UGBA 101b Midterm 2 Chapter 10 & 11
What are the 4 factors that cause the long-run aggregate supply curve to shift to the right?
1) a rise in the total amount of capital in the economy, 2) a rise in the total amount of labor supplied in the economy, 3) better technology that generates more output from the same amount of capital and labor 4) a fall in the natural rate of unemployment
Real money balances are positively related to income for what two reasons?
1. As income rises, households and firms conduct more transactions and so keep more money on hand to make purchases. 2. Higher incomes make households and firms wealthier, and the wealthy tend to hold larger quantities of all financial assets, including money.
What are the 2 main conclusions to draw from the research on the demand for money?
1. The rate of interest on loans. 2. The number / value of monetary transactions that we expect to carry out.
3 important conclusions of long and short term Phillips curves
1. There is no long-run trade-off between unemployment and inflation because, as the vertical long-run Phillips curve shows, a higher long-run inflation rate is not associated with a lower level of unemployment. 2. There is a short-run trade-off between unemployment and inflation because with a given expected inflation rate, policy makers can attain a lower unemployment rate at the expense of a somewhat higher than the expected inflation rate, as at point 2 in Figure 11.2. 3. There are two types of Phillips curves, long-run and short-run. The expectations-augmented Phillips curves—PC1, PC2, and PC3—are actually short-run Phillips curves: they are drawn for given values of expected inflation and will shift if deviations of unemployment from the natural rate cause inflation and expected inflation to change.
Consider the money market. Suppose that the price level rises. What happens to the equilibrium interest rate if the central bank holds the money supply constant? Describe what leads to the final result.
A nation's money supply and interest rates have an inverse relationship. This means interest rates should be lower if there is a higher supply of money in a country's economy. Conversely, rates should be higher if the money supply is lower.
Liquidity Trap
A situation in a severe recession in which the Fed's injection of additional reserves into the banking system has little or no additional positive impact on lending, borrowing, investment, or aggregate demand.
Using the expression for the short-run aggregate supply curve obtained in Problem 6, draw a new short-run aggregate supply curve on the same graph if there is a price shock such that ρ = 2. Calculate inflation when output is $8, $10, and $12 trillion, respectively. ------------------ ^^ Assuming that Okun's law is given by U - U_n = -0.75 * (Y - Y^P) and that the Phillips curve is given by π = π^e - 0.6 * (U - U_n)+ ρ a) Obtain the short-run aggregate supply curve if expectations are adaptive, inflation was 3% last year, and potential output is $10 trillion (assume ρ = 0). b) Calculate inflation when output is $8, $10, and $12 trillion, and plot the short-run aggregate supply curve.
A). π = π^e -.6*(-.75*(Y-Y^p)) + P π = 3 + .45*(8-10) + 0 = 4.1 π = 3 + .45*(10-10) + 0 = 5 π = 3 + .45*(12-10) + 0 = 5.9 B). X-axis is inflation, y-axis is aggregate output (y). AS curve is sloping upwards
What are adaptive expectations? What justifies the assumption of adaptive expectations in Phillips curve analysis?
Adaptive expectations theory is the concept that people or decision makers believe the best indicator of future is what has happended in the recent past. For example people would expect prices to be stable if the prices were stable during the last 3-4 years. Similarly if prices had risen during the past 3-4 years then people expect the prices to rise in the future. Thus according to adaptive expectations theory , the actual occurrence during the most recent period determines people's future expectations. This means that expected inflation is based on past values of the inflation rate. This assumption is justified by the view that inflation expectations are sticky and adjust slowly to past inflation changes and by the fact that some wage and price contracts are backward looking and slow to adjust to changes in expected inflation. expected inflation rate = inflation rate in previous period
When does an autonomous tightening of monetary policy occur? When does an autonomous easing of monetary policy occur?
An autonomous tightening of monetary policy occurs when monetary policy makers raise the real interest rate at any given inflation rate, resulting in an upward shift in the monetary policy curve. An autonomous easing of monetary policy and a downward shift in the monetary policy curve occur when monetary policy makers lower the real interest rate at any given inflation rate
How does the demand curve shift when there is an autonomous tightening of monetary policy?
An autonomous tightening of monetary policy—that is, an increase in real interest rates at any given inflation rate—leads to a decline in aggregate demand, and the aggregate demand curve shifts to the left.
Interest rate effect
As price level (P) rises, the real money supply (=nominal money supply/P) falls. This leads to an increase in interest rate. As interest rate rises, investment spending falls because of the increased cost of borrowing to finance investment. As investment falls, aggregate expenditure (AE) falls, in turn leading to a fall in real GDP (or Y). (Hence we see as P increases, Y decreases.) Try picturing this in terms of the IS-LM model too. The fall in the real money supply, which leads to an increase in interest rate, causes the LM curve to shift leftwards. Along an unchanged downward sloping IS curve, this results in a fall in equilibrium real GDP because of an upward movement** along the IS curve (**we say upward movement because as interest rate rises, investment spending falls, AE falls and hence real GDP falls). This confirms our conclusion that a rise in P leads to a fall in real GDP. NOTE: The interest rate effect is by far the dominant reason for a downward sloping AD curve.
Investment Savings Curve
As the interest rate reduces, output increases. If you can borrow money cheaply, real interest rates will decrease, and in turn, people will invest more and the GDP will increase. Output on x-axis(GDP), and inflation on y-axis
Liquidity
Availability of resources to meet short-term cash requirements.
According to the portfolio theory approach to money demand, what would be the effect of a stock market crash on the demand for money? (Hint: Consider both the increase in stock price volatility following a market crash and the decrease in the wealth of stockholders.)
Crash in stock market considerably reduce the wealth of stockholders and price movement after stock market crash also tends to be highly volatile. This refrains the investor from putting their money in stock market and thus their demand for money decreases.
risk
Degree of uncertainty of return on an asset; in business, the likelihood of loss or reduced profit.
risk averse
Having a low tolerance for risk
How do public expectations of higher future inflation affect the short-run aggregate supply curve? Show your answer in a graph
If the public expects more inflation in the near future, the short-run aggregate demand curve will shift leftwards from AS to AS1. Because rising inflation leads to higher prices, producers are currently reducing aggregate supply in the economy in order to supply products and services at higher prices.
According to modern Phillips curve analysis, what factors determine the rate of inflation? How do changes in each factor affect the short-run Phillips curve?
In modern Phillips curve analysis, the rate of inflation increases one-for-one with changes in expected inflation and price shocks and moves inversely to the unemployment gap. Price shocks and changes in expected inflation shift the short-run Phillips curve up or down and changes in the unemployment gap cause movements along a given short-run Phillips curve.
What can increase the equilibrium interest rate in the liquidity preference framework?
In the liquidity preference framework, expectations of higher prices cause the demand for money to shift to the right, raising the interest rate. A business expansion will cause interest rates to increase by increasing the demand for money (causing the money demand curve to shift right).
Foreign purchases effect
It is applicable only to open economies with foreign trade being introduced into our explanation. With an increase in domestic price level relative to those of trading partners, domestic consumers will spend less on domestically produced goods and services and more on imports (M). Also, foreigners will buy less of our exports (X). The increase in M and decrease in X (that is, a decrease in net exports) means a decrease in real GDP. In terms of our IS-LM model, the decrease in net exports causes a fall in AE, a fall in real GDP and hence a leftward shift in the IS curve. With an unchanged LM curve, we notice an overall fall in both interest rate and real GDP (as we have explained in our "real balance effect"). It is conclusive that a rise in P leads to a fall in Y.
liquidity preference function
M^d/P = L(i, Y) (i= -, Y=+) Money demanded for a given price level is related to inflation and output. There is an inverse relationship with inflation, and a direct relationship with output (gdp) money demanded and inflation have an inverse relationship. Money demanded and output have a direct relationship
Assume the demand for real money balances is given by M^d/P = Y/6 - 150i. a) Find the equilibrium interest rate if the money supply is $1,700 billion and output equals $12,900 billion. b) Find the new equilibrium interest rate if the money supply is $1,700 billion and output increases to $13,800 billion. c) Plot both interest rates and demand curves on the same graph
M^d/P = Y/6 - 150i. a). money supply: 1,700 GDP: 12,900 1,700 = 12,900/6 - 150i 12,900/6 - 1,700 = 150i 2133= 150i i= 3 Price: 150i= 12,900/6 =2150 2,150 / 150 i= 14.33 b). 1,700 = 13,800/6 - 150i 600=150i i= 4 Price: 150i= 13,800/6 =2300 2,300 / 150 i= 15.33 c). plot (2150, 14.33) and (2300, 15.33) (draw a straight line between both points here) x-axis is output and y-axis is interest rate. have a vertical line at M^s at 1700. Have a dashed line at 3 and 4% on the y axis to the equilibrium.
Consider the portfolio theory of money demand. How do you think the demand for money would be affected by a hyperinflation (i.e., monthly inflation rates in excess of 50%)?
Money demand would decrease, but only little. Customers would prefer to have more reliable assets and, as a result, less money, since money is more volatile than other commodities. Hyperinflation will also result in sky-high interest rates, lowering money demand.
Net exports are one of the components of aggregate demand, and an increase in net exports shifts the IS curve to the right. Does it also affect the monetary policy curve? Explain why or why not.
No, the monetary policy does not shift. The aggregate demand curve shifts to the right same direction as IS curve ALWAYS
What is Okun's law? How do we combine it with Phillips curve analysis to derive the short-run aggregate supply curve?
Okun's Law relates the unemployment gap U − U^n, where U is the unemployment rate and U^n is the natural rate of unemployment, to the output gap Y − Y^P, where Y is aggregate output and Y^P is the economy's potential output. U - U^n = -0.5 x (Y - Y^P) The relationship between the two gaps is negative because when the economy produces less than its potential output, the unemployment rate is greater than the natural rate of unemployment. Combining Okun's Law and Phillips curve analysis helps to derive the short-run aggregate supply curve that relates total output supplied to the inflation rate because a negative short-run Phillips curve relationship between unemployment and inflation implies a positive relationship between output and inflation.
According to the short-term Phillips curve, what should Spanish policymakers do to lower the high unemployment rates resulting from the 2007-09 financial crisis?
Policymakers can increase inflation to decrease unemployment.
What is portfolio theory and what does it indicate?
Portfolio theory indicates that not only is the demand for money determined by interest rates, income, and payment technology, as in the Keynesian analysis, but also by wealth, riskiness of other assets, inflation risk, and liquidity of other asset
Real balance effect
Real balance effect (also known as real wealth effect or real money balances effect):It operates through consumption. As price level rises, purchasing power of money balances falls. As our real wealth falls, we will cut back on our consumption spending; hence autonomous consumption (Co) falls. This results in a decrease in AE and hence a decrease in real GDP. We can also picture this in terms of the IS-LM model. The fall in AE leading to a decrease in real GDP occurs at an assumed unchanged interest rate. This shifts the IS curve leftwards from IS(0) to IS(1). With an unchanged upward sloping LM curve, the fall in real GDP lowers transactions demand for money and hence total money demand (which comprises both transactions demand and asset demand components). This in turn lowers interest rate (that is, a downward movement along the LM curve). As interest rate falls, we know that investment spending will rise and hence AE and real GDP will rise (that is, a downward movement along IS(1)). [Of course, this rise in real GDP is not enough to offset the original fall in real GDP because to the downward sloping nature of the LM curve.] This ensures attainment towards simultaneous equilibrium in money market and output market. Overall, we trace that a rise in P leads to a fall in Co, AE, and hence Y.
opportunity cost
Recall that opportunity cost is the amount of income forgone (sacrificed) by holding money rather than alternative assets such as bonds. In Keynes's analysis, money earns little, if any, interest, since it is held as currency or in checking accounts. The opportunity cost of holding money is i, the nominal interest paid on bonds. As the interest rate i rises, it becomes more costly to hold money instead of bonds—that is, the opportunity cost rises—and the quantity of money demanded falls. Note that the demand for real money balances is related to the nominal interest rate i, while spending decisions are related to the real interest rate
What other than new capital affects the long-run aggregate supply curve?
Shifts in the long-run aggregate supply curve result from changes in the total quantities of capital and labor in the economy and in the available technology. When any of these increase, the economy's potential output increases and the long-run aggregate supply curve shifts to the right. Decreases in any of these factors shift the long-run aggregate supply curve to the left.
What is the relationship between the MP curve and the aggregate demand curve?
The AD curve links the inflation rate from the MP curve to equilibrium output.
How do changes in planned expenditures affect the aggregate demand curve?
The aggregate demand curve shifts to the right if autonomous consumption, autonomous investment, autonomous net exports, or government purchases increase, or if taxes decrease.
What does the aggregate demand curve tell us, and what direction does it slope?
The aggregate demand curve tells us the level of equilibrium aggregate output (which equals the total quantity of output demanded) for any given inflation rate. It slopes downward because a higher inflation rate leads the central bank to raise real interest rates, which leads to a lower level of equilibrium output. The aggregate demand curve shifts in the same direction as the IS curve; hence it shifts to the right when government purchases increase, taxes decrease, "animal spirits" encourage consumer and business spending, financial frictions decrease, or autonomous net exports increase
What relationship does the aggregate supply curve describe? How is this relationship depicted with the long-run aggregate supply curve?
The aggregate supply curve shows the relationship between the total quantity of output supplied and the inflation rate. In the long run, the amount of output an economy can produce is determined by its labor, capital, and technology. Because none of these factors are related to the inflation rate, neither is the economy's potential output in the long run, and its long-run aggregate supply-curve is, therefore, a vertical line.
How does the demand for real money balances respond to changes in each of these variables? a). Nominal interest rates b). Real income
The demand for money is inversely related to the nominal interest rate and positively related to real income
Suppose a given country experienced low, stable inflation rates for quite some time, but then inflation picked up and has been relatively high and quite unpredictable over the past decade. Explain how this new inflationary environment would affect the demand for money according to the portfolio theory of money demand. What would happen if the government decided to issue inflation protected securities?
The demand for money would almost definitely diminish. Because money is more volatile than other assets, people would prefer to have more reliable assets and much less money. Furthermore, volatility and unpredictability of inflation would result in excessively high interest rates, limiting money demand. If the government provides inflation-protected assets as a substitute to risky money holdings, consumer spending will decline even lower.
In Keynes's liquidity preference theory, what variables determine the demand for real money balances?
The demand for real money balances depends on the nominal interest rate and real income.
What is Okun's law?
The generalization that any 1-percentage-point rise in the unemployment rate above the full-employment unemployment rate will increase the GDP gap by 2 percent of the potential output (GDP) of the economy.
What is the liquidity preference framework, and what does it show?
The liquidity preference framework, which analyzes how nominal interest rates are determined as a result of the interaction between the demand and supply of real money balances in the money market, indicates that nominal interest rates rise when income or the price level rises, and fall when the money supply is increased.
When is the long-run aggregate supply curve vertical?
The long-run aggregate supply curve is vertical at potential output, YP.
What does the monetary policy (mp) curve show, and what policy does it follow?
The monetary policy (MP) curve shows the relationship between inflation and the real interest rate arising from monetary authorities' actions. Monetary policy follows the Taylor principle, in which higher inflation results in higher real interest rates, as represented by a movement upward along the monetary policy curve
Some payment technologies require infrastructure (e.g., merchants need to have access to credit card swiping machines). In most developing countries, this infrastructure is either nonexistent or very costly. Everything else being the same, would you expect the transaction component of the demand for money to be larger or smaller in a developing country than in a rich country?
The need for costly infrastructure to support new payment technologies would mean that cash would be used more in developing countries relative to rich countries. As a result, the transactions demand for money would be greater in developing countries relative to rich countries.
Define open market operations and explain how they are related to money supply
The open market operation is the activity of the central bank wherein the central bank sells or buys government bonds in the open market. The central bank performs this activity to regulate the supply of money. When the money is deposited in the banks, the banks loan out that money to business entities and consumers.
In many countries, people hold money as a cushion against unexpected needs arising from a variety of potential scenarios (e.g., banking crises, natural disasters, health problems, unemployment, etc.) that are usually not covered by insurance markets. Explain the effect of such behavior on the precautionary component of the demand for money.
The precautionary component of the demand for money in such countries will be higher than in countries where individuals do not need to hold money for such purposes
What causes the short-run aggregate supply curve to shift?
The short-run aggregate supply curve shifts upward when expected inflation increases, when positive price shocks occur, or when there is a positive and persistent output gap that increases expected inflation. Opposite changes in these factors shift the short-run aggregate supply curve downward.
What is the short-run aggregate supply curve and equation? What direction does it slope and why, and how can you re-write the equation?
The short-run aggregate supply curve, π = π^e + γ (Y - Y^P) + ρ, slopes upward because as output rises relative to potential output and labor markets tighten, inflation rises. Assuming that expectations of inflation are adaptive so that π^e = π_-1, the short-run aggregate supply curve can be written as π = π_-1 + γ (Y - YP) + ρ.
Plot the Phillips curve for Canada using the following data. Do you find evidence in favor of the Phillips curve in your plot? Explain. 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 Inflation Rate (%) 1.4 1 1.1 1.6 1.9 2.3 3.8 3.6 4.1 4.6 Unemployment Rate (%) 7 7.2 6 5.6 4.7 4 3.4 3.8 4.5 4.4 ------------------------- The following graph shows inflation and unemployment rates for Canada for the period between 1970 and 2012. Does this graph show evidence in favor of the Phillips curve?
There should be a negative relationship between inflation and unemployment, as the Phillips curve predicts. Inflation is on the x-axis and unemployment on the y-axis. As inflation increases, unemployment should decrease and vice-versa.
Suppose Okun's law can be expressed according to the following formula: U - U_n = -0.75 * (Y - Y^P). Assuming that potential output grows at a steady rate of 2.5% and that the natural rate of unemployment remains unchanged. a) Calculate by how much unemployment increases when real GDP decreases by one percentage point. b) Calculate by how much real GDP increases when unemployment decreases by two percentage points.
U - U_n = -0.75 * (Y - Y^P) a). Δu/Δy = -.75 put Δy= -1% [real gdp decreases by one percentage point] Δu = (-.75) * (-1%) Δu = .75 ^^ unemployment will increase by .75% b). U-U_n = -.75(Y-Y^p) U-U_n/(-.75) = (Y-Y^p) Y= U-U_n/(-.75) +Y^p U/(-.75) - U_n/(-.75) + Y^p Y= -4U/3 + 4U_n/3 + Y^p [.75 = 3/4) ΔY/ΔU = -4/3 Put Δ= -2% [unemployment decreases by 2 percent for every 1% decrease in gdp] ΔY = -4/3 * ΔU ΔY = (-4/3) *(-2%) ΔY = 8/3% ΔY= 2.67% Real gdp will increase by 2.67%
Suppose that the expectations-augmented Phillips curve is given by π = π^e - 0.5(U - U_n). If expected inflation is 3% and the natural rate of unemployment is 5%, complete the following: a) Calculate the inflation rate according to the Phillips curve if unemployment is at 4%, 5%, and 6%. b) Plot the points from part (a) on a graph, and label the Phillips curve. c) If wages were to become more rigid, what would happen to the slope of this Phillips curve?
Unemployment rate : 4% π = π^e -0.5 (u - u_n) π = 3% -0.5 (4% - 5%) = 0.035 Unemployment rate : 5% π = π^e -0.5 (u - u_n) π = -0.5 ( 5% - 5%) = 0.03 Unemployment rate : 6% π = π^e -0.5 (u - u_n) π = -0.5 ( 6% - 5%) = 0.025 b). Inflation is on the y-axis, and unemployment is on the x-axis. Draw a downward sloping line for SRPC. And have a vertical line at 5% representing LRPC c). If wages become more rigid the slope of the Philips curves will become steeper π = inflation π^e is expected inflation. U= unemployment, h= is a fixed positive coefficient U_n is the "natural rate of unemployment"
Suppose the liquidity preference function is given by L(i, Y) = Y/8 - 1,000i. For the data given in the table below, calculate velocity using Equation 2 Period 1 Period 2 Period 3 Period 4 Period 5 Period 6 Period 7 Y (in $ billions) 12,000 12,500 12,250 12,500 12,800 13,000 13,200 Interest rate 0.05 0.07 0.03 0.05 0.07 0.04 0.06
V= Y/(L(i,Y) Period 1: L(i,Y) = 12,000/8-1000*.05 =1500-50 Liquidity Preferences =1450 V= 12,000/1450 Volume =8.28 ^^ copy above for each period 8.28, 8.38, 8.16, 8.26, 8.37, 8.20, 8.30
Why does the short-run aggregate supply curve slope upward?
When output increases relative to potential output, Y − Y^Pincreases. At the same time, according to Okun's Law, U − U^n decreases, which means the unemployment rate is falling relative to the natural rate of unemployment. As the short-run Phillips curve shows, this tightening in the labor-market as output rises causes the inflation rate to rise. Therefore the short-run aggregate supply curve, which shows the relationship between output and inflation, slopes upward because when the quantity of output supplied increases, a decline in the unemployment gap causes the inflation rate to also increase.
How does an autonomous tightening or easing of monetary policy by a central bank affect the MP curve?
When the Fed decides to raise the real interest rate at any given inflation rate, the MP curve shifts upward. Monetary policy easing, a decision to lower the real interest rate at any given inflation rate, shifts the MP curve downward.
How does the Federal Reserve lower and increase the federal funds rate, and what happens to interest rates in the short run?
When the Federal Reserve lowers the federal funds rate by providing more liquidity to the banking system, real interest rates fall in the short run; and when the Federal Reserve raises rates by reducing the liquidity in the banking system, real interest rates rise in the short run.
portfolio theories
Where people decide how much of an asset, such as money, they want to hold as part of their overall portfolio of assets
Suppose a plot of the values of M2 and nominal GDP for a given country over forty years shows that these two variables are very closely related. In particular, a plot of their ratio (nominal GDP/M2) yields very stable and easy-to-predict values. Based on this evidence, would you recommend that the monetary authorities of this country conduct monetary policy by focusing mainly on the money supply, or by focusing on interest rates? Explain.
You should recommend the monetary authorities to focus mostly on the money supply (as measured by M2), as its growth rate would be a good indicator of the stance of monetary policy.
expectations-augmented Phillips curve
a diagram that shows that while there may be a trade-off between unemployment and inflation in the short run, there is no trade-off in the long run. Regarding inflation, it shows that ion 1 is also referred to as the expectations-augmented Phillips curve: it indicates that inflation is negatively related to the difference between the unemployment rate and the natural rate of unemployment (U - U_n). π = π^e - ω (U - U_n)
liquidity preference framework
a model developed by John Maynard Keynes that predicts the equilibrium nominal interest rate on the basis of the supply of and demand for money
According to the expectations-augmented Phillips curve, what factors determine the rate of inflation? How do changes in each factor affect the short-run Phillips curve
a) Rising wages: At times trade unions demand high wage rates and the higher wage rates are one of the factors which push price of commodities. Because wages are the factor payments to labors. Therefore, higher the wage rate, higher will be the price of goods and services. b) Import duty (tax): When there is devaluation, the import price of goods and services becomes high. As a result, inflation would increase. c) Decline in productivity: Productivity is the important factor to determine prices of goods and services. If firms become less productive this would increase the cost of production. Hence, the prices would start rising. When wage rates, import duty and decline in productivity causes rise in the inflation rate it would induce decrease in the unemployment rates. Therefore, the short run Phillips curve would be downward sloping that shows negative relationship between inflation and unemployment rate.
Assume the monetary policy curve is given by r = 1.5 + 0.75 π. a) Calculate the real interest rate when the inflation rate is at 2%, 3%, and 4%. b) Plot the monetary policy curve and identify the points from part (a).
a). 1.5 + 0.75 π. 1.5*.75(2)= 3 1.5*.75(3)= 3.75 1.5*.75(4)= 4.5 b). inflation rate is on the x-axis (2,3,4%). Real interest rate is on the y-axis (3,3.75,4.5). Then draw a line sloping downwards.
What is the real interest rate? Why can the Fed control the real interest rate in the short run but not in the long run?
a). A real interest rate is the interest rate that take into account the inflation rate. The real interest rate adjusts for the inflation and gives the real rate of a bond. Real interest rate = Nominal interest rate - Inflation rate b). It adjusts for inflation, and prices are sticky in the short run. Hence, when a change in the Fed's monetary policy causes the nominal interest rate to change, the real interest rate also changes in the same direction. In the long run, actual and expected inflation change in response to changes in monetary policy, leaving the real interest rate unaffected.
According to the portfolio theory of money demand, what are the 5 factors that determine money demand? What changes in these factors can increase the demand for money?
a). Expected return, Price level, Wealth, Liquidity of other assets, Risk of other assets. b). The demand for money increases when wealth or the risk associated with other assets increases, and it decreases when expected return or liquidity of other assets increases or when the risk of inflation increases.
Assuming that Okun's law is given by U - U_n = -0.75 * (Y - Y^P) and that the Phillips curve is given by π = π^e - 0.6 * (U - U_n)+ ρ a) Obtain the short-run aggregate supply curve if expectations are adaptive, inflation was 3% last year, and potential output is $10 trillion (assume ρ = 0). b) Calculate inflation when output is $8, $10, and $12 trillion, and plot the short-run aggregate supply curve.
a). First substitute the unemployment gap with Okun's law into the Phillips curve to get π = π^e -.6*(-.75*(Y-Y^p)) + P According to the assumptions about inflation expectations, not price shock and the level of potential output, the short-run aggregate supply curve is: π = 3+.45*(Y-10) b). π = 3 + .45*(8-10) = 2.1% π = 3 + .45*(12-10) = 3% π = 3 + .45*(10-10) = 3.9% Replacing the values for output into the above expression yields inflation rates of 2.1%, 3%, and 3.9% when output is $8, $10, and $12 trillion graph: 8,10,12 (output) are the x-axis, and inflation rates are y-axis
Suppose the monetary policy curve is given by r = 1.5 + 0.75 π, and the IS curve is given by Y = 13 - r. a) Find the expression for the aggregate demand curve. b) Calculate aggregate output when the inflation rate is at 2%, 3%, and 4%. c) Plot the aggregate demand curve and identify the three points from part (b).
a). Given the new monetary policy: r= 1.5+.75π Y= 13 - r Calculate an expression for the aggregate demand curve: Y= 13-r 13 - (1.5+.75π) (13-1.5) -.75π 11.5-.75π b.) expression for ad curve: 12-.75π 11.5^ use 2,3,4% for aggregate output Aggregate output: 10, 9.25, 8.5% x-axis is aggregate output, Y and has (8.5,9.25,10%) y-axis is the real interest rate of (2,3,4%). Draw a downward sloping AD curve (straight line)
What is the monetary policy curve? Why does it slope upward?
a). It indicates the relationship between the inflation rate and the real interest rate b). When inflation increases, the supply of real money balances declines. This increases the equilibrium nominal interest rate in the money market, which also increases the real interest rate in the short run. Monetary policymakers will follow the Taylor principle and respond aggressively to an increase in the inflation rate by raising nominal interest rates by an even greater amount so that the real interest rate also rises.
Refer to the monetary policy curve described in Problem 1. Assume now that the monetary policy curve is given by r = 2.5 + 0.75 π. a) Does the new monetary policy curve represent an autonomous tightening or loosening of monetary policy? b) Plot the new monetary policy curve on the graph you created in Problem 1. (2,3,4% is inflation)
a). It represents an autonomous tightening of monetary policy because the real interest rate has increased at each level of inflation. The curve shifts upward by 1 unit b). r = 2.5 + 0.75 π r= 2.5 + 0.75 (2) r=4% r= 2.5 + 0.75 (3) r=4.75% r= 2.5 + 0.75 (4) r=5.5% x-axis is inflation rate (2,3,4%). y-axis is real interest rate (4,4.75,5.5%)
What condition is required for equilibrium in the money market? Why does the money market move toward equilibrium?
a). Money market equilibrium occurs at the interest rate at which the quantity of money demanded equals the quantity of money supplied b). a shift in money demand or supply will lead to a change in the equilibrium interest rate and therefore to changes in the level of real GDP and the price level.
What is the aggregate demand curve? Why does it slope downward?
a). The aggregate demand curve represents the total of consumption, investment, government purchases, and net exports at each price level in any period. b). It slopes downward because of the wealth effect on consumption, the interest rate effect on investment, and the international trade effect on net exports.
What evidence is used to assess the stability of the money demand function? What does the evidence suggest about the stability of money demand, and how has this evidence affected monetary policy making?
a). The data on money supply (which in equilibrium equals money demand), output, and interest rates are used to estimate the money demand function. b). Until the early 1970s, evidence strongly supported the stability of the money demand function. However, after 1973, there has been substantial instability in estimated money demand functions. Monetary policy makers have downgraded the importance of money supply in setting monetary policy and now think largely in terms of the setting of interest rates.
Explain how the following events will affect the demand for money according to the portfolio theory approach to money demand: a) The economy experiences a business cycle contraction. b) Brokerage fees decline, making bond transactions cheaper
a). The economy goes through a business cycle shrinkage: As the threat of alternative assets increases, so will their accessibility, so interest rates are predicted to decline, leading to a rise in monetary aggregates. It is important to note that even if wealth drops, the impact on economic growth will be minimal. b). Brokerage fees fall, making bond transactions more affordable: Lower bond lender or borrower costs make the bond market increasingly liquid, raising demand for treasury bonds and, as a consequence, decreasing purchasing power.
What three motives for holding money did Keynes consider in his liquidity preference theory of the demand for real money balances? Based on these motives, what variables did he think determined the demand for money?
a). the transactions, precautionary and speculative motives. b). demands for money depends on the price level, the interest rate, and real gross domestic product.
inflation hedges
alternative assets whose real returns are less affected than that of money when inflation varies
Dominated Assets
assets such as currency and checkable assets, which earn lower returns than other assets that are just as safe
autonomous easing of monetary policy
if the economy is going into a recession, monetary policy makers will want to lower real interest rates at any given inflation rate in order to stimulate the economy and prevent inflation from falling. This autonomous easing of monetary policy would result in a downward shift of the monetary policy curve, say by one percentage point, from MP1 to MP3 in Figure 10.2. real interest rate on y-axis, inflation rate on x-axis. As you decrease interest rate, the economy will tighten
Phillips curve
indicates a short-run inverse relationship between inflation and unemployment rates. π = π^e − h (U − U_n ),h > 0. π = inflation π^e is expected inflation. U= unemployment, h= is a fixed positive coefficient U_n is the "natural rate of unemployment"
what is = π_-1?
is the inflation rate in the previous period
Is the long-run Phillips curve different from the short-run Phillips curve? What does this imply for the Spanish policymakers mentioned in question 1? q1: According to the short-term Phillips curve, what should Spanish policymakers do to lower the high unemployment rates resulting from the 2007-09 financial crisis?
long run is different because In the long run, expected inflation is taken into account when making work and hiring decisions. They would look to find ways to decrease inflation
autonomous tightening of monetary policy
lowering real interest rates at any given inflation rate. This autonomous monetary tightening would shift the monetary policy curve upward by one percentage point from MP1 to MP2 in Figure 10.2, thereby causing the economy to contract and inflation to fall. Or, the banks may have information unrelated to inflation that suggests interest rates must be adjusted to achieve good economic outcomes. real interest rate on y-axis, inflation rate on x-axis. As you increase interest rate, the economy will tighten
Payment technology
methods of payment that include credit cards and electronic payments
adaptive expectations
or backward-looking expectations, is the theory that people look at past experience and gradually adapt their beliefs and behavior as circumstances change
reserves
represent increased liquidity in the banking system ex: The Fed pays for the bonds by depositing $1 billion into accounts that banks must maintain at the central bank. These deposits, which we refer to as reserves
aggregate supply curve
represents the relationship between the total quantity of output that firms are willing to produce and the inflation rate.
price shocks
shifts in inflation that are independent of the tightness in the labor markets or of expected inflation. ex: e, when the supply of oil was restricted following the war between the Arab states and Israel in 1973, the price of oil more than quadrupled and firms had to raise prices to reflect their increased costs of production, thus driving up inflation
monetary policy (MP) curve
shows the relationship between the real interest rate set by the central bank and the inflation rate r = r + λπ
accelerationist Phillips curve
the Phillips curve indicates that a negative unemployment gap (tight labor market) causes the inflation rate to rise, that is, accelerate. ∆π = π - π_-1 = -ω (U - U_n) + ρ
aggregate demand curve (ad)
the amount of goods and services in the economy that will be purchased at all possible price levels Y = 11 - 0.5 π
unemployment gap
the difference between the unemployment rate and the natural rate of unemployment
In 2008 the price of oil peaked at more than $130 per barrel, causing increases in inflation rates in most developed countries. Unemployment rates did not seem to immediately respond to this shock. Explain what happened to inflation and unemployment in 2008 using the modern Phillips curve.
the modern Phillips curve is derived by adding price shocks to the expectations augmented PC. π = π^e - w(U - U,n) + p A price shock therefore increases prices and inflation but has no affect on unemployment. An increase in oil prices will result in an increase in the value of p. This increase in p will increase inflation without affecting the unemployment gap. the Philips curve will shift when hit by a price-shock. PC will shift upwards and raise inflation for every given level of unemployment. That is why while unemployment stayed the same, inflation rose from
short-run Phillips curve
the negative short-run relationship between the unemployment rate and the inflation rate. π = π^e - ω (U - U_n) + ρ
natural rate of unemployment
the normal rate of unemployment, consisting of frictional unemployment and structural unemployment
What is the Taylor principle
the principle that the monetary authorities should raise nominal interest rates by more than the increase in the inflation rate π🡡 ⇒ r🡣 ⇒ Y🡡 ⇒ π🡡 ⇒ r🡣 ⇒ Y🡡 ⇒ π🡡
natural rate of output
the production of goods and services that an economy achieves in the long run when unemployment is at its normal rate
long-run Phillips curve
the relationship between unemployment and inflation after expectations of inflation have had time to adjust to experience
Expected Return
the return on a risky asset expected in the future
What are the 3 motives for holding money according to John Maynard Keynes?
the transactions motive, the precautionary motive, and the speculative motive. His resulting liquidity preference theory views the transactions and precautionary components of money demand as proportional to income. However, the speculative component of money demand is viewed as sensitive to interest rates as well as to expectations about the future movements of interest rates. This theory, then, implies that velocity is unstable and cannot be treated as a constant
Suppose a new payment technology allows individuals to make payments using U.S. Treasury bonds (i.e., U.S. Treasury bonds are immediately cashed when needed to make a payment, and that balance is transferred to the payee). How do you think this payment technology would affect the transaction component of the demand for money?
this would lead to a decreased need to hold cash for transactions, thus the transactions demand for money would decrease
backward-looking expectations
use only information on the past behavior of economic variables
non-accelerating inflation rate of unemployment (NAIRU)
when inflation stops accelerating (changing) when the unemployment rate is at U_n
real money balances
when people decide how much money they want to hold (demand), they consider real money balances, the quantity of money in real terms.
cost-push shocks
workers push for wages higher than productivity gains, thereby driving up costs and inflation.
What is the modern Phillips curve, and what is the equation?
π = π^e - ω (U - U_n) + ρ indicates that inflation is negatively correlated to the unemployment gap and is positively correlated to expected inflation and price shocks. Although the long-run Phillips curve is vertical—that is, unemployment is at the natural rate of unemployment for any inflation rate—the short-run Phillips curve, which is determined for a given level of expected inflation, is downward-sloping (a lower level of the unemployment gap leads to higher inflation). In other words, there is no long-run trade-off between unemployment and inflation, but there is a short-run trade-off.
