Section 6: Mod 31 - 36
What is the difference between inflation targeting and the Taylor rule?
t inflation targeting is forward -looking rather than backward -looking. That is, the Taylor rule adjusts monetary policy in response to past inflation, but inflation targeting is based on a forecast of future inflation.
Effective federal funds rate
the Daily Average Rate of Interest Costs of Fed Funds transactions throughout the country
a target federal funds rate
the Federal Reserve's desired federal funds rate. The Federal Reserve can move the interest rate through open-market operations that shift the money supply curve. In practice, the Fed sets a target federal funds rate and uses open-market operations to achieve that target.
monetary neutrality,
the idea that changes in the money supply have no real effects on the economy Economists argue that money is neutral in the long run. This is, however, a good time to recall the dictum of John Maynard Keynes: "In the long run we are all dead." In the long run, changes in the money supply don't have any effect on real GDP, interest rates, or anything else except the price level. But it would be foolish to conclude from this that the Fed is irrelevant. ****IMPORTANT EX: : if the economy starts out in long - run macroeconomic equilibrium and the money supply changes, restoring long - run macroeconomic equilibrium requires restoring all real values to their original values. This includes restoring the real value of the money supply to its original level. So if the money supply falls 25%, the aggregate price level must fall 25%; if the money supply rises 50%, the price level must rise 50%; and so on.
cost-push inflation
**When prices rise due to an increase in the cost of production. caused by a LEFT shift of the aggregate supply curve i.e. 1970s Oil crisis
. Suppose the economy begins in long-run macroeconomic equilibrium. What is the long-run effect on the aggregate price level of a 5% increase in the money supply? Explain.
. A 5% increase in MS will cause a 5% increase in the aggregate price level in the long run. The process begins in the short run, when the larger MS DECREASES the interest rate and investment increases. This then leads to an increase in AD, which causes real GDP to increase beyond potential output. The resulting upward pressure on nominal wages and other input prices shifts AS to the left until a new long-run equilibrium is reached. Although real GDP returns to its original level, both the increase in AD and the decrease in AS cause the aggregate price level to increase. The end result is 5% more money being spent on the same quantity of goods and services, which could only mean a 5% increase in the aggregate price level.
a. Draw a correctly labeled graph of aggregate demand and supply showing an economy in long-run macroeconomic equilibrium. b. On your graph, show what happens in the short run if the central bank increases the money supply to pay off a government deficit. Explain. c. On your graph, show what will happen in the long run. Explain. REVISED: JUST TELL ME *why* the AS curve will shift back to the left in the long-run. What is the cause of this?
. The aggregate demand curve shifts to the right, creating a new equilibrium price level and real GDP. The higher money supply leads to a lower interest rate, which increases investment spending and consumer spending, and in turn aggregate demand. c. Wages rise over time, shifting short-run aggregate supply to the left. This brings equilibrium back to potential output with a higher price level.
Advantages of Inflation Targeting
1. Transparency: economic uncertainty is reduced because the public knows the objective of an inflation -targeting central bank. 2. Accountability: the central bank's success can be judged by seeing how closely actual inflation rates have matched the inflation target, making central bankers accountable
Give the equation for the Taylor rule
: Federal funds rate = 1 + (1.5 × inflation rate) + (0.5 × output gap)
new Keynesian economics
According to new Keynesian economics, market imperfections can lead to price stickiness for the economy as a whole.
natural rate hypothesis
According to the natural rate hypothesis, to avoid accelerating inflation over time, the unemployment rate must be high enough that the actual inflation rate equals the expected inflation rate.
open-market operations
Buying & selling government securities to change the supply of money
A graph of percentage increases in the money supply and average annual increases in the price level for various countries provides evidence that a. changes in the two variables are exactly equal. b. the money supply and aggregate price level are unrelated. c. money neutrality holds only in wealthy countries. d. monetary policy is ineffective. e. money is neutral in the long run.
E. money is neutral in the long run.
Which event demonstrated that economists could no longer SAFELY ignore the short run?
Great Depression; Not only was the economic pain severe, it threatened to destabilize societies and political systems.
1. In the long run, changes in the quantity of money affect which of the following? (Check ALL that apply!) I. real aggregate output II. interest rates III. the aggregate price level
III only. aggregate price level.
If the inflation rate is 5%, then a year from now, how many goods and services will $1 buy?
It's worth only $0.95 of today. So a 5% inflation rate in effect imposes a tax rate of 5% on the value of all money held by the public
Explain how the interest rate changes in expansionary monetary policy affect aggregate supply and demand in the short run.
No change in aggregate supply; aggregate demand increases. Low interest rates lead to greater investment spending and more consumption. AD is made up of C + I + G + (X − IM), so an increase in I and C increases AD. Interest rate changes don't affect short-run aggregate supply.
How well does the Taylor rule fit the Fed's actual behavior? Explain
Not exactly, but fairly well It does better than any one measure alone, and it has always correctly predicted the direction of change of interest rates.
Is there anything to prevent a government from paying for some of its expenses by printing money (INSTEAD of raising taxes or borrowing)?
Nothing. governments, including the U.S. gov do it often
real seignorage
Real seignorage = Rate of growth of the money supply × Real money supply Real seignorage = (ΔM/M) × (M/P)
Money Market Graph
Supply of money vertical and demand for money downward sloping
Why are some problems with inflation targeting, according to critics?
They argue that it's too restrictive because there are times when other concerns—like the stability of the financial system—should take priority over achieving any particular inflation rate. EX: late 2007 and early 2008 the Fed cut interest rates much more than either the Taylor rule or inflation targeting would have dictated because it feared that turmoil in the financial markets would lead to a major recession (which it did, in fact)
Why is the classical model a poor assumption during low inflation?
W/ a low inflation rate, it may take a while for workers and firms to react to a monetary expansion by raising wages and prices. In this scenario, some nominal wages and prices of some goods are sticky in the short run. As a result, under low inflation there is an upward -sloping SRAS curve, and changes in the money supply CAN INDEED change real GDP in the short run.
monetary policy rule
a formula that determines the central bank's actions.
Taylor rule for monetary policy
a rule for setting the federal funds rate that takes into account both the inflation rate and the output gap. The rule Taylor originally suggested was as follows: Federal funds rate = 1 + (1.5 × inflation rate) + (0.5 × output gap)
New classical macroeconomics
an approach to the business cycle that returns to the classical view that shifts in the aggregate demand curve affect only the aggregate price level, not aggregate output.
4. Monetary neutrality means that, in the long run, changes in the money supply a. can not happen. b. have no effect on the economy. c. have no real effect on the economy. d. increase real GDP. e. change real interest rates.
c. have no real effect
4. Which of the following is a goal of monetary policy? a. zero inflation b. deflation c. price stability d. increased potential output e. decreased actual real GDP
c. price stability
Real business cycle theory
claims that fluctuations in the rate of growth of total factor productivity cause the business cycle.
What can the Fed do with each of its tools to implement expansionary monetary policy during a recession?
decrease the discount rate, decrease the reserve requirement, open market purchases
Quantity Theory of Money
emphasizes the positive relationship between the price level and the money supply. It relies on the velocity equation (M × V = P × Y ).
seignorage
government revenue obtained from printing currency Economists say that the right to print money is itself a source of revenue!! Woah. **Seignorage accounts for only a tiny fraction (less than 1%) of the U.S. government's budget Furthermore, concerns about seignorage don't have any influence on the Federal Reserve's decisions about how much money to print; the Fed is worried about inflation and unemployment, not revenue. (BUT this hasn't held true historically!)
Demand-pull inflation
inflation that is caused by an increase or RIGHT shift in aggregate demand. **means that the aggregate demand for goods and services is outpacing the aggregate supply and driving up the prices of goods.
Monetarism
m asserts that GDP will grow steadily if the money supply grows steadily.
Expansionary monetary policy
monetary policy that increases aggregate demand. (to the right) EX: Suppose that the Federal Reserve expands the money supply. As we've seen, this leads to a lower interest rate. A lower interest rate, in turn, will lead to more investment spending, which will lead to higher real GDP, which will lead to higher consumer spending, and so on through the multiplier process. So the total quantity of goods and services demanded at any given aggregate price level rises when the quantity of money increases, and the AD curve shifts to the right
inflation targeting
occurs when the CENTRAL BANK sets an explicit target for the inflation rate and sets monetary policy in order to hit that target. - English bank wants 2% rat *(The Federal reserve does not explicitly commit itself to achieving any particular inflation, although it is widely believed to prefer inflation at around 2% per year)
What determines the expected rate of inflation?
people base their expectations about inflation on experience. If the inflation rate has hovered around 0% in the last few years, people will expect it to be around 0% in the near future. But if the inflation rate has averaged around 5% lately, people will expect inflation to be around 5% in the near future.
inflation tax
printing money causes inflation, which is like a tax on everyone in the public who holds money. So when a government prints more money to cover its budget deficit, it's basically imposing an inflation tax.
M/P
real money supply Money supply / price level
political business cycle
results when politicians use macroeconomic policy to serve political ends
Rational expectations
s the view that individuals and firms make decisions optimally, using all available information.
Why is the classical model good during high inflation?
short - run stickiness of nominal wages and prices tends to vanish quicker under High inflation. Workers and businesses are quick to raise wages and prices in response to changes in the money supply. So the SRAS curve shifts LEFT MORE QUICKLY & there is a quicker return to long - run equilibrium.
Long-Run Phillips Curve (LRPC)
shows the relationship between unemployment and inflation AFTER expectations of inflation have had time to adjust to experience It is vertical because any unemployment rate below the NAIRU leads to ever - accelerating inflation. In other words, the long-run Phillips curve shows that there are limits to expansionary policies because an unemployment rate below the NAIRU cannot be maintained in the long run. AND any unemployment rate above the NAIRU leads to decelerating inflation.
Short-Run Phillips Curve (SRPC)
the negative short-run relationship between the unemployment rate and the inflation rate Supply shocks that affect AS ALSO shift the SRPC> In general, a negative supply shock shifts SRPC up, as the inflation rate increases for every level of the unemployment rate, and a positive supply shock shifts it down as the inflation rate falls for every level of the unemployment rate.
disinflation
the process of bringing the inflation rate down
velocity of money
the ratio of nominal GDP to the money supply. It is a measure of the number of times the average dollar bill is spent per year.
debt deflation
the reduction in aggregate demand arising from the increase in the real burden of outstanding debt caused by deflation probably played a significant role in the Great Depression.
nonaccelerating inflation rate of unemployment NAIRU
the unemployment rate at which inflation does not change over time. Keeping the unemployment rate below the NAIRU leads to ever - accelerating inflation and cannot be maintained. Most macroeconomists believe that there is a NAIRU and that there is no long - run trade - off between unemployment and inflation
Discretionary monetary policy
the use of changes in the interest rate or the money supply to stabilize the economy
What is the relationship between unemployment and inflation?
there is a short-run trade-off between unemployment and inflation—lower unemployment tends to lead to higher inflation, and vice versa. The key concept is that of the Phillips curve. ***t when the unemployment rate was high, the wage rate tended to fall, and when the unemployment rate was low, the wage rate tended to rise
supposing the economy begins in long-run macroeconomic equilibrium, what is the long-run effect on the interest rate of a 5% increase in the money supply? Explain.
A 5% increase in the money supply will have NO EFFECT on the interest rate in the long run. As explained in the previous answer, a 5% increase in the money supply is matched by a 5% increase in the aggregate price level in the long run. Changes in the aggregate price level, in turn, cause proportional changes in the demand for money. So a 5% increase in the aggregate price level increases the quantity of money demanded at any given interest rate by 5%. This means that at the initial interest rate, the quantity of money demanded rises exactly as much as the MS, and the new, long-run interest rate is therefore no different from the initial interest rate.
How can countries get themselves into situations of extreme inflation?
High inflation arises when the government must print a large quantity of money, imposing a large inflation tax, to cover a large budget deficit in the face of high inflation the public reduces the amount of money it holds, so that the far righthand term in the real seignorage equation, M/P, gets smaller. Suppose that the govt needs to print enough money to pay for a given quantity of goods —that is, it needs to collect a given real amount of seignorage. Then, as people hold smaller amounts of real money due to a high rate of inflation, the govt has to respond by accelerating the rate of growth of the money supply, ΔM/M. This will lead to an even higher rate of inflation. And people will respond to this new higher rate of inflation by reducing their real money holdings, M/P, AGAIN. As the process repeats it can easily spiral out of control. ***Although the amount of real seignorage that the govt must ultimately collect to pay off its deficit does not change, the inflation rate the govt needs to impose to collect that amount RISES. So the the govt is forced to increase the money supply more rapidly, leading to an even higher rate of inflation, and so on. - HYPERINFLATION often happens in poor and politically unstable countries. The governments of wealthy, politically stable countries like the United States and Britain don't find themselves forced to print money to pay their bills.
Use a correctly labeled aggregate supply and demand graph to illustrate cost-push inflation. Give an example of what might cause cost-push inflation in the economy.
Higher equilibrium aggregate price level at new intersection of SRAS and AD This could be caused by anything that would shift the short-run aggregate supply curve to the left, such as an increase in the price of energy, labor, or another input with economy-wide importance
WHY does an increase expected inflation rate shift SRPC UP?
If the expected rate is higher, workers will want a wage rate that takes into account future declines in the purchasing power. And the employer will be more willing to agree to a wage increase now if hiring workers later will be even more expensive. Also, rising prices will make paying a higher wage rate more affordable for the employer because the employer's output will sell for more
Assume that there is an increase in the demand for money at every interest rate. Now assume that the Fed is following a policy of targeting the federal funds rate. What will the Fed do in the situation described in question 1 to keep the federal funds rate unchanged?
In order to prevent the interest rate from rising, the Federal Reserve must make an open-market purchase of Treasury bills, shifting the money supply curve rightward.
What is the difference between the U.S. Treasury and the Federal REserve? (summary)
The U.S. Treasury is best known for printing money (literally) and offering economic advice to the President. The Federal Reserve is the U.S. central bank, ensuring lenders and borrowers have access to credit and loans. FROM TEXTBOOK: Treasury and the Federal Reserve work in concert. The Treasury issues debt to finance the government's purchases of goods and services, and the Fed monetizes the debt by creating money and buying the debt back from the public through open -market purchases of Treasury bills.
What does the Taylor rule predict will happen if the economy sinks further into a recession? Explain.
The federal funds rate will decrease. According to the equation, the federal funds rate decreases by 0.5 percentage points for every one percentage point decrease in the output gap, as from −1% to −2%, indicating a deeper recession. OR, the Taylor rule predicts expansionary monetary policy during periods of recession.
What does the Taylor rule predict will happen when the inflation rate increases? Explain.
The federal funds rate will increase. According to the equation, the federal funds rate increases by 1.5 percentage points for every one percentage point increase in inflation. OR, the Taylor rule predicts contractionary monetary policy during periods of inflation.
expected inflation rate
The inflation rate that people forecast and use to set the money wage rate and other money prices changes in THIS affect the short -run trade - off between unemployment and inflation and SHIFT the SRPC!!!
zero bound
There is a zero bound on the nominal interest rate: it cannot go below zero. EX: what would happen if the expected rate of inflation were −5%? Would the nominal interest rate fall to −1%, meaning that lenders are paying borrowers 1% on their debt? No. Nobody would lend money at a negative nominal rate of interest because they could do better by simply holding cash. T This zero bound can limit the effectiveness of monetary policy. Suppose the economy is depressed, with output below potential output and the unemployment rate above the natural rate. Normally, the central bank can respond by cutting interest rates so as to increase AD. If the nominal interest rate is already zero, however, the central bank cannot push it down any further. Banks refuse to lend and consumers and firms refuse to spend because, with a negative inflation rate and a 0% nominal interest rate, holding cash yields a positive real rate of return. Any further increases in the monetary base will either be held in bank vaults or held as cash by individuals and firms, without being spent
classical model of the price level
a simplified model of the price level in which the real quantity of money, M/P, is always at its long-run equilibrium level. This model ignores the distinction between the short run and the long run but is useful for analyzing the case of high inflation. In this, the effect of a change in the money supply on the aggregate price level takes place instantaneously rather than over a long period of time. the classical model ignores temporary short - run movements from E1 to E2, instead assuming it goes directly from E1 to E3, and that real GDP stays the same. **BUT this is a poor assumption during periods of low inflation.
A liquidity trap
a situation in which conventional monetary policy is ineffective because nominal interest rates are up against the zero bound. EX: 2008 and 2009, the Federal Reserve also found itself up against the zero bound. In the aftermath of the bursting of the housing bubble and the ensuing financial crisis, the interest on short-term U.S. government debt had fallen to virtually zero.
1. Assume the central bank increases the quantity of money by 25%, even though the economy is initially in both short -run and long -run macroeconomic equilibrium. Describe the effects, in the short run and in the long run (giving numbers where possible), on the following: a. aggregate output b. the aggregate price level c. the real value of the money supply (its purchasing power for goods and services) d. the interest rate DO B AND C !
a. Aggregate output rises in the short run , but will fall back to potential output in the long run. b. The aggregate price level increases by LESS THAN 25% in the short run. However it increases by 25% in the long run. c. The real value of the money supply increases in the short run. But in the long run it does not change. d. The interest rate FALLS in the short-run but rises back to its OG level in the long-run. NOTES: Aggregate price level is the ONLY factor that stays (sort of) the same in the LRAS. If MS increases, the real value of the MS also increases. Demonstrates how printing too much money can cause permanent price increases, and if unregulated would lead to hyperinflation.
Contractionary monetary policy
monetary policy that reduces aggregate demand. (to the left) EX: the Federal Reserve reduces the money supply. This leads to a higher interest rate. The higher interest rate leads to lower investment spending, which leads to lower real GDP, which leads to lower consumer spending, and so on. So the total quantity of goods and services demanded falls when the money supply is reduced, and the AD curve shifts to the left.
Macroeconomic policy activism
the use of monetary and fiscal policy to smooth out the business cycle. Macroeconomic policy activism wasn't something completely new. Before Keynes, many economists had argued for using monetary expansion to fight economic downturns—though others were fiercely opposed. Some economists had even argued that temporary budget deficits were a good thing in times of recession—though others disagreed strongly. In practice, during the 1930s many governments followed policies that we would now call Keynesian. In the United States, the administration of Franklin Roosevelt engaged in modest deficit spending in an effort to create jobs.