THE CENTRAL BANK & THE ECONOMYPolicymakers Modelof the Economy

Monetary Transmission Mechanism

Economy

Inventories

Trade Balance

Investment

Consumption

Money Market Rates

Interbank Interest Rate

LT In

terest RatesStock

Prices

F/X Rates

FinancialMarkets

Output Gap• Disequilibrium in labor market (caused by wage stickiness

and job-search frictions) causes swings in unemployment.• Potential output is the hypothetical level of output when

labor markets are in equilibrium. • The output gap is the percentage deviation between

potential real GDP and real GDP.

Pt t

t Pt

Y YOutput Gap

Y

AS-AD Model• Inflation and the output gap are jointly determined by the

intersection of aggregate expenditure and production decisions.

• Negative relationship between inflation and expenditure on goods and services.• High inflation reduces competitiveness of exports• High inflation reduces spending power of nominal assets (money)

• (Temporary) positive relationship between inflation and producers willing to provide goods.• Wages tend to be locked in by inflation expectations. When

inflation is ahead of expectation, firms will hire more workers.

AD Curve• Negative relationship between inflation stems from

• Accelerating inflation makes exports less competitive and imports more.

• Inflation reduces spending power of nominal assets (like money)• Policy response of central bank (more later)

• AD curve may shift due to external shocks, fiscal policy, exchange rates, asset prices, interest rates and but importantly confidence about the future.

Short Run Aggregate Supply Curve• Some wages and prices will be pre-set based on price-

setters inflation expectations. When inflation is accelerating ahead of expectations, firms will respond with extra production (ex. McDonalds).

• Potential output is an efficient level of production when inflation expectations match actual inflation. Associated with an economy with flexible prices and wages.

• Over time, inflation expectations will adjust to actual market outcomes.

AS-AD Model

Y*

π

π*

Y

ASAD

πE

Inflation sets to clear supply equal to demand.

When inflation equals inflation expectations, output is equal to potential and Gap is zero.

YP

Gap

Recessionary Cycle

Gap*

π

π*

Y

ASAD

πE

AD

AS’

Self-correction process occurs through the adjustment of expectations

YP

Economy begins in equilibrium. Demand contracts for some reason.

Economy finds new equilibrium with slowing inflation and a negative output gap.

Inflation expectations

ratchet downwards in

response to low inflation and supply shifts out as wage

demands moderate

In new equilibrium, inflation continues to fall but output gap falls

Monetary Policy Transmission Mechanism

Monetary Policy has no long-term effect on output gap

Gap*

π

Y

ASAD

πE

AD

AS’

Central bank engages in expansionary monetary policy

Aggregate Demand shifts out.

Temporary business cycle expansion with higher inflation

Inflation expectations accelerate until they catch up with actual inflation

πE

Aggregate Supply Shifts up

New long-term equilibrium with zero gap and higher inflation

YP

Simple Macroeconomics• Monetary policy primarily affects the demand through

various channels. Cutting interest rates shifts demand out; raising interest rates shifts demand inward.

• In the face of an unstable demand curve (driven by external shocks or animal spirits) counter-cyclical monetary policy can simultaneously stabilize both inflation and output.

• In the face of an unstable supply curve (driven by cost or productivity shocks), the central bank faces a trade-off between unstable inflation or unstable

Recession with Counter-cyclical policy

Gap*

π

π*

Y

ASAD

πE

AD

RECESSIONARY DEMAND SHOCK

CUT POLICY RATE

INFLATION AND OUTPUT GAP STABILIZED

YP

Trade-off w/ Supply Shocks

π

Gap

ASAD

πE

AS SUPPLY SHOCK RAISES COSTS AND INFLATION

MONETARY POLICY CHOICE:

A. RAISE POLICY RATE

AD

INFLATION STABILIZES BUT OUTPUT GAP IS DEEPER

B. CUT POLICY RATES

OUTPUT STABILIZES BUT INFLATION RISES

AD

YP

Difficult Dynamics• A number of factors related to the fact that the economy is

evolving over time make monetary policy more difficult.

1. Long and variable lags – Interest rate changes affect economic decisions but inertia among firms and consumers means this does not occur right away.

Today’s monetary policy must be set for future economic conditions. Central bank must forecast the future and take that into account.

Lags• Data Lag – Measurement of the economy• Recognition Lag – Time for data to cohere into actionabl

pattern.• Legislative Lag• Implementation Lag – Time for policymakers to take

action. • Effectiveness Lag – Time for changes in policy to affect

economic outcome. Most important for monetary policy.

Difficult Dynamics pt. II

2. Asset prices and LT interest rates depend on market expectations of future interest rates and strength of impact on monetary policy.

Central bank controls only the overnight rate directly. Central bank influences most rates and asset prices through market expectations. The central bank must communicate direction of policy with markets to enhance effect on economy. Further, credibility of central bank stabilization policies reduces financial market uncertainty being a source of shocks to demand curve.

Asset Prices are function of the future path of interest rates. • Assets entitle the owner to a stream of future payments,

• Present value of stream of payments is sum of payments discounted by the interest rate.

• Asset prices anchored by fundamental value

1 2 3 4{ , , , ,.....}DIV DIV DIV DIV

31 2 42 3 4

2 3 4

.....1 (1 ) (1 ) (1 )

DIVDIV DIV DIVPV

i i i i

Difficult Dynamics Part III

3. Current demand driven by consumers’ and firms’ expectations of future economic conditions.

Expectations channel an important part of economic stabilization. Uncertainty about central bank commitment to future stabilization policies could be a source of demand shocks. Long-term credibility of monetary policy framework as important to stabilization as current decisions.

Real Interest Rates and Demand• Components of aggregate demand are sensitive to the

real interest rate in a negative way. • Consumer Durables• Residential Housing• Corporate Investment

20

•Real interest rate impacts demand for goods.•Real interest rate is rt = it - E[πt+1]

•When E[πt+1] rises, central bank should increase it

more than 1-for-1 to raise real interest rate, limit demand and limit inflation.•When E[πt+1] falls, central bank should reduce it

more than 1-for-1 to drop real interest rate, raise demand and avoid deflation.

Example of the Policy Mechanism Taylor Principle

Forward Looking Aggregate Demand Equation

• Current theories of aggregate demand suggest that spending is determined as a trade-off with future spending with the real interest rate determining the balance of the trade-off

• New Keynesian Aggregate Demand

1 1D Dt t tY a r b Y b

Forward Looking Demand

1 .....D Dt t tY a r b Y

1 1 2 .....D Dt t tY a r b Y

21 2.....D D

t t t tY a r b r b Y

2 2 3 .....D Dt t tY a r b Y

......DtY 2

1 2t t ta r b r b r 3

3Dtb Y

3 3 4 .....D Dt t tY a r b Y

2 3 4 51 2 3 4 5 ......D

t t t t t t tY a r b r b r b r b r b r

Current demand is determined by the path of future real interest rates

Difficult Dynamics pt. 4

4. Worker’s wage demands driven by inflation expectations.

Unstable inflation expectations can be a source of instability in supply curve and may be responsible for a wage price spiral. “Thirty years ago, the public's expectations of inflation were not well anchored. With little confidence that the Fed would keep inflation low and stable, the public at that time reacted to the oil price increases by anticipating that inflation would rise still further. A destabilizing wage-price spiral ensued as firms and workers competed to "keep up" with inflation. … The episode highlights the crucial importance of keeping inflation expectations low and stable, which can be done only if inflation itself is low and stable.” Bernanke, 2006

Wage Price Spiral

π

Leads to stagflation

AD

πE

Workers inflation expectations rise

Wage demands and firms costs rise

AS

AS

If central bank tries to close output gap, they need to ratify inflation expectations.

AD

YP

Implications• Avoid monetary policy surprises since they can destabilize

the aggregate demand curve. Further, instability of expectations of future monetary policy path can destabilize financial markets and aggregate demand.

• Monetary policymakers need to communicate policy path in order to have full effect on demand. Communication policy should indicate future policy should move in a stabilizing direction.

• Monetary policy must have credible commitment to a stable, future inflation path.