Monetary Economics Introduction · 2018. 10. 2. · Bilgin Bari Monetary Economics Introduction....
Transcript of Monetary Economics Introduction · 2018. 10. 2. · Bilgin Bari Monetary Economics Introduction....
Aggregate DemandAggregate Supply
Monetary Policy TheoryMonetary Policy Analysis
Monetary EconomicsIntroduction
Bilgin Bari
Bilgin Bari Monetary Economics Introduction
Aggregate DemandAggregate Supply
Monetary Policy TheoryMonetary Policy Analysis
God put macroeconomists on earth not to propose andtest elegant theories but to solve practical problems.The problems He gave us, moreover, were not modest indimension.
Gregory Mankiw
Bilgin Bari Monetary Economics Introduction
Aggregate DemandAggregate Supply
Monetary Policy TheoryMonetary Policy Analysis
1 Aggregate DemandThe Goods Market and the IS ModelThe Money Market and the LM CurveThe Short-Run Equilibrium in the IS-LM ModelDerivation of Aggregate Demand
2 Aggregate SupplyThe Basic Theory for Aggregate SupplyAggregate Supply and Phillips Curve
3 Monetary Policy TheoryMonetary Policy and Aggregate DemandMonetary Policy and Interest Rate Rule
4 Monetary Policy AnalysisThe Objectives of Monetary PolicyThe Effects of PolicyTools of Monetary Policy
Bilgin Bari Monetary Economics Introduction
Aggregate DemandAggregate Supply
Monetary Policy TheoryMonetary Policy Analysis
The Goods Market and the IS ModelThe Money Market and the LM CurveThe Short-Run Equilibrium in the IS-LM ModelDerivation of Aggregate Demand
Aggregate Demand I
Great Depression
Classical theory was incapable of explaining the GreatDepression.
According to Classical theory, national income depends on- factor suppplies ( capital and labor) - avaliable technology
They didn’t change substantially from 1929 to 1933.
So many economists believed that a new model was needed.
Bilgin Bari Monetary Economics Introduction
Aggregate DemandAggregate Supply
Monetary Policy TheoryMonetary Policy Analysis
The Goods Market and the IS ModelThe Money Market and the LM CurveThe Short-Run Equilibrium in the IS-LM ModelDerivation of Aggregate Demand
Aggregate Demand II
Keynes (1936), The General Theory of Employment, Interest, andMoney
Bilgin Bari Monetary Economics Introduction
Aggregate DemandAggregate Supply
Monetary Policy TheoryMonetary Policy Analysis
The Goods Market and the IS ModelThe Money Market and the LM CurveThe Short-Run Equilibrium in the IS-LM ModelDerivation of Aggregate Demand
Aggregate Demand III
Aggregate Demand : The total amount of outputdemanded in the economy.
Keynes proposed that low aggregate demand is responsible forlow income and high employment.
He criticized classical theory which assumes aggregate supplyalone determines national income.
Bilgin Bari Monetary Economics Introduction
Aggregate DemandAggregate Supply
Monetary Policy TheoryMonetary Policy Analysis
The Goods Market and the IS ModelThe Money Market and the LM CurveThe Short-Run Equilibrium in the IS-LM ModelDerivation of Aggregate Demand
Using Models
In the long-run, prices are flexible, and aggregate supplydetermines income.
In the short-run, prices are sticky, and aggregate demandinfluence income.
We focus on aggregate demand to study economicfluctuations.
The model of aggregate demand : IS-LM model.
Bilgin Bari Monetary Economics Introduction
Aggregate DemandAggregate Supply
Monetary Policy TheoryMonetary Policy Analysis
The Goods Market and the IS ModelThe Money Market and the LM CurveThe Short-Run Equilibrium in the IS-LM ModelDerivation of Aggregate Demand
IS-LM Model
The goal of the model :
to show what determines national income for a given pricelevel (sticky prices).to show what causes the aggregate demand curve to shift.
IS (Investment-Saving) : markets for goods and services
LM (Liquidity-Money) : markets for money
The key determinant is the interest rate, because it influencesboth investment and money demand.
Bilgin Bari Monetary Economics Introduction
Aggregate DemandAggregate Supply
Monetary Policy TheoryMonetary Policy Analysis
The Goods Market and the IS ModelThe Money Market and the LM CurveThe Short-Run Equilibrium in the IS-LM ModelDerivation of Aggregate Demand
Importance of Expenditures
Keynes proposes that
In the short-run, economy’s total income is determined largelyby the spending of plans of households, firms, and thegovernment.
The problem during recessions was inadequate spending.
Bilgin Bari Monetary Economics Introduction
Aggregate DemandAggregate Supply
Monetary Policy TheoryMonetary Policy Analysis
The Goods Market and the IS ModelThe Money Market and the LM CurveThe Short-Run Equilibrium in the IS-LM ModelDerivation of Aggregate Demand
Planned Expenditure
Actual expenditure (AE): the amount households, firms andthe government spend on goods and services (GDP)
Planned expenditure (PE): the amount households, firms andthe government would like to spend on goods and services.
Planned Expenditure = Aggregate Demand
Ype = C + I + G + NX
Bilgin Bari Monetary Economics Introduction
Aggregate DemandAggregate Supply
Monetary Policy TheoryMonetary Policy Analysis
The Goods Market and the IS ModelThe Money Market and the LM CurveThe Short-Run Equilibrium in the IS-LM ModelDerivation of Aggregate Demand
Bilgin Bari Monetary Economics Introduction
Aggregate DemandAggregate Supply
Monetary Policy TheoryMonetary Policy Analysis
The Goods Market and the IS ModelThe Money Market and the LM CurveThe Short-Run Equilibrium in the IS-LM ModelDerivation of Aggregate Demand
Keynesian Cross I
Keynesian Multiplier
Y = C + I + G + NXY = C + (mpc × YD) + I + G + NXY = C + I + G + NX + (mpc × Y )− (mpc × T )
subtracting mpc × Y from both dies of equation
Y − (mpc × Y ) = Y (1−mpc) = C + I + G + NX − (mpc × T )
dividing both sides of equation (1−mpc)
Y = 11−mpc × [C + I + G + NX − (mpc × T )]
Bilgin Bari Monetary Economics Introduction
Aggregate DemandAggregate Supply
Monetary Policy TheoryMonetary Policy Analysis
The Goods Market and the IS ModelThe Money Market and the LM CurveThe Short-Run Equilibrium in the IS-LM ModelDerivation of Aggregate Demand
Keynesian Cross II
Keynesian cross gives that the relation between expenditure andincome (production).
Y = 11−mpc × [C + I + G + NX − (mpc × T )]
For example
When there is a change in one of the autonomouscomponents (e.g. goverment expenditures: ∆G ), the changein production (or income) will be :
∆Y
∆G=
1
1−mpc
Bilgin Bari Monetary Economics Introduction
Aggregate DemandAggregate Supply
Monetary Policy TheoryMonetary Policy Analysis
The Goods Market and the IS ModelThe Money Market and the LM CurveThe Short-Run Equilibrium in the IS-LM ModelDerivation of Aggregate Demand
Keynesian Cross III
Bilgin Bari Monetary Economics Introduction
Aggregate DemandAggregate Supply
Monetary Policy TheoryMonetary Policy Analysis
The Goods Market and the IS ModelThe Money Market and the LM CurveThe Short-Run Equilibrium in the IS-LM ModelDerivation of Aggregate Demand
Keynesian Cross IV
When there is a change in one of the autonomouscomponents (e.g. goverment expenditures: ∆G ), the changein production (or income) will be :
∆Y
∆T=−mpc
1−mpc
Bilgin Bari Monetary Economics Introduction
Aggregate DemandAggregate Supply
Monetary Policy TheoryMonetary Policy Analysis
The Goods Market and the IS ModelThe Money Market and the LM CurveThe Short-Run Equilibrium in the IS-LM ModelDerivation of Aggregate Demand
Keynesian Cross V
Bilgin Bari Monetary Economics Introduction
Aggregate DemandAggregate Supply
Monetary Policy TheoryMonetary Policy Analysis
The Goods Market and the IS ModelThe Money Market and the LM CurveThe Short-Run Equilibrium in the IS-LM ModelDerivation of Aggregate Demand
Derivation of IS Curve
IS curve describes the relationship between interest rate andaggregate output when goods market is in equilibrium for a givenprice level.
Bilgin Bari Monetary Economics Introduction
Aggregate DemandAggregate Supply
Monetary Policy TheoryMonetary Policy Analysis
The Goods Market and the IS ModelThe Money Market and the LM CurveThe Short-Run Equilibrium in the IS-LM ModelDerivation of Aggregate Demand
Shifts in IS Curve
Bilgin Bari Monetary Economics Introduction
Aggregate DemandAggregate Supply
Monetary Policy TheoryMonetary Policy Analysis
The Goods Market and the IS ModelThe Money Market and the LM CurveThe Short-Run Equilibrium in the IS-LM ModelDerivation of Aggregate Demand
The Theory of Liquidity Preference I
The theory is the building block for the LM curve.
The theory assumes that there is a fixed supply of real moneybalances:
(M
P)s =
M
P
The theory posits that interest rate is one determinant ofmoney demand. It is the opportunity cost of holding money.
Economy’s level of income (Y) also effect the demand ofmoney.
The demand for real money balances :
(M
P)d = L(r ,Y )
Bilgin Bari Monetary Economics Introduction
Aggregate DemandAggregate Supply
Monetary Policy TheoryMonetary Policy Analysis
The Goods Market and the IS ModelThe Money Market and the LM CurveThe Short-Run Equilibrium in the IS-LM ModelDerivation of Aggregate Demand
The Theory of Liquidity Preference II
Bilgin Bari Monetary Economics Introduction
Aggregate DemandAggregate Supply
Monetary Policy TheoryMonetary Policy Analysis
The Goods Market and the IS ModelThe Money Market and the LM CurveThe Short-Run Equilibrium in the IS-LM ModelDerivation of Aggregate Demand
Derivation of LM Curve
Bilgin Bari Monetary Economics Introduction
Aggregate DemandAggregate Supply
Monetary Policy TheoryMonetary Policy Analysis
The Goods Market and the IS ModelThe Money Market and the LM CurveThe Short-Run Equilibrium in the IS-LM ModelDerivation of Aggregate Demand
Shifts in LM Curve
Bilgin Bari Monetary Economics Introduction
Aggregate DemandAggregate Supply
Monetary Policy TheoryMonetary Policy Analysis
The Goods Market and the IS ModelThe Money Market and the LM CurveThe Short-Run Equilibrium in the IS-LM ModelDerivation of Aggregate Demand
Bilgin Bari Monetary Economics Introduction
Aggregate DemandAggregate Supply
Monetary Policy TheoryMonetary Policy Analysis
The Goods Market and the IS ModelThe Money Market and the LM CurveThe Short-Run Equilibrium in the IS-LM ModelDerivation of Aggregate Demand
Planned Expenditure
Planned Expenditure : The total amount of spending ondomestically produced goods and services.
Planned Expenditure = Aggregate Demand
Ype = C + I + G + NX
Bilgin Bari Monetary Economics Introduction
Aggregate DemandAggregate Supply
Monetary Policy TheoryMonetary Policy Analysis
The Goods Market and the IS ModelThe Money Market and the LM CurveThe Short-Run Equilibrium in the IS-LM ModelDerivation of Aggregate Demand
Consumption Expenditure (C)
C = C + (mpc × YD)− cr
C : autonomous consumption expenditurempc : marginal propensity to consumeYD : disposable income (Y-T)c : a parameter reflects how consumption respond changes in thereal interest rater : real interest rate
⇒ Real interest rate affects on savings decisions.
Bilgin Bari Monetary Economics Introduction
Aggregate DemandAggregate Supply
Monetary Policy TheoryMonetary Policy Analysis
The Goods Market and the IS ModelThe Money Market and the LM CurveThe Short-Run Equilibrium in the IS-LM ModelDerivation of Aggregate Demand
Planned Investment Spending (I)
I = I − dr
I : Fixed Investmentd : a parameter reflects how investment respond to changes in thereal interest rate.
⇒ Real interest rate affects on investment decisions through costof finance.
Goverment Purchases and Taxes
Goverment Purchases : G = GTaxes T = T → disposable income : Y − T
Bilgin Bari Monetary Economics Introduction
Aggregate DemandAggregate Supply
Monetary Policy TheoryMonetary Policy Analysis
The Goods Market and the IS ModelThe Money Market and the LM CurveThe Short-Run Equilibrium in the IS-LM ModelDerivation of Aggregate Demand
Net Exports (NX)
NX = NX − xr
NX : autonomous net exportx : a parameter reflects how net export respond to changes in thereal interest rate
⇒ real interest rate affect net export through the exchange rate :
changes in real interest rate → changes in return → capital flow →changes in export and import prices → changes in net export
Bilgin Bari Monetary Economics Introduction
Aggregate DemandAggregate Supply
Monetary Policy TheoryMonetary Policy Analysis
The Goods Market and the IS ModelThe Money Market and the LM CurveThe Short-Run Equilibrium in the IS-LM ModelDerivation of Aggregate Demand
Goods Market Equilibrium
Y = Ype
Y = C + I + G + NXY = C + (mpc × YD)− cr + I − dr + G + NX − xrY = C + I + G + NX + (mpc × Y )− (mpc × T )− (c + d + x)r
subtracting mpc × Y from both dies of equation
Y − (mpc × Y ) = Y (1−mpc) =C + I + G + NX − (mpc × T )− (c + d + x)r
dividing both sides of equation (1−mpc)
Y = [C + I + G + NX − (mpc × T )]× 11−mpc −
c+d+x1−mpc r
Bilgin Bari Monetary Economics Introduction
Aggregate DemandAggregate Supply
Monetary Policy TheoryMonetary Policy Analysis
The Goods Market and the IS ModelThe Money Market and the LM CurveThe Short-Run Equilibrium in the IS-LM ModelDerivation of Aggregate Demand
IS Curve
Y = [C + I + G + NX − (mpc × T )]× 1
1−mpc︸ ︷︷ ︸−c + d + x
1−mpcr︸ ︷︷ ︸
The equation shows how to determine aggregate output whengoods market is in equilibrium.
It shows the relationship between aggregate output and thereal interest rate when the goods market is in equilibrium.
First component of the equation explains shifts in IS curve(given interest rate)
Second component of the equation explains movements on IScurve (changes in real interest rate)
Bilgin Bari Monetary Economics Introduction
Aggregate DemandAggregate Supply
Monetary Policy TheoryMonetary Policy Analysis
The Basic Theory for Aggregate SupplyAggregate Supply and Phillips Curve
Introduction I
Aggregate supply behaves differently in the short-run than in thelong-run.
In the long-run, prices are flexible, and the aggregate supplycurve is vertical.
shifts in aggregate demand curve affect the price level andoutput remains its natural level.
In the short-run, prices are sticky, and the aggregate supplycurve is not vertical.
shifts in aggregate demand curve affect the output and docause fluctuations in output.
Bilgin Bari Monetary Economics Introduction
Aggregate DemandAggregate Supply
Monetary Policy TheoryMonetary Policy Analysis
The Basic Theory for Aggregate SupplyAggregate Supply and Phillips Curve
Introduction II
The aim is to understand upward sloping short-run AS curve.
Some prices are sticky and others not.This is the better reflection of the real world.
All prices are fixed (horizontal AS curve) is an extremesituation.
Bilgin Bari Monetary Economics Introduction
Aggregate DemandAggregate Supply
Monetary Policy TheoryMonetary Policy Analysis
The Basic Theory for Aggregate SupplyAggregate Supply and Phillips Curve
The Basics I
There are two types of market imperfection in the economy.
These imperfections (frictions) cause the output of economyto deviate from its natural level.
As a result of these imperfections, the short-run aggregatesupply curve is upward sloping.
As a result of upward sloping AS curve, shifts in aggregatedemand curve cause output to fluctuate.
This devations of output from its natural level represent thebooms and busts of the business cycle.
The equation for the short-run AS curve :
Y = Y + α(P − EP)
Bilgin Bari Monetary Economics Introduction
Aggregate DemandAggregate Supply
Monetary Policy TheoryMonetary Policy Analysis
The Basic Theory for Aggregate SupplyAggregate Supply and Phillips Curve
The Basics II
Y = Y + α(P − EP)
The equation states that output deviates from its natural levelwhen the price level deviates from the expected price level.
α indicates how much output respond to unexpected changesin the price level.
The model explains :why unexpected movements in the price level are related tofluctuations in aggregate output.
Bilgin Bari Monetary Economics Introduction
Aggregate DemandAggregate Supply
Monetary Policy TheoryMonetary Policy Analysis
The Basic Theory for Aggregate SupplyAggregate Supply and Phillips Curve
The Sticky-Price Model I
The model emphasizes that firms do not instantly adjust theprices they charge in response to changes in demand.
Building the model
we first consider the pricing decisions of individual firmsthen we add together the decisions of many firms to explainthe behavior of the economy as a whole.
Main assumption : Firms have at least some monopolisticcontrol over the prices they charge.
Bilgin Bari Monetary Economics Introduction
Aggregate DemandAggregate Supply
Monetary Policy TheoryMonetary Policy Analysis
The Basic Theory for Aggregate SupplyAggregate Supply and Phillips Curve
The Sticky-Price Model II
Desired price p depends on two macroeconomic variables:
The overall level of prices : P⇒ A higher price level implies that the firm’s cost are higher.
The level of aggregate income : Y⇒ A higher level of income raises the demand for the firm’sproduct.⇒ And marginal cost increases at higher levels of production.
Firms with flexible prices:
p = P + a(Y − Y )
a > 0 : measures how much the firm’s desired price responds tothe level of aggregate output.
Bilgin Bari Monetary Economics Introduction
Aggregate DemandAggregate Supply
Monetary Policy TheoryMonetary Policy Analysis
The Basic Theory for Aggregate SupplyAggregate Supply and Phillips Curve
The Sticky-Price Model III
Firms with sticky prices:
p = EP + a(EY − EY )
for simplicity, assume that these firms expect output to be at itsnatural level : a(EY − EY ) = 0
then, these firms set the price : p = EP
Bilgin Bari Monetary Economics Introduction
Aggregate DemandAggregate Supply
Monetary Policy TheoryMonetary Policy Analysis
The Basic Theory for Aggregate SupplyAggregate Supply and Phillips Curve
The Sticky-Price Model IV
In the overall economy, there are two pricing group as flexible andsticky.The weighted average of the pricing :s: fraction of firms with sticky prices1-s: fraction with the flexible prices
Then the overall price level
p = sEP + (1− s)[P + a(EY − EY )]
substract (1− s)P from both sides
sP = sEP + (1− s)[a(Y − Y )]
Bilgin Bari Monetary Economics Introduction
Aggregate DemandAggregate Supply
Monetary Policy TheoryMonetary Policy Analysis
The Basic Theory for Aggregate SupplyAggregate Supply and Phillips Curve
The Sticky-Price Model V
divide both sides by S
P = EP + [(1− s)a
s](Y − Y )
When firms expect a high price level, they expect high costs.
When output is higher, the demand for goods is higher. Sofirms set prices higher.
When we use α = s(1−s)a ;
Y = Y + α(P − EP)
The Result: The sticky-price model says that the deviation ofoutput from the natural level is positively associated with thedeviation of price level from the expected price level.
Bilgin Bari Monetary Economics Introduction
Aggregate DemandAggregate Supply
Monetary Policy TheoryMonetary Policy Analysis
The Basic Theory for Aggregate SupplyAggregate Supply and Phillips Curve
The Imperfect Information Model I
Assumptions :
Markets clear. (flexible prices)
The short-run and long-run aggregate supply curves differbecause of temporary misperceptions about prices.
Each supplier in the economy produces single good andconsume many goods.
They monitor closely the prices of what they produce but lessclosely the prices of all the goods they consume.
Because of imperfect information, they sometimes confusechanges in overall price level with changes in relative prices.
Bilgin Bari Monetary Economics Introduction
Aggregate DemandAggregate Supply
Monetary Policy TheoryMonetary Policy Analysis
The Basic Theory for Aggregate SupplyAggregate Supply and Phillips Curve
The Imperfect Information Model II
The result: This confusion influences decisions about how muchto supply, and it leads to positive relation between the price leveland output in the short-run.
Actual prices exceed expected prices, suppliers raise their output :
Y = Y + α(P − EP)
Bilgin Bari Monetary Economics Introduction
Aggregate DemandAggregate Supply
Monetary Policy TheoryMonetary Policy Analysis
The Basic Theory for Aggregate SupplyAggregate Supply and Phillips Curve
Implications for the Model I
Y = Y + α(P − EP)
If the price level is higher than the expected price level, outputexceeds its natural.
If the price level is lower than the expected price level, outputfalls short of its natural level.
Bilgin Bari Monetary Economics Introduction
Aggregate DemandAggregate Supply
Monetary Policy TheoryMonetary Policy Analysis
The Basic Theory for Aggregate SupplyAggregate Supply and Phillips Curve
Phillips Curve
A.W.Phillips (1958), ”The Relationship Between Unemploymentand the Rate of Change of Money Wages in the United Kingdom:1861-1957”, Economica 25
”periods of low unemployment were associated with rapidrises in wages, while periods of high unemployment wereassociated by low growth in wages”
Phillips curve shows the negatif relationship betweenunemployment and inflation.When labor markets are tight (the unemployment rate is low)
firms may have difficulty hiring qualified workers and may havehard time keeping their present employees.Because of shortage of workers in the labor market, firms willraise wages to attract needed workers and raise their prices ata more rapid rate.
Bilgin Bari Monetary Economics Introduction
Aggregate DemandAggregate Supply
Monetary Policy TheoryMonetary Policy Analysis
The Basic Theory for Aggregate SupplyAggregate Supply and Phillips Curve
Modern Phillips Curve I
M. Friedman (1967), ”The Role of Monetary Policy”, AmericanEconomic Review 58E. Phelps (1968), ”Money-Wage Dynamics and Labor-MarketEquilibrium”, Journal of political Economy 76
Real wages ⇒ When workers and firms expect the price levelto rise, they will adjust nominal wages upward so that the realwage does not decrease.
The Long Run ⇒ In the long run, all wages and prices areflexible. This is called natural rate of unemployment
π = πe − ω(U − Un)
Bilgin Bari Monetary Economics Introduction
Aggregate DemandAggregate Supply
Monetary Policy TheoryMonetary Policy Analysis
The Basic Theory for Aggregate SupplyAggregate Supply and Phillips Curve
Modern Phillips Curve II
Bilgin Bari Monetary Economics Introduction
Aggregate DemandAggregate Supply
Monetary Policy TheoryMonetary Policy Analysis
The Basic Theory for Aggregate SupplyAggregate Supply and Phillips Curve
Modern Phillips Curve III
The short run and the long run :
There is a short-run trade-off between inflation andunemployment.
There is no long-run trade-off between inflation andunemployment.
1973-1979 Oil Price Shocks
oil price shock → negative supply shock
import price shock → cost-push shock
workers push wages to keep nominal wages constant
π = πe − ω(U − Un) + ρ
Bilgin Bari Monetary Economics Introduction
Aggregate DemandAggregate Supply
Monetary Policy TheoryMonetary Policy Analysis
The Basic Theory for Aggregate SupplyAggregate Supply and Phillips Curve
Modern Phillips Curve
Firms and households form their expectations about inflationby looking at past inflation.πe = π−1
π = π−1 − ω(U − Un) + ρ
Inflation expectations are formed by looking at the past andtherefore change only slowly over time. (sticky)
Negative unemployment gap (tight labor market) causes theinflation rate to rise :∆π = π − π−1 = −ω(U − Un) + ρ
U = Un : inflation stops accelerating (changing).NAIRU: non-accelerating inflation rate of unemployment
Bilgin Bari Monetary Economics Introduction
Aggregate DemandAggregate Supply
Monetary Policy TheoryMonetary Policy Analysis
The Basic Theory for Aggregate SupplyAggregate Supply and Phillips Curve
Aggregate Supply Curve I
U − Un : Unemployment gapY − Yp : Output gap
A.M. Okun (1970), ”The Political Economy of Prosperity”
Okun’s Law :
for each percentage point that output is above potential,the unemployment rate is one-half of a percentage pointbelow the natural rate of unemployment.
U − Un = −0.5× (Y − Yp)
Bilgin Bari Monetary Economics Introduction
Aggregate DemandAggregate Supply
Monetary Policy TheoryMonetary Policy Analysis
The Basic Theory for Aggregate SupplyAggregate Supply and Phillips Curve
Aggregate Supply Curve II
We get the inflation equation :
π = πe + γ(Y − Yp) + ρ
whereπe = π−1
γ : how inflation respond to the output gap
higher γ → more flexible wages (ω ↑) → steeper PC → steeper AS
Bilgin Bari Monetary Economics Introduction
Aggregate DemandAggregate Supply
Monetary Policy TheoryMonetary Policy Analysis
The Basic Theory for Aggregate SupplyAggregate Supply and Phillips Curve
The Short-Run and The Long-Run AS Curve
Bilgin Bari Monetary Economics Introduction
Aggregate DemandAggregate Supply
Monetary Policy TheoryMonetary Policy Analysis
The Basic Theory for Aggregate SupplyAggregate Supply and Phillips Curve
Shifts in AS Curve
The Short-Run : Inflation depends on inflation expectations,output gap and price shocks.
π = πe + γ(Y − Yp) + ρ
The Long-Run : Output is determined by production function.
Y = F (K , L) = AKαLβ
Bilgin Bari Monetary Economics Introduction
Aggregate DemandAggregate Supply
Monetary Policy TheoryMonetary Policy Analysis
The Basic Theory for Aggregate SupplyAggregate Supply and Phillips Curve
The relationship between the long-run and the short-runAS Curve
Bilgin Bari Monetary Economics Introduction
Aggregate DemandAggregate Supply
Monetary Policy TheoryMonetary Policy Analysis
Monetary Policy and Aggregate DemandMonetary Policy and Interest Rate Rule
The Aggregate Demand
Y = [C + I + G + NX − (mpc × T )]× 1
1−mpc︸ ︷︷ ︸−c + d + x
1−mpcr︸ ︷︷ ︸
The equation shows how to determine aggregate output whengoods market is in equilibrium.
It shows the relationship between aggregate output and thereal interest rate when the goods market is in equilibrium.
First component of the equation explains demand shocks.
Second component of the equation explains policy shocks.
Bilgin Bari Monetary Economics Introduction
Aggregate DemandAggregate Supply
Monetary Policy TheoryMonetary Policy Analysis
Monetary Policy and Aggregate DemandMonetary Policy and Interest Rate Rule
Monetary Policy
Central Banks use a very short-term interest rate as theirprimary policy tool.
The interest rate is overnight interest rate at which bankslend to each other.
We need real interest rate : r = i − πe- changes in nominal interest rate → changes in real interestrate (only if actual and expected inflation remain unchangedin the short-run)- We know prices are sticky in the short-run.
Central bank can determine the real interest rate in theshort-run.
Bilgin Bari Monetary Economics Introduction
Aggregate DemandAggregate Supply
Monetary Policy TheoryMonetary Policy Analysis
Monetary Policy and Aggregate DemandMonetary Policy and Interest Rate Rule
MP Curve I
MP curve indicates the relationship between the real interestrate which central bank sets and the inflation rate.
r = r + λπ
MP has an upward slope :- Policy makers follow Taylor principle to stabilise inflation.- Interest rate is raised more than any rise in expectedinflation.- Real interest rate rise if there is a rise in inflation.
Bilgin Bari Monetary Economics Introduction
Aggregate DemandAggregate Supply
Monetary Policy TheoryMonetary Policy Analysis
Monetary Policy and Aggregate DemandMonetary Policy and Interest Rate Rule
MP Curve II
Bilgin Bari Monetary Economics Introduction
Aggregate DemandAggregate Supply
Monetary Policy TheoryMonetary Policy Analysis
Monetary Policy and Aggregate DemandMonetary Policy and Interest Rate Rule
The Taylor Rule I
Taylor rule was invented by John Taylor, a Stanfordeconomist, outlined the rule in his precedent-setting 1993study ”Discretion vs. Policy Rules in Practice.”
It’s a proposed guideline for how central banks should alterinterest rates in response to changes in economic conditions.
It’s a forecasting model used to determine what interest rateswill, or should, be as shifts in the economy occur.
It makes the recommendation that the central bank should- raise interest rates when inflation is high or whenemployment exceeds full employment levels.- decrease interest rate when inflation and employment levelsare low.
Bilgin Bari Monetary Economics Introduction
Aggregate DemandAggregate Supply
Monetary Policy TheoryMonetary Policy Analysis
Monetary Policy and Aggregate DemandMonetary Policy and Interest Rate Rule
The Taylor Rule II
Real federal funds rate :
r = 2.0 + 0.5(π − πT ) + 0.5(Y − Y P)
Nominal federal funds rate :
i = π + 2.0 + 0.5(π − πT ) + 0.5(Y − Y P)
Bilgin Bari Monetary Economics Introduction
Aggregate DemandAggregate Supply
Monetary Policy TheoryMonetary Policy Analysis
Monetary Policy and Aggregate DemandMonetary Policy and Interest Rate Rule
The Taylor Rule III
Example :
Long-term GDP growth : 2.5 %Current GDP growth : 3.5 %Inflation target : 2.0 %Current inflation : 4 %
i = 3% + 2.0% + 0.5(4%− 2%) + 0.5(3.5%− 2.5%)
6.5% = 3% + 2.0% + 0.5(2%) + 0.5(1%)
Bilgin Bari Monetary Economics Introduction
Aggregate DemandAggregate Supply
Monetary Policy TheoryMonetary Policy Analysis
Monetary Policy and Aggregate DemandMonetary Policy and Interest Rate Rule
The Taylor Rule IV
Bilgin Bari Monetary Economics Introduction
Aggregate DemandAggregate Supply
Monetary Policy TheoryMonetary Policy Analysis
The Objectives of Monetary PolicyThe Effects of PolicyTools of Monetary Policy
The Policy Objectives
There are two primary objectives:
Stabilizing economic activity
Achieving natural rate of unemployment is equivalent tostabilizing the economy.At the natural level of unemployment, the economy moves toits natural level of output, which we refer to more commonlyas potential output.Minimizing output gap: Y − Yp
Stabilizing inflation around a low level
Price stabilityMaintanig inflation (π) close to a target level (πT )Minimizing inflation gap: π − πT
Loss Function: L = α(π − πT )2 + (1− α)(Y − Y p)2
Bilgin Bari Monetary Economics Introduction
Aggregate DemandAggregate Supply
Monetary Policy TheoryMonetary Policy Analysis
The Objectives of Monetary PolicyThe Effects of PolicyTools of Monetary Policy
Lags and Policy Implementation
The data leg: It is the time it takes for policymakers toobtain the data that describe what is happening in theeconomy.
The recognition lag: It is the time it takes for policymakersto feel confident about the signals the data are sending aboutthe future course of the economy.
The legislative lag: It is the time it takes to get legislationpassed to implement a particular policy.
The implementation lag: It is the time it takes forpolicymakers to change policy instruments once they havedecided on a new policy.
The effectiveness lag: It is the time it takes for the policy tohave real impact on the economy.
Bilgin Bari Monetary Economics Introduction
Aggregate DemandAggregate Supply
Monetary Policy TheoryMonetary Policy Analysis
The Objectives of Monetary PolicyThe Effects of PolicyTools of Monetary Policy
Transmission Mechanism of Monetary Policy
Bilgin Bari Monetary Economics Introduction
Aggregate DemandAggregate Supply
Monetary Policy TheoryMonetary Policy Analysis
The Objectives of Monetary PolicyThe Effects of PolicyTools of Monetary Policy
Equilibrium in the Market for Reserves
Bilgin Bari Monetary Economics Introduction
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Monetary Policy TheoryMonetary Policy Analysis
The Objectives of Monetary PolicyThe Effects of PolicyTools of Monetary Policy
Demand and Supply in the Market for Reserves
The demand for reserves
Required reserves : required reserve ratio x the amount ofdepositsExcess reserves : the additional reserves banks choose to hold.Opportunity cost of holding excess reserves is the interest rate.
The supply for reserves
Nonborrowed reserves (NBR): the amount of reserves that aresupplied by open market operations.Borrowed reserves (BR): The amount of reserves borrowedfrom the central bank.
Bilgin Bari Monetary Economics Introduction
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Monetary Policy TheoryMonetary Policy Analysis
The Objectives of Monetary PolicyThe Effects of PolicyTools of Monetary Policy
Monetary Policy Tools
Open Market Operations
Open market purchases expand reserves and the monetarybase,increasing money supply and lowering short-term interest rates.Open market sales shrink reserves and the monetary base,decreasing money supply and raising short-term interest rates.
Discount policy
The facility at which banks can borrow reserves form thecentral bank.The central bank change the discount rate.
Reserve Requirements
Changes in reserve requirements affects the money supply bycausing the money supply multiplier to change.A rise in reserve requirements increases the demand forreserves and raises the interest rate.
Bilgin Bari Monetary Economics Introduction
Aggregate DemandAggregate Supply
Monetary Policy TheoryMonetary Policy Analysis
The Objectives of Monetary PolicyThe Effects of PolicyTools of Monetary Policy
The Interest Rate Corridor
Bilgin Bari Monetary Economics Introduction
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Monetary Policy TheoryMonetary Policy Analysis
The Objectives of Monetary PolicyThe Effects of PolicyTools of Monetary Policy
The Interest Rate Corridor
Bilgin Bari Monetary Economics Introduction
Aggregate DemandAggregate Supply
Monetary Policy TheoryMonetary Policy Analysis
The Objectives of Monetary PolicyThe Effects of PolicyTools of Monetary Policy
Turkey data
Bilgin Bari Monetary Economics Introduction
Aggregate DemandAggregate Supply
Monetary Policy TheoryMonetary Policy Analysis
The Objectives of Monetary PolicyThe Effects of PolicyTools of Monetary Policy
Turkey data
Bilgin Bari Monetary Economics Introduction
Aggregate DemandAggregate Supply
Monetary Policy TheoryMonetary Policy Analysis
The Objectives of Monetary PolicyThe Effects of PolicyTools of Monetary Policy
Price Stability
Price stability is so crucial to the long-term health of aneconomy.
Low and stable inflation rates promotes economic growth inthe long-run
Inflation target gives net signals to economic agents.Risk premium of investment instruments and interest rate fallsSustainable economic growth and employment are experienced.
A central element in successful monetary policy is pricestability.
Bilgin Bari Monetary Economics Introduction
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Monetary Policy TheoryMonetary Policy Analysis
The Objectives of Monetary PolicyThe Effects of PolicyTools of Monetary Policy
Inflation Targeting
Public announcement of medium-term numerical objectives(targets) for inflation.
An institutional commitment to price stability as the primarygoal of monetary policy and a commitment to achieving theinflation goal.
Inflation target gives net signals to economic agents.
Increased transparency of the monetary policy strategy.
Increased accountability of the central bank for attaining itsinflation objectives.
Bilgin Bari Monetary Economics Introduction
Aggregate DemandAggregate Supply
Monetary Policy TheoryMonetary Policy Analysis
The Objectives of Monetary PolicyThe Effects of PolicyTools of Monetary Policy
Turkey data
Bilgin Bari Monetary Economics Introduction
Aggregate DemandAggregate Supply
Monetary Policy TheoryMonetary Policy Analysis
The Objectives of Monetary PolicyThe Effects of PolicyTools of Monetary Policy
Turkey data
Bilgin Bari Monetary Economics Introduction
Aggregate DemandAggregate Supply
Monetary Policy TheoryMonetary Policy Analysis
The Objectives of Monetary PolicyThe Effects of PolicyTools of Monetary Policy
Turkey data
Bilgin Bari Monetary Economics Introduction
Aggregate DemandAggregate Supply
Monetary Policy TheoryMonetary Policy Analysis
The Objectives of Monetary PolicyThe Effects of PolicyTools of Monetary Policy
Pros and Cons of Inflation Targeting
Inflation targeting can reduce political pressures on the centralbank to pursue inflationary monetary policy and therebyreduce the likelihood of the time-inconsistency problem.
Inflation targeting has the advantage that it is readilyunderstood by the public and is thus highlytransparent.(communication policy)
Transparency and communication go hand in hand withincreased accountability.
Inflation targeting promotes the accountability of the centralbank to elected officials.
Inflation targeting countries seem to have significantlyreduced both the rate of inflation and inflation expectations.
’Inflation nutter’ polices lead to large output fluctuations.
Bilgin Bari Monetary Economics Introduction
Aggregate DemandAggregate Supply
Monetary Policy TheoryMonetary Policy Analysis
The Objectives of Monetary PolicyThe Effects of PolicyTools of Monetary Policy
Prerequisites for The Inflation Targeting Regime
Strict commitment to price stability
Independent, accountable and reliable the central bank
Strong and advanced financial markets
Low fiscal dominance
Providing technical infrastructure
Bilgin Bari Monetary Economics Introduction
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Monetary Policy TheoryMonetary Policy Analysis
The Objectives of Monetary PolicyThe Effects of PolicyTools of Monetary Policy
Implementation of Inflation Targeting
Target setting (central bank / government)
Target variable (CPI / core inflation)
Point or band target
Target horizon
Decision-making mechanism
Accountability
Communication policy
Bilgin Bari Monetary Economics Introduction