Output, Inflation and Monetary Policy
- Mishkin and Serletis Ch. 21-24
- A variation on the ECON 1100 Aggregate Demand – Aggregate Supply model.
- Differences from ECON 1100?
Focus on inflation rather than the price level.
Central bank: sets interest rates in pursuit of an inflation target.
This aspect of monetary policy is built into the AD curve.
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Aggregate expenditure (AE) and the IS Curve (see Ch. 21)
- Aggregate expenditure (AE): planned spending on an economy’s final goods and Services.
(about $2.1 trillion based on 2nd quarter 2019 estimates)
- Components of AE:
AE = C + I + G + NX
C = Consumption spending ($1.2 trillion )
I = Investment spending ($350 billion)
G = government spending ($500 billion)
NX = net exports (Export spending – Import spending)
($677 billion - $663 billion)
- Autonomous spending: is spending that doesn’t depend on current income.
- At least part of each component (C, I, G, NX) can be treated as exogenous,
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Consumption spending (C)
- Spending on final goods and services by the household sector. e.g. food, clothing, leisure, consumer durables (furniture, cars etc.)
- Roughly half of AE in Canada.
- What determines C?
Household disposable income (YD): Income (Y) minus taxes net of transfers (T)i.e. income in household sector’s hands.
e.g, in the textbook algebraic model:
C = C*+ m ∙YD = C*+ m ∙ (Y-T) ‘m’ is a constant (0<m<1)
Marginal propensity to spend (m): share of an additional $1 of YD spent on C
C* is ‘Autonomous consumption spending’ (C*): consumer spending that doesn’t depend on disposable income.
- Other determinants of C (these work through the value of C*):
- Household sector wealth (Assets-Debts): another measure of household sector financial resources.
- Real (inflation-adjusted) interest rates (r) (r= i-i=nominal interest rate; =inflation rate)
- Saving: an alternative to spending: high r, save more, spend less - Borrowing costs: high r, less borrowing, less spending.
- Expectations of future income, jobs prospects, etc.
- Demographics (age structure of population)
- Preferences (a microeconomic story)
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Investment spending (I):
- Spending on investment goods (adds to physical capital stock):- buildings, structures, machinery and equipment- new residential housing- inventories- spending is primarily by businesses
- Roughly 20% of AE in Canada (but volatile!)
- Some key determinants:
- borrowing conditions: - level of real interest rates (r): cost of borrowing.- the real (inflation-adjusted) interest rate is the relevant rate- credit market constraints, financial frictions (f*).
- business expectations: is it profitable to expand? (animal spirits) what return is expected on capital investments? Optimistic? Pessimistic?
- taxes on business income, tax incentives for investment.
- Text model: I a simple function of I = I* -d∙ (r+f*)
- depends on interest rates (r) and financial frictions (f*): d is a constant (>0) that measures the effect of these variables on I.
- effects of other factors (business expectations, taxes etc) are captured by I*.
(I* is ‘autonomous’: independent of Y in the textbook model)
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Government expenditures (G):
- Public sector spending on goods and services (all levels of government)
e.g. infrastructure spending, office supplies, bureaucrat salaries.
(much of government budgetary spending is on transfers: - this spending is not part of G as it becomes someone else’s income
and is spent by them.)
- Roughly 25% of AE.
- Some is government investment (e.g. infrastructure), rest is government consumption (about 85% in 2019).
- Determinants:
- Much of this spending is at the discretion of the government.
- So we will treat it as autonomous (unaffected by Y): G*
- Fiscal policy acts through G as well as through T (taxes net of transfers)
- Inertia? Is it hard to ramp up G quickly?
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Net export spending (NX): X-M= Exports-Imports
- Spending by foreigners on Canadian goods and services (exports) minus Canadian spending on foreign goods and services (imports).
(note: some of the spending in C, I and G will be on foreign goods so import spending is deducted to obtain spending on Canadian output)
- X and M each around 30%-35% of AE.
- Some key determinants of NX:
- Exchange rates: affects the cost of Cdn. vs. foreign goods.
- Cdn. prices vs. foreign prices.
- Level of Cdn. Incomes (affects import spending)
- Level of foreign income (affects foreign spending on Cdn. goods and services)
- Text equation is very simple: NX = NX* - x∙ r x=a constant>0
- NX* captures the effect of variables other than ‘r’.
- Interest rate (r) has a negative effect via the exchange rate- rise in Cdn. r (assume foreign r constant)- Canadian financial assets more attractive.- foreigners demand more Cdn. $ to buy Cdn. assets.- Canadians buy less foreign currency to buy foreign assets.- Extra demand for, less supply of Cdn. $ in foreign exchange
markets: Cdn. dollar appreciates.- Cdn goods are more expensive (X falls)- Foreign goods now cheaper for Canadians. (M rises).- The rise in r has lowered NX.
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- NX is autonomous in the text model. Common extension is to have it depend on
income.
Equilibrium Aggregate Spending
- Goods market equilibrium:
Aggregate Spending = Output (Y)
AE = Y
- if not then output is changing:
AE > Y more spending than output; firms raise output to satisfy extra demand
AE < Y more output than spending, unsold output, firms respond with lower output.
- In the text model AE depends on Y via effects of disposable income on C.
- Equilibrium builds in the interdependence of spending, output and income.
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i.e. more spending, more output, more jobs and incomes gives still more spending.
- A change in autonomous spending or a change in the real interest rate causes equilibrium Y to change in the same direction.
- changes in autonomous spending shift the AE curve.
- size of the change in equilibrium Y is larger than the change in autonomous spending (vertical shift up) due to multiplier
effects.
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- Textbook algebraic version of the model:
AE = C + I + G + NX
C = C*+ m ∙(Y-T)
I = I*- d∙(r+f*)
G = G*
NX = NX* -x∙ r
(m, x, d are positive constants measuring the effect of a righthand-side variable on a lefthand-side variable, e.g. if ‘r’ rises by 1, NX falls by ‘x’)
So:
AE = (C*+I*+G*+NX*) – (d+x)∙r -d∙f* + m ∙(Y-T)
Equilibrium requires:
Y = AE
Y= (C*+I*+G*+NX*) – (d+x)∙r -d∙f* + m ∙(Y-T)
Solving for Y gives the equilibrium level of spending:
Y = (C*+I*+G*+NX*-d∙f* -m∙T )∙ 11−m – r∙ d+x
1−m
Autonomous spending multiplier = 1/(1-m)
Interest rates have a negative effect on equilibrium Y( ↑r by 1 then ↓Y by (d+x)/(1-m)
IS curve (next page) plots this negative relationship.
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IS Curve:
- Text model had:
Y = (C*+I*+G*+NX*-d∙f* -m∙T )∙ 11−m – r∙ d+x
1−m
solving for r:
r = (C*+I*+G*+NX*-d∙f* -m∙T )∙ 1d+x – 1−m
d+x Y
- IS curve shows the Y vs. r relationship for which Y=AE.
- Negative slope reflects effect of the interest rate (r) on I, NX in the textbook model (could also affect C).
At a given level of r:
- if at a point to right of IS: Output (Y) > Spending so output falls.
- if at a point to left of IS: Spending > Output, output rises.
- must be on the IS curve for Y to be unchanging.
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Shifts in the IS curve:
- Increases in autonomous spending, fall in financial frictions, fall in taxes could all shift IS right.
- Decreases in autonomous spending, rise in financial frictions, rise in taxes could all shift IS left.
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Appendix: An Extended Version of the Textbook Model
- Allows: C to depend on ‘r+f*’; allows import spending to depend on Y-T.
AE = C + I + G + NX
C = C*+ m ∙(Y-T) - a∙(r+f*) (added term)I = I*- d∙(r+f*)G = G*NX = NX* -x∙ r - b∙(Y-T) (added term)
Solution:
AE = (C*+I*+G*+NX*) – (a+d+x)∙r –(a+d)∙f* + (m-b) ∙(Y-T)
Equilibrium requires:
Y = AE = (C*+I*+G*+NX*) – (a+d+x)∙r –(a+d)∙f* + (m-b) ∙(Y-T)
Solving for Y gives the equilibrium level of spending:
Y = [C*+I*+G*+NX*-d∙f* -(m-b)∙T ] ∙ 11−m+b – r∙ a+d+x
1−m+b
(this is the IS curve for this extended model)
Some other possible extensions?
Let I depend on Y? Could G depend on Y? Allow relationships to be non-linear.
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Interest Rate Determination in the model: See Text Chapter 22
- How are interest rates determined in this type of model?
LM Curve approach: Money Demand = Money Supply
- interest rate settles to the level where this is true: driven by shifts between financial assets and money.
- Central bank conducts monetary policy by changing money supply which affects interest rates.
- this is probably what you did in first year (origins: Hicks (1937), Keynes (1936)
MP Curve approach: (textbook, a typical modern approach)
- Treat the central bank as an interest rate setter.
- Central bank follows some policy rule when setting interest rates.
- This is often how central banks talk about the monetary policy.
- Bank of Canada: targets the overnight interest rate.
( http://www.bankofcanada.ca/ )
- a change in the overnight rate can shift the entire structure of interest rates (substitutes story).
(see Term structure and Risk structure models later in the course)
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Monetary Policy Curve (MP Curve):
- Behaviour of the central bank?
- Seeks to control the inflation rate (π)
- may have an explicit target rate (Bank of Canada: 2%)
- may be trying to just keep π stable
- Key link: Interest rate affects spending, which affects inflation.
↑r → ↓Y (move along IS curve, less demand) → ↓π
↓r → ↑Y (move along IS curve, more demand) → ↑π
- Central bank then sets r according to a relationship like:
r = r* + ∙ π where >0 measures how much the central bank changes r in response to inflation.
(Plotting this gives the MP Curve (next page) )
- Why might this be a sensible way to model how ‘r’ is determined?
- empirical: it is what many central banks do (since 1990s)e.g. Bank of Canada 2% inflation target 1-3% range.
- underlying reason for inflation targeting?
- inflation is viewed as costly.- theoretical viewpoint: in the long-run central bank can affect inflation and nominal variables but not real variables (like real
GDP, unemployment)
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MP Curve:
- Moving along MP: if inflation rises the central bank counters by setting a higher interest rate.
if inflation falls the central bank counters by setting a lower interest rate.
- Focus is on the real interest rate (r).
- The real rate is most relevant for spending.
- In practice Central bank policy focuses on setting nominal interest rate levels (iNominal).
- Approximation: iNominal=r + πexpected
- the two will move together if expected inflation ( πexpected) is stable.
- given knowledge of expected inflation the central bank can change nominal interest rates to achieve a desired real interest rate.
(Technical point: both r and can sometimes be negative. So imagine that the axes scales allows for this, i.e. 0 is part way along each axis)
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Shifts in the MP curve:
- Why might MP shift?
- Central bank tightens or loosens monetary policy.- changes the interest setting rule: (tighter then r* rises; looser
then r* falls.)
- this may be due to a change in its inflation target
e.g. 2% (midpoint of 1%-3% range) since early-1990s; implicitly higher target before this (so MP curve was lower before 1990s).
- lower inflation target requires less AD, so higher r at any given π.
- A change in the structure of the economy may require the bank to set higher ‘r’ for any given inflation rate if it is to achieve its inflation goal.
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The MP Curve in Practice:
- A common alternative way of writing the MP curve:
r = rn + (-T) where T is the inflation target of the central bank.
(this is the same as earlier if we let: r*= rn - T – this version makes it explicit that r* depends on the inflation target)
- In practice the behavior the ‘MP curve’ seeks to capture can be a quite complex:
- Bank of Canada: forecasting models of the entire economy tell it what r is needed for any given target inflation rate.
i.e. it takes into account the structure of the rest of the model (exact relationship of AE to its determinants, input price and inflation
expectations determination, value of Y at full employment).
- The simple linear equation in the just text represents the idea that interest rate setting is done with an inflation objective in mind.
- Model assumes that inflation is the central bank’s sole concern.
- If it cares about unemployment or output stabilization then these should be part of the interest rate setting rule.
e.g. US Federal Reserve has such a ‘dual mandate’ (text p. 436)
- See text discussion of the ‘Taylor Rule’ pp. 453-456)
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The Aggregate Demand Curve
- Relationship between value of Aggregate Demand (Y) and the actual inflation rate (π).
- downward sloping relationship: higher means lower Y.
- in the text version of the model this is due entirely to monetary policy.
Monetary policy: - MP curve says that ↑π causes central bank to ↑r, which ↓AE and
so lowers Y (a move up the IS curve).
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Some other reasons for a negatively sloped AD curve?
- Above AD is negatively sloped due to monetary policy.
- Other stories:
(2) Wealth effects:
- ↑π reduces real value of money stock and financial assets denominated in nominal (money) terms.
- lower asset values, people not as wealthy, spend less, ↓AE
(3) International substitution:
- ↑π domestic goods more expensive vs. foreign goods
- ↓Exports, ↑Imports so ↓AE
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Shifts in the AD curve?
- Shifts in AE (rise in AE, causes rise in AD)
- A decrease in spending creates shifts in the opposite direction.- AE falls, IS shifts left, AD shifts left.
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Monetary policy changes (shifts in MP curve) and the AD curve:
- Looser monetary policy (lower r for any value of )
- lower r
- raises interest sensitive spending (move down the IS curve)
- this gives more spending at the current inflation rate (AD shifts right)
- Tighter monetary policy (higher r for any value of ): reverse the shifts above
- higher r for give (MP shift up), less spending, AD will shift left.
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Aggregate Supply
- Shows relationship between the value of output (real GDP) supplied and the inflation rate.
Long-run Aggregate Supply (LRAS): vertical at ‘potential output’ (YP)
- Potential output: determined by ‘real’ factors - quantities and qualities of productive inputs available at full
employment;
- technologies dictating how inputs can be turned into output.
- ‘frictions and imperfections’ in the economy that determine the level of full employment of inputs and the efficiency of their allocation.
- Inflation does not affect YP.
- LRAS shifts: more inputs, technological improvements, fewer frictions and imperfections all shift LRAS right over time.
Fewer inputs, greater frictions and imperfections (more regulation?) can shift LRAS left.
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Short-run Aggregate Supply (AS in text, SRAS here):
- Short-run aggregate supply: upward sloping in vs. Y space
= e+ ∙(Y-YP) + with >0
- inflation ():
- increases/decreases one-for-one with expected inflation (e)
e.g. if everyone expects 5% inflation then everyone (workers, businesses) plan to raise their wages and prices by 5% to keep pace.
- inflation also depends on the ‘output gap’ (Y-YP)
- inflation is higher if output is greater than potential (low unemployment, high input demand drives up input prices, higher costs lead businesses to raise output prices)
- lower inflation if output is below potential (higher unemployment, weak input demand, leads to low wages, low input prices, low costs and lower prices)
- strength of this effect determines the slope of SRAS.
- increasing in ‘shocks’ (), e.g. shocks to costs of production (oil price shock; bad harvest)
SRAS curve:
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- upward slope reflects effect of the output gap on inflation.
- changes in expected inflation, inflation shocks or changes in YP shift SRAS.
(ASIDE: SRAS in the graphs above are linear – this need not be. A common argument is that SRAS is quite flat at low Y, i.e. inflation response to low output is weak especially around zero inflation:
)
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SRAS and LRAS:
- Say there is a persistent output gap (so Y≠YP):
- if Y-YP>0 for an extended period people will come to expect higher inflation (↑e) – this raises inflation and shifts SRAS upward.
i.e. at Y>YP actual inflation > expected inflation; if this persists people update their expectations.
- if Y-YP<0 for an extended period people will come to expect lower inflation (↓e) – this lowers actual inflation and shifts SRAS downward.
- SRAS is only stable if Y=YP, i.e. if on LRAS. (inflation is at its expected level, neither e or changes)
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Equilibrium in the Aggregate Demand – Aggregate Supply Model: Short-run
- Short-run equilibrium: AD = SRAS (0, Y0 in diagram)
- on SRAS (inflation-output combination consistent with how inflation is determined).
- on AD curve: inflation-output combination consistent with- central bank is setting r according to its MP curve; and- goods market equilibrium (on IS curve): else Y is changing.
(say instead output is Ylow then SRAS says inflation must be low but this implies that AD is YHigh in which case businesses will be raising output to meet this high demand. As output rises, inflation rises i.e. move along SRAS toward the intersection of AD and SRAS)
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Equilibrium in the Aggregate Demand – Aggregate Supply Model: Long-run
- A short-run equilibrium is only a long-run equilibrium if Y=YP
- If Y≠YP actual inflation differs from expected inflation. In the long-run this mistake is corrected, expected inflation changes and SRAS shifts:
i.e. SRAS shift raises inflation which decreases AD along the AD curve.
i.e. SRAS shift lowers inflation which increases AD along the AD curve.
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Effects of a Fall in AD:
- Could be due to fall in autonomous spending; increased financial frictions; a more anti-inflationary (tighter) monetary policy.
- Short-run: recession – output and inflation both fall (pt. 0 to pt. 1) i.e. after shift AD<YP at 0, firms ↓output then as ↓Y, ↓ along SRAS.
- Long-run: at pt.1 output is below YP so inflation is below its expected level.
- expected inflation falls, SRAS shifts down, inflation falls still more and output grows back towards YP.
- new equilibrium is at pt. 2:
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Effects of a Rise in AD:
- Short-run: inflation and output both rise (boom!), leaving output above YP (pt.1)
(process: after AD shifts AD>YP at 0, businesses ↑Y, this causes↑ along SRAS)
- Long-run: high output, causes ↑expected inflation, SRAS shifts up. Inflation rises still further, output returns to YP at pt. 2.
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SRAS shifts up (negative supply shock):
- Could be due to a shock to input prices or a rise in expected inflation.
- Short-run (pt. 0 to 1): inflation rises, output falls below YP (stagflation of mid-late 1970s!)
- Long-run (pt.1 to 0): since Y<YP expected inflation falls, SRAS shifts back down, return to pt. 0.
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LRAS shifts left:
- Possible cause? fewer inputs; more inefficient production (regulation?): result potential output is lower.
- Short-run: with lower YP inflation is higher at any Y (SRAS shifts up) and the economy goes from pt.0 to pt.1.
- Long-run: at pt.1, Y>YP1 so actual inflation exceeds expected inflation,
And in the long-run expected inflation rises shifting SRAS still more. This continues until Y is at the new lower potential level of output (pt. 2)
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Applications: Text uses the model to think about some business cycle episodes
- Early 1980s disinflation (Figure 23-10)- Bank of Canada shifts AD left in an effort to lower inflation. - Recession results, expected inflation falls shifting SRAS down.
- US 2001-2004 (Figure 23-11)- Same diagram as Canada in the early 1980s.- Difference? AD shift left is caused by a combination of shocks
(Stock market decline at the end of the ‘tech bubble’, confidence shocks to consumer and business spending from 9/11 and Enron scandal)
- Text shows SRAS shift as moving the economy back to potential at a lower inflation rate.
- A possible complication? Did the Federal Reserve also shift AD right? i.e. were the interest rate cuts made larger than those suggested by MP curve?
- Oil shocks of the 1970s (Figure 23-13)- Rise in oil prices shifts SRAS up.- Stagflation results (recession, higher inflation)- Expected inflation fall, shifting SRAS back down.
- US financial crisis 2007-09 (Figure 23-16):- Increase in financial frictions (AD shifts left) coinciding with rising
oil prices (SRAS shifts up).- Recession (both shifts reduce Y). Muted effect on inflation (AD
shock lowers it, SRAS shock raises it).- Further shift left in AD as crisis worsens in August 2008.- Recession deeper, inflation lower by 2009.
- See later discussion of what happens next:- inflation expectations should be falling (SRAS will shift
down)- Federal Reserve is attempting to shift AD right; fiscal policy
is mixed (raising AD at Federal level; reducing AD at state level).
- Complications outside the model arise due to zero lower bound on interest rates.
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- China and the financial crisis:- AD shifts left (fall in spending on exports as trading partners
experience recession)- Chinese government counters this with fiscal policy: more
government spending which shifts AD back to the right.
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Monetary Policy in the AD-AS Model
- Chapter 24 looks at using monetary policy to stabilize the economy.
- MP curve and monetary policy.
- MP curve: the interest rate set by the central bank depends positively on the inflation rate.
- this already builds in the idea that the central bank is conducting monetary policy to stabilize inflation.
- so without a change in policy the central bank moves the economy along the MP curve in response to changes in the inflation rate.
- this chapter is mainly concerned with shifts in the MP curve, i.e. when the central bank changes its interest rate setting rule.
- so if MP curve is: r = r* + ∙
- concern is with changes to r* (autonomous changes in monetary policy)
- rise in r*: ‘tightening’ – a more anti-inflationary policy: shifts AD left.
- fall in r*: ‘ looser’ - a less anti-inflationary policy: shifts AD right.
(note: could also talk about this in terms of changes to )
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- Changes in monetary policy can shift the AD curve:
- This ability to shift the AD curve creates the possibility that the central bank can change its policy to stabilize the economy.
- stabilize? Keep inflation low or stable.
Keep output near potential, e.g. avoid recessions.
- it is a possibility: not possible to stabilize both for some shocks.Practical problems may also limit the usefulness of such policies.
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Monetary policy and Shocks to AD:
- In theory, monetary policy could reverse shifts in AD and so avoid any changes in inflation and output associated with AD shifts.
- Left panel: no change in policy - Right panel: monetary policy counters the AD shift
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Monetary Policy Response to a permanent supply shock (shift in LRAS):
- Monetary policy can smooth the adjustment.
- LRAS shifts left, tighten monetary policy (shift AD left too).
- in both cases Y falls to YP1 but inflation is stabilized in the version with a monetary policy response.
- what would happen if the central bank tried to hold output at (YP)?
- LRAS shifts right, loosen monetary policy (shift AD right too).
- this could stabilize inflation. (Draw this!)
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Monetary Policy Response to a Temporary Supply Shock (SRAS shift):
- Dilemma: monetary policy can only stabilize output or inflation but not both.
- Negative shock to SRAS (shift left):
- no policy: stagflation in the short-run; this is reversed by fall in e and a shift down in SRAS in the long-run (first panel)
- policy can stabilize output by raising AD but more inflation (second panel).
- policy can stabilize inflation by lowering AD but the recession is bigger:
- So if shocks to the economy are mainly demand or permanent supply shocks a central bank that seeks to stabilize inflation will also stabilize output.
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Monetary Policy Transmission mechanism
- Transmission mechanism describes the channels through which monetary policy affects AD.
- Model above: assumes that the transmission mechanism works through interest rate effects.
- interest rate affects investment spending, a part of AE.
- interest rate affects exchange rate and then Net exports (NX).
- Chapter 26 discusses other possible channels through which monetary policy may affect AD (see Figure 26-1 for a summary)
- Bank of Canada on the transmission mechanism:
( http://www.bankofcanada.ca/wp-content/uploads/2010/11/how_monetary_policy_works.pdf )
(Assignment reading)
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Zero Lower Bound on Interest Rates: Implications for Monetary Policy
- Monetary policy in the model works by altering interest rates.
- central bank cuts ‘r’ by reducing nominal interest rates.
- Nominal interest rates are subject to a lower bound: ‘zero lower bound’ (ZLB)
- source of the problem: if interest rates are negative lenders will choose to hold currency rather than assets that pay negative interest.
- ZLB vs. Effective Lower Bound (ELB): interest rates could be slightly negative rather than 0 provided there is some other advantage to holding the asset or disadvantage to holding currency e.g. storage costs. B of C estimates an ELB for Canada of -0.5%.(http://www.bankofcanada.ca/wp-content/uploads/2016/05/boc-review-spring16-witmer.pdf )
- in a future without currency does the ZLB problem disappear?
- Once at the ZLB the central bank can’t cut the nominal interest rate so it loses the ability to cut r (at least in the usual way)
- How does our model work if the economy is at the ‘zero lower bound’?
- A concern given Japan since the 1990s; performance of Europe, US, Canada since 2008.
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MP Curve and the Zero Lower Bound (ZLB):
Before: r = r* + ∙ with >0
- rule says that as inflation falls, central bank cuts r (real interest rate).
- if inflation falls far enough the nominal interest rate hits the ZLB.
- if inflation decreases beyond this point central bank can’t cut r any further.
- so fall in inflation will raise the real interest rate! (r = i-, indeed at ZLB i=0 so r= -)
- so MP curve is downward sloping at low inflation rates:
- When is this likely? Low inflation, low interest rate environment.
- Japan since the 1990s; Canada now?
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The AD curve and the Zero Lower Bound:
- When not at ZLB (higher inflation rates): ↑ → ↑r → ↓Spending (↓Y)i.e. usual downward sloping AD curve (see pt. 0 to pt. 1)
- When ZLB is binding (at low inflation rates): ↑ → ↓r → ↑Spending (↑Y)i.e. AD curve is upward sloping in the inflation rate! (pt. 2 to pt. 3)
(policy rate is held steady at ZLB between pt.2 and pt.3)
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A Kinked AD Curve:
- The AD curve now has a kink: above the kink higher inflation lowers AD (Y); below the kink higher inflation raises AD (Y).
- The same factors as earlier shift AD.
- How does this affect the workings of the model?
- In the diagram below the model works much the same as before (unless start with SRAS=AD at a pt. like 5):
(What if SRAS is steeper? – think about!)
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Kinked AD: An Uglier Case
- Here the LRAS is always to the right of AD and the economy behaves much differently:
- this economy can’t get to potential output on its own even in the long-run.
- the usual adjustment mechanism: falling expected inflation, leading to lower SRAS doesn’t get the economy to YP.
- Stabilization policy that shifts AD to the right would be especially useful here!
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Shifting AD Right at the ZLB:
- How can a shift in AD be generated?
- Fiscal policy is a possibility (cut taxes, raise transfers, raise government spending)
- Monetary policy: can it generate more demand if at the Zero Lower Bound?
- Monetary policy works by cutting interest rates in the version of the model above.
- but now interest rates have hit the ZLB.
- are there other channels by which monetary policy can raise AD?Wealth effects? Stock market effects and Tobin’s Q?
- ‘Unconventional monetary policy’, ‘Quantitative Easing’
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‘Unconventional monetary policy’, ‘Quantitative Easing’ and the ZLB
- Some possible monetary policy tools at the ZLB.
- Lowering financial frictions:
- Additional liquidity can ease credit constraints in a time of crisis.(useful if a financial crisis is the cause of low Y)
- Asset purchases (OMOs on longer-term or riskier assets than usual).- intention is to lower interest rates on longer-term, riskier
assets rather the usual short-term rates.- This is ‘Quantitative Easing’ (QE)
(note this can also run into ZLB type problems)
- concerns: banks have massively increased reserves via this type of measure. Are there likely to be future consequences for inflation?
- Expectations and ‘forward guidance’ - central bank can commit to keeping usual policy rates at low levels
for an extended period. This can affect expectations of future interest rates and so lower longer-term rates via term structure effects.
- can commit to a higher future inflation target. This can shift SRAS curve up.
- See also transmission mechanism (Ch. 26): - wealth effects? Could they be a factor?- Tobin’s Q and investment.
- Questions of how effective the unconventional monetary policy tools are.
- US, Canada made use of these during the crisis. - Japan and Abenonomics (text Fig. 24-15) an example.
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Monetary Policy in Practice:
- Model gives some idea of what is possible.
- Reality is more complicated.
- Some Issues?
- Information: where is the economy and where is it going?
- Need to know this if the desired direction of policy is to be determined.
- Potential output (YP): how to identify it?
- What does the future hold? Problem of forecasting the future state of the economy.
- Information: structure of the economy.
- Parameters of the model (‘m’, responsiveness of I to r, etc.)
- Speed of adjustment processes:- in the model SRAS shifts when Y≠YP.- how large and how fast is this response?
- Information and central banks: - estimating the structure of the economy;- monitoring the economy;- forecasting.- technical models plus judgement and experience.
- Lags and policy:
- Information and data lags- GDP and national accounts data (C, I, G, NX) is only seen
with a considerable lag)
- Recognition lags
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- Even with the desired data it takes some time for policy-makers to be sure about the state of the economy.
- Canadian debates about the 1990s economy; US FOMC meeting minutes.
- Implementation and effectiveness lags:- after deciding the direction and size of a policy action how
long before the desired AD shift occurs?
(Friedman: monetary policy is powerful but is subject to ‘long and variable lags’)
Bank of Canada :« Monetary policy actions (changes in the policy rate) take time—usually between six and eight quarters—to work their way through the economy and to have their full effect on inflation. »
http://www.bankofcanada.ca/wp-content/uploads/2010/11/monetary_policy.pdf
Monetary Policy vs. Fiscal Policy
- Monetary policy can affect the economy by shifting the AD curve.
- Fiscal policy can potentially achieve the same thing.
- Fiscal policy: government spending on goods and services (G* above); Tax and transfer policies (T in the model above)
- Which is best?
- Implementation issues: which is faster to initiate? – probably monetary policy (depends on policy environment: independent central bank is quite flexible)
- policy environment and rules: monetary policy rules; budget balance and other such policies; exchange rate regime.
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- After initiation how quickly does the policy work? (how long does it take for AD to shift to the desired place)
- Effectiveness may vary with the economic environment.
- Fiscal policy in face of high government debt: could confidence issues counter AD effects of expansionary fiscal policy?
- Monetary policy in the model above works through interest rates. What about the zero lower bound problem?
- Fiscal policy may be constrained by political considerations (post-financial crisis policies in US, UK)
- Fiscal policy may be constrained by debt burden concerns (Japan? Greece?)
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