978-1259285295 Chapter 21 Lecture Note Part 1

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Chapter 21 – Output, Inflation, and Monetary Policy

Chapter 21

Output, Inflation, and Monetary Policy

Chapter Overview

Everyone is preoccupied with monetary policy, from traders to consumers to politicians.

The objective of this chapter is to understand fluctuations in inflation and real output and

how central banks use interest rate policy to stabilize them. To accomplish this, we will

develop a macroeconomics model of fluctuations in the business cycle in which monetary

policy plays a central role. The model is developed in three steps: (1) long-run

equilibrium is described (2) the dynamic aggregate demand curve is derived and (3)

aggregate supply is introduced. As we move through chapter, keep in mind that our

ultimate objective is to understand how modern central bankers set interest rates, what

they are reacting to when they change the target, and the impact on the economy.

Learning Objectives: Establish an understanding of:

1. Output and inflation in the long run

2. Aggregate demand and supply

3. Equilibrium in the short run and the long run

Important Points of the Chapter

To understand monetary policy we need to develop a macroeconomic model of

fluctuations in the business cycle in which monetary policy plays a central role.

Short-run movements in inflation and output can arise from changes in aggregate demand

and changes in aggregate supply. Modern monetary policymakers work to eliminate the

volatility that such changes cause by adjusting the target interest rate, which influences

the components of aggregate demand.

Application of Core Principles

Principle #5: Stability. In the short run, output can be above or below its potential.

Principle #4: Time. An investment can be profitable only if its internal rate of return

exceeds the cost of borrowing, so the higher the real interest rate, the lower the level of

investment.

Principle #5: Stability. The relationship between the real interest rate and aggregate

demand helps central bankers stabilize current output at a level close to potential output;

they adjust the rate to close any output gap.

Principle #5: Stability. Central bankers envision themselves as reacting to changes in the

economic environment. They change nominal interest rates in order to bring about

changes in real interest rates that will affect the economic decisions of firms and

households and so return the economy to the desired level.

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Chapter 21 – Output, Inflation, and Monetary Policy

Principle #4: Time. Inflation expectations refer to assessments of what inflation may be

in the future. However, since individuals act to protect themselves from future inflation,

changes in inflation expectations are analogous to changes in production costs.

Teaching Tips/Student Stumbling Blocks

This chapter presents an approach to macroeconomics that centers on what central

bankers really do. It culminates in a simpler and more realistic macroeconomic

model to explain business cycle fluctuations.

Chapter 21 (as well as Chapter 22) are about stability, emphasizing Core Principle

5. Focus your students’ attention on the monetary policy reaction curve, including

the factors that determine its position, slope, and why it shifts. They will then be

well prepared for the full analysis of economic fluctuations presented in Chapter

22, where the ability (and limitations) of monetary policy to control inflation and

output fluctuations is discussed.

A point to stress: The importance of the properties of the monetary policy reaction

curve is that the central bank can use these properties to exert control over the

slope and position of the economy’s aggregate demand curve.

This chapter will lay a foundation for the concept of dynamic aggregate demand

and how monetary policy can affect it. The concept of aggregate supply is also

introduced. With aggregate demand and supply together, you will then be able to

explain how to analyze economy-wide equilibrium. In particular, you can

explicitly point out how the central bank, through its control of the position and

slope of the dynamic aggregate demand curve, can influence equilibrium in the

economy.

Also included in Chapter 21 is a presentation of the idea of the long-run real

interest rate, a key concept in determining the long-run equilibrium of the

economy. As interest rates show the time value of money, the discussion and

analysis of the long-run real rate is another application of Core Principle 1.

Features in this Chapter

Your Financial World: Using the Word Inflation

In normal conversation, when people use the word “inflation” they are talking about price

increases. As it is commonly used, the term does not distinguish a one-time change in the

price level from a situation in which prices are rising continuously. To economists,

inflation means a continually rising price level, a sustained rise that continues for a

substantial period. Economists emphasize the distinction between a temporary change in

inflation (a one-time adjustment in the price level) and a permanent change in inflation (a

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Chapter 21 – Output, Inflation, and Monetary Policy

rise or fall in the long-run course of inflation). Only changes in monetary policy can

cause permanent increases or decreases in inflation.

Applying the Concept: Investment and the Business Cycle

Fluctuations in investment spending are one of the most important sources of changes in

aggregate expenditure. The level of investment changes because of changes in the real

interest rate and changes in expectations about future business conditions. The higher the

real interest rate and the less optimistic business people are about the future, the fewer

investments firms will undertake and the more likely it is that the economy will fall into a

recession.

Your Financial World: It’s the Real Interest Rate that Matters

High nominal interest rates can be misleading; they fool people into thinking that their

incomes are high. But since high nominal rates almost always result from high inflation,

spending all the interest income causes a gradual decline in the purchasing power of one’s

savings. To maintain the real purchasing power of their interest income, retirees can

spend only the real return.

Applying the Concept: Inflation Changes and Output Gaps

The idea that inflation responds to the output gap is confirmed by a close examination of

the data. Inflation clearly tends to fall when there is a recessionary output gap and rise

when current output exceeds potential output. An output gap has little immediate impact

on inflation; its effect takes roughly five to six quarters to be felt.

Tools of the Trade: Output Growth and Output Gaps

Monetary policymakers tend to talk about sustainable economic growth while textbook

models talk about output gaps. To reconcile the two, consider that the economy is always

growing due to investment, more people working, and technological advances that raise

productivity. As a result of growth potential output is constantly rising. Increases in the

economy’s productive capacity shift the long-run aggregate supply curve to the right.

Therefore, as long as actual and potential output both grow at the same pace, no output

gap will develop.

In the News: Yellen Says Higher Rates Not Assured After Thresholds Hit

Federal reserve Vice Chairman (at the time) Janet Yellen said the Fed may hold the

benchmark lending rate near zero even if unemployment and inflation hit policy targets,

stating that those objectives are not triggers. The vice chairman said she believes that

high unemployment is the result of too little demand and that the economy faces

headwinds.

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Lessons of the Article: Beginning in December 2012, the FOMC announced

unemployment and inflation thresholds for raising its target interest rate from

the zero bound. This new form of forward guidance aimed to strengthen the

Fed’s commitment to keep interest rates low until the labor market improved.

The article highlights the Fed’s judgment that

high unemployment reflected a shortfall of aggregate demand. It also

underscores the Fed’s sensitivity to both aspects of its dual mandate and its

efforts to balance policy when inflation deviates from its target and

unemployment deviates from its longer‐run norm.

Additional Teaching Tools

In a November 20, 2013 article entitled “What Many More Years of Easy Money Could

Do to the World Economy,” the Wall Street Journal explores the easy money policies of

the US and the European Union.

(http://blogs.wsj.com/moneybeat/2013/11/20/what-many-more-years-of-easy-money-coul

d-do-to-the-world-economy/)

Virtual Tools

Here’s a good site for calculating inflation:

http://www.calculator.net/inflation-calculator.html.

For More Discussion

How important is consumer confidence? Do consumers really change their spending

patterns based on their expectations about the economy?

Chapter Outline

I. Output and Inflation in the Long Run

A. Potential Output

1. Potential output is what the economy is capable of producing when its

resources are used at normal rates.

2. Potential output is not a fixed level, because the amount of labor and capital in

an economy can grow, and improved technology can increase the efficiency of

the production process.

3. Unexpected events can push current output away from potential output,

creating an output gap; if current output is greater than potential output, it is

an expansionary gap and if it is less then there is a recessionary gap.

4. In the long run, current output equals potential output.

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B. Long-Run Inflation

1. In the long run, since current output equals potential output, real growth must

equal growth in potential output.

2. Ignoring changes in velocity, in the long run inflation equals money growth

minus growth in potential output.

II. Monetary Policy and the Dynamic Aggregate Demand Curve

A. Aggregate Expenditure and the Real Interest Rate

1. The Components of Aggregate Expenditure and the Real Interest Rate

a. The first step in understanding the impact of monetary policy on the

economy is to link the real interest rate to the level of output.

b. To do so we begin by stating the national income accounting identity:

Aggregate expenditures = Consumption + Investment + Government

Purchases + (Exports – Imports)

c. Aggregate expenditure has two parts, one which is sensitive to real interest

rates and one which is not.

d. Consumption, investment, and net exports are sensitive to changes in the

real interest rate.

e. Among these, investment is the most important. The higher the real

interest rate the lower the level of investment and vice versa.

f. Similarly, higher interest rates reduce consumer borrowing and increase

saving and so decrease consumption (and vice versa).

g. For net exports, when the real interest rate in the United States rises, U.S.

assets become more attractive to foreigners. This causes the value of the

dollar to rise, which in turn leads to more imports and less U.S. exports,

reducing net exports and therefore aggregate expenditure.

h. Increases in the real interest rate may increase the government’s cost to

borrow, but the impact on the budget is small and can be ignored.

i. Putting this all together, a rise in the real interest rate reduces the level of

aggregate expenditure (and vice versa).

j. This helps us see how central bankers can use real interest rate changes to

stabilize current output at a level close to potential output: they adjust the

rate to close an expansionary or recessionary gap.

2. The Long-Run Real Interest Rate

a. Over the long run there is a level of the real interest rate at which

aggregate expenditure equals potential output. We can call this the

long-run real interest rate.

b. If the level of potential output remains fixed but there is a rise in those

components of aggregate expenditure that are not sensitive to the real

interest rate, then the long-run real interest rate must rise.

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c. If the level of potential output rises the long-run real interest rate falls.

d. The long-run real interest rate is a consequence of the structure of the

economy; it is not something policymakers can choose.

B. Inflation, the Real Interest Rate, and the Monetary Policy Reaction Curve

1. Policymakers set their short-run nominal interest rate targets in response to

economic conditions in general and inflation in particular.

2. While they state their policies in terms of nominal rates they do so knowing

that changes in the nominal interest rate will eventually translate into changes

in the real interest rate, and it is those changes that influence the economic

decisions of firms and households.

3. Deriving the Monetary Policy Reaction Curve

a. To ensure that deviations of inflation from the target are only temporary,

monetary policymakers respond to change in inflation by changing the real

interest rate in the same direction.

b. The monetary policy reaction curve is set so that when current inflation

equals target inflation, the real interest rate equals the long-run real

interest rate.

c. The slope of the curve depends on policymakers’ objectives; when central

bankers decide how aggressively to pursue their inflation target, and how

willing they are to tolerate temporary changes in inflation, they determine

the slope of the curve.

d. Policymakers who are aggressive in keeping current inflation near target

will have a steep curve, meaning that a small change in inflation will be

met with a large change in the real interest rate.

e. A relatively flat curve means that central bankers are less concerned than

they might be with keeping current inflation near target over the short

term.

4. Shifting the Monetary Policy Reaction Curve

a. When policymakers adjust the real interest rate they are either moving

along a fixed monetary policy reaction curve or shifting the curve.

b. A movement along the curve is a reaction to a change in current inflation;

a shift in the curve represents a change in the level of the real interest rate

at every level of inflation.

c. If either target inflation or the long-run real interest rate change, then the

entire curve will shift.

d. With a higher inflation target, the central bank will set a lower current real

interest rate at every level of current inflation, shifting the monetary policy

reaction curve to the right (a reduction would have the opposite effect).

e. The long-run real interest rate is determined by the structure of the

economy; if it were to rise as a result of an increase in government

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purchases (or some other component of aggregate demand that is not

sensitive to the real interest rate) then the monetary policy reaction curve

would shift left.

f. Any shift in the monetary policy reaction curve can be characterized as

either a change in target inflation or a shift in the long-run real interest

rate.

C. The Dynamic Aggregate Demand Curve

1. Deriving the Dynamic Aggregate Demand Curve

a. The dynamic aggregate demand curve relates inflation and the level of

output, accounting for the fact that monetary policymakers respond to

changes in current inflation by changing the interest rate.

b. When current inflation rises, monetary policy makers raise the real interest

rate, moving the economy upward along the monetary policy reaction

curve. The interest-sensitive components of aggregate expenditure

decrease, meaning that there is less aggregate output demanded.

c. The reverse happens when policymakers respond to lower current inflation

by reducing the real interest rate.

d. Thus, changes in current inflation move the economy along a

downward-sloping dynamic aggregate demand curve.

2. Why the Dynamic Aggregate Demand Curve Slopes

Down

a. There are other reasons (in addition to the actions of policymakers) why

the dynamic aggregate demand curve slopes down.

b. One is that higher inflation rates reduce people’s real money balances and

so cause them to buy less.

c. In addition, higher inflation reduces wealth, which lowers consumption.

That’s because inflation erodes the value of money holdings and is also

bad for the stock market.

d. Another reason for the downward slope is that inflation impacts the poor

more than the wealthy and the redistribution of income to the wealthy

results in less spending in the economy.

e. Then there is the fact that inflation creates risk, which means more saving

and less consumption.

f. Finally, rising inflation makes foreign goods cheaper and so decreases net

exports.

g. In every case, higher inflation means a lower level of aggregate output

demanded, and that’s why the dynamic aggregate demand curve slopes

down.

3. Shifting the Dynamic Aggregate Demand Curve

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a. Whenever the monetary policy reaction curve shifts, the aggregate demand

curve will shift as well.

b. Changes in the long-run real interest rate, which is a consequence of the

structure of the economy, will also shift aggregate demand.

c. Either a fall in target inflation or a rise in the long-run real interest rate

will shift the monetary policy reaction curve to the left and the aggregate

demand curve to the left.

d. Any change in a component of aggregate demand that is caused by a

factor other than a change in the real interest rate will shift the aggregate

demand curve.

e. When firms become more optimistic about the future, or consumer

confidence increases, investment or consumption will increase and

aggregate demand will shift to the right.

f. Increases in government purchases will increase aggregate demand, as will

decreases in taxes.

g. Increases in net exports that are unrelated to changes in real interest rates

will shift the aggregate demand curve to the right.

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