Macro: Chapter 12

The mission of the Federal Reserve is to

- preserve price stability. - foster maximum sustainable growth in output and employment. - promote a stable and efficient financial system.

Misperceiving a long-lasting slowdown in labor productivity as a recession will result in:

A productivity slowdown implies that potential output has declined. As policymakers lower interest rates to the perceived recession, they will actually stimulate output above potential, thus increasing inflation.

The Federal Reserve will lower short-run output by:

decreasing the money supply.As the central bank lowers the money supply, the nominal interest rate will increase. As the nominal interest rate increases, the real interest rate increases, and the IS-MP diagram implies that short-run output will decline.

ex-ante: before

ex-ante real interest rate= nominal rate- expected inflation

nominal interest rate

real interest rate+ expected inflation

Economists now believe

that the change in inflation influences output and thus only a temporary reduction in economic performance is needed to alter the inflation rate.

Phillips Curve

- the phillips curve displays a relationship between short run output (Yswigglyt) and the change in the inflation rate(change in pie) -when short run output is positive, inflation is rising -when short run output is negative, inflation is falling -when there is a price shock, the phillips curve shifts

MP curve

-called the MP curve b/c it is determined by monetary policy -describes how the Fed sets the nominal interest rate - Fed funds rate:the interest rate banks charge each other for short term loans of reserves(used as a base for many other interest rates in the economy)

Short run Model

1) Mp curve -nominal interest rates determines real interest rate 2) IS curve -real interest rate influences GDP in the short run 3)Phillips Cruve -describes how fluctuations in GDP affect the movements in inflation

A tight monetary policy by the European Central Bank will result in an increase in the nominal interest rate.

A tight monetary policy will reduce the money supply. Reductions in the money supply lead to increases in the nominal interest rate.

An economy starts at its long-run values. A recession will then cause

As an economy enters into a recession, firms see demand for their products fall. Thus, firms desire to sell more by raising prices less aggressively. This causes the inflation rate to begin to fall.

How does the Federal Reserve impact the federal funds rate?

Federal reserve sets a federal funds rate target -they conduct open market sales and purchases to keep the rate at the target -the Fed controls the total supply of reserves in the maker even though they are not a party of the loans -in the short run, inflation doesn't respond to changes in the money supply -the Fed has the ability to set the real rate in the short-run

At the interest rate targeted by the central bank, the money supply is

HORIZONTAL Although the money supply is generally vertical, for a targeted interest rate, the money supply is horizontal. The central bank is willing to supply any amount of money that is demanded at the desired interest rate.

Suppose prices adjust immediately because there is no sticky inflation. Then, monetary policy will

If inflation is not sticky, then the classical dichotomy will hold in the short run. This means that nominal variables will have only nominal effects on the economy.

Price-setting behaviors become more sensitive to demand conditions. This results in

If price-setting behavior is more sensitive, the Phillips curve becomes steeper, and thus, a smaller recession is needed to reduce the inflation rate.

What shifts the phillips curve?

Price shocks shift the Phillips curve. If the bargaining power of unions increases, wages will be increased and this will increase the cost of inputs facing firms. The inflation rate will increase.

o create disinflation, the Federal Reserve must

Raising the interest rate will be equivalent to a tight monetary policy, which in turn will lower the rate of inflation.

If the aggregate demand parameter increases, and the central bank wishes to stabilize output at potential, it should:

The central bank can raise the nominal interest rate, which will raise the real interest rate. This will lower investment in the economy, and the economy will return to potential. If the Federal Reserve buys government bonds, it expands the money supply and lowers the nominal interest rate.

Why does the classical dichotomy fail to hold in the short run?

The classical dichotomy fails for a number of reasons, including imperfect information, costly consumption, contractual obligations, bargaining costs, social norms, and money illusion. -Firms have imperfect information. -Unions negotiate contracts that set wages for long periods of time. -Sometimes people think it is unfair to lower nominal wages.

sticky inflation

leads to differences in real interest rates when inflation is changing

ex-post: after

nominal rate- actual observed inflation