how inflation evolves over time as a function of short-run
output
If output is below potential prices rise more slowly than usual
If output is above potential prices rise more rapidly than usual
π = πt−1 + vỸt (5)
∆π = vỸt (6)
where ∆π = πt − πt−1

Phillips Curve
Price Shocks
We can add shocks to the Phillips curve to account for temporary
increases in the price of inflation:
π = πt−1 + vỸt + o (7)
where o are price shocks
∆π = vỸt + o (8)

Phillips Curve
An Oil Shock

Phillips Curve
Cost-Push and Demand-Pull Inflation
Price shocks to an input in production
Cost-push inflation
Tends to push the inflation rate up
The effect of short-run output on inflation in the Phillips curve
Demand-pull inflation
Increases in aggregate demand pull up the inflation rate.

Using the Short-Run Model
Disinflation - Sustained reduction of inflation to a stable lower rate
during the 1980’s
The Great Inflation of the 1970s which resulting by misinterpreting
the productivity slowdown contributed to rising inflation.

Inflation

Volcker Disinflation
Reducing the level of inflation requires a sharp reduction in the rate of
money growth, a tight monetary policy.
Because of the stickiness of inflation the classical dichotomy is
unlikely to hold exactly in the short run.
Just a reduction in the rate of money growth may not slow inflation
immediately.
Thus, the real interest rate must increase to induce a recession.
The recession causes inflation to become negative. As demand falls
firms raise their prices less aggressively to sell more

Monetary Tightening

A Recession and Falling Inflation

Lowering the inflation rate can create the cost of a slumping
economy, high unemployment, and lost output
Once inflation has declined sufficiently, real interest rates can be
lowered back to MPK allowing output to rise back to potential

Disinflation over Time

Inflation of the 1970s
Inflation rose in the 1970s for three reasons:
1 OPEC coordinated oil price increases. Oil shock as shown in the
model
2 The U.S. monetary policy was too loose.
The conventional wisdom was that reducing inflation required
permanent increases in employment.
In reality, disinflation requires only a temporary recession.
3 The Federal Reserve did not have perfect information
Thought the productivity slowdown was a recession
The Fed lowered interest rates in response to what they perceived was
a demand shock.

Mistaking Potential and Actual

The Short-Run Model
MP Curve: it directly relates to Rt.
IS Curve: Rt directly relates to Ỹt.
Phillips Curve: Ỹt directly relates to ∆πt

Microfoundations
Microfoundations
The short run model changes in the nominal interest rate affect the
real interest rate.
The classical dichotomy changes in nominal variables have only
nominal effects on the economy.
If monetary policy affects real variables, the classical dichotomy fails in
the short run.

Microfoundations
Classical Dichotomy in the Short Run
How to make the classical dichotomy hold at all points in time?
All prices, including wages and rental prices, must adjust in the same
proportion immediately.
Reasons that the classical dichotomy fails in the short run:
Imperfect information
Costs of setting prices
Contracts also set prices and wages in nominal rather than real terms.

Microfoundations
Classical Dichotomy in the Short Run
There are bargaining costs to negotiating prices and wages.
Social norms and money illusions will cause concerns about whether
the nominal wage should decline as a matter of fairness.
Money illusion is the idea that people sometimes focus on nominal
rather than real magnitudes.

How the Central Bank Sets the Nominal Interest Rate
The central bank controls the level of the nominal interest rate by
supplying the money that is demanded at that rate.
The nominal interest rate is the opportunity cost of holding money
The money market clears through changes in velocity.
Which is driven by changes in the nominal interest rate

Money Market
The demand for money
Is a decreasing function of the nominal interest rate
Is downward sloping
Higher interest rates reduce the demand for money.
The supply of money
Is a vertical line for the level of money the central bank provides

Raising the Nominal Interest Rate
The central bank reduces the money supply
Creates an excess of demand over supply
A higher interest rate on savings accounts reduces excess demand.
The markets adjust to a new equilibrium.

Raising the Nominal Interest Rate

Targeting the Nominal Rate
The interest rate is crucial even when central banks focus on the
money supply.
The money demand curve is subject to many shocks, which shift the
curve.
Changes in price level
Changes in output
If the money supply is constant
The nominal interest rate fluctuates
Resulting in changes in output

Targeting the Nominal Rate

Inside the Federal Reserve
Conventional Monetary Policy
Reserves: Deposits held in accounts with the central bank
Reserve requirements: Banks required to hold a certain fraction of
their deposits
Discount rate: Interest rate charged by the Federal Reserve on loans
made to commercial banks

Inside the Federal Reserve
Open Market Operations
The central bank trades interest-bearing government bonds in
exchange for currency or non-interest bearing reserves.
To increase the money supply, the Fed buys government bonds in
exchange for currency or reserves.
The price at which the bond sells determines the nominal interest rate.

Chapter 12 - Monetary Policy

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