Monetary Policy and Inflation

1
Monetary Policy and Inflation

• Chapter 29 30

2
Monetary Policy
3
Channel of Monetary Policy

• When the central bank increases the monetary
  base, the money supply will increase.
• Banks have excess liquidity which they use to
  make more loans.
• The supply of liquidity will exceed demand and
  banks must compete to attract borrowers who will
  hold this liquidity only at a lower interest
  rate.

4
Dynamics of Monetary Transmission

• Money supply expansion reduces interest rates
• Lower interest rates implies an increase in
  borrowing and affects demand for interest
  sensitive goods.
• Lower interest rates increase demand for US in
  forex market depreciating the exchange rate.
• Aggregate demand shifts out. Given fixed input
  prices this increase in demand stimulates output.
  

5
Monetary Transmission Mechanism
ECB Web Site
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Monetary Policy Money Supply Expands
Money Supply
i
Money Supply
i
1
Money Demand
i
2
M
7
Expansionary Monetary Policy
P
?I
?C, ?NX
AD'
AD
Y
8
An Expansionary Cycle Driven by
monetary policy

1. Economy at LT YP.
2. Monetary Policy Cuts Interest Rate
3. Investment rises. The AD curve shifts out.
4. Tight labor markets. SRAS returns to long run
   equilibrium

YP
P
SRAS
3
2
P
1
AD'
AD
Y
Output Gap
9
Monetary Policy Short-term vs. Long Term

• In the short-run, expansionary monetary policy
  can boost economic growth.
• But in the long-run, expansionary monetary policy
  only leads to rising prices (i.e. inflation).

10
Interest Rate Management

• In most economies around the world, the central
  bank does not simply act to maintain a fixed
  money supply.
• Rather, they adjust money supply to maintain and
  manage interest rate changes in response to
  business cycle conditions.

11
Monetary Policy

• In the US (and Euroland and Japan and most OECD
  economies), the central bank sets monetary policy
  by picking a short-run interest rate they would
  like to prevail.
• In HK, the central bank sets monetary policy by
  picking a fixed exchange rate.

12
U.S. Central bank cuts interest rates during
recessions
13
Demand Driven Recession
w/ Counter-cyclical monetary policy

1. Economy in a recession. Fed detects deflationary
   pressure
2. Monetary Policy Cuts Interest Rate
3. Investment increases spending to shift the AD
   curve back to long run equilibrium

YP
P
SRAS
AD'
1
3
P
2
AD
Y
Gap lt 0
14
Demand Driven Expansion
w/ Counter-cyclical monetary policy

1. Economy in expansion. Fed detects inflationary
   pressure
2. Monetary Policy Raises Interest Rate
3. Investment decreases spending to shift the AD
   curve back to long run equilibrium

YP
P
SRAS
2
P
AD'
1
3
AD
Y
Gap gt 0
15
Price Stability

• Counter-cyclical monetary policy stabilizes
  output near potential output, YP, but also
  stabilizes the price level near P.
• Central banks may pursue price stability as a
  goal and also stabilize output as well if
  business cycles are caused by demand shocks.

16
Policy FrameworkPrice Stability

• Fed Objective Humphrey Hawkins Act (1978) Fed
  instructed by Congress to be conducting the
  nation's monetary policy .. in pursuit of maximum
  employment, stable prices, and moderate long-term
  interest rates
• ECB Objective The primary objective of the
  ECBs monetary policy is to maintain price
  stability. The ECB aims at inflation rates of
  below, but close to, 2 over the medium term.
• Japan Objective Bank of Japan Act Article 2
  Currency and monetary control by the Bank of
  Japan shall be aimed at achieving price
  stability, thereby contributing to the sound
  development of the national economy

17
The Great Moderation

• The Great Moderation by Federal Reserve Bank of
  Dallas

18
Taylor Rule

• Economist named John Taylor argues that US target
  interest rate is well represented by a function
  of
• current inflation
• Inflation GAP current inflation vs. target
  inflation
• Output Gap deviation of GDP from long run path
  
• Function Inflation Target p .02

19
The Taylor Rule Download
20
What should be the current Fed Funds rate? Will
they be increasing it soon?

• Step 1. Find Inflation Rate
• Step 2. Find Output Gap
• Step 3. Calculate Taylor Rule implied rate and
  compare with current rate.

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Answer
22
Stagflation
w/ Counter-cyclical monetary policy

1. Economy experiences stagflation
2. Monetary Policy Cuts Interest Rate
3. Investment increases spending to shift the AD
   curve to long run equilibrium with higher prices.

YP
P
SRAS
3
P
2
P
AD'
1
AD
Y
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Stagflation
w/ Price Stabiliztion

1. Economy experiences stagflation
2. Monetary Policy Raises Interest Rate
3. Investment decreases spending to shift the AD
   curve to equilibrium with lower output.

YP
P
SRAS
2
3
P
1
AD
AD'
Y
24
Monetary Policy and Supply Shocks

• In the face of demand shocks, no trade-off
  between price and output stability.
• In the face of supply shocks, such a trade-off
  exists.

25
Question Problem with Central Bank Stabilization

• Situation Economy is in long-run equilibrium,
  but central bank overestimates potential output.
• Draw outcome if central bank believes that the
  potential output is higher than it is.

26
A Bias toward Expansionary
monetary policy

1. Central Bank repeatedly expands the money supply
2. Inflation recurs

YP
P
5
4
P
3
2
SRAS'
AD'
1
SRAS
AD
Y
YPhantom
27
Monetary Policy Lags

• Counter-cyclical fiscal policy beset by lags
  between the time a recession is recognized and
  the time the government can form consensus to
  act.
• Monetary policy beset by lags between the time
  policy shifts and time for private sector to
  respond to lower interest rates.

28
Inflation
29
Quantity Theory

• Simplest monetary theory is the Quantity Theory
  of Money.
• Purchasing power of money is equal to the
  quantity of money (Mt) times the speed of
  circulation (V, of transactions)
• Purchasing power means of goods (Yt) multiplied
  by price per good (Pt)
• Moneyt Velocity Pt Yt

30
Rule of Thumb

• Rule of Thumb The growth rate of product is
  approximately equal to the sum of the growth
  rates of the elements of a product.

31
Money and Inflation

• Assuming stable velocity
• Inflation occurs when money growth speeds ahead
  of output growth. The unbounded creation of fiat
  money leads to inflation which ultimately will
  make the money worthless.

32
Money Inflation 1975-1994
33
Ex Ante Rate and the Fisher Effect

• Savings and investment decisions must be made
  before future inflation is known so they must be
  made on the basis of an ex ante (predicted) real
  interest rate.
• Fisher Hypothesis Ex ante real interest rate is
  determined by forces in the financial market.
  Money interest rate is just the real ex ante rate
  plus the markets consensus forecast of inflation.

34
Great Inflation of the 1970s
Source St. Louis Federal Reserve
http//research.stlouisfed.org/fred2/
Great Inflation Download
35
Fisher Effect OECD Economies Great Inflation of
1970s
36
Loanable Funds MarketFisher Effect
S
i
r
I
LF
LF
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Ex Ante vs. Ex post

• We can also examine the ex post real return on a
  loan as the money interest rate less the actual
  outcome for inflation.
• The gap between actual and forecast inflation
  determines the gap between the ex post (actual)
  and ex ante (forecast) return.

38
Unexpected Inflation Winners and Losers

• Higher than expected inflation means ex post real
  rates are lower than ex ante. Borrowers are
  winners/lenders are losers.
• Lower than expected inflation means ex post real
  rates are higher than ex ante. Lenders are
  winners/borrowers are losers.

39
Inflation Risk

• When inflation is variable, lenders will demand
  some premium for inflation risk. This will put
  cost on borrowers.
• High inflation rates tend to be associated with
  unpredictable inflation.

40
Costs of Anticipated Inflation

• Shoe Leather Costs Money is a technology for
  engaging in transactions. The greater is
  inflation, the greater the cost for individuals
  of holding money. Individuals must make efforts
  as a substitute for the convenience of holding
  money.
• Menu Costs Firms must engage in costs of
  changing posted prices. More generally, when
  prices change rapidly over time, more time and
  effort must be put into calculating relative
  prices.

41
The Inflation Tax

• Banknotes do not pay interest.
• The real interest rate on banknotes is
• If inflation is high, currency has sharply
  negative returns. People will avoid holding money
  leading to society losing the convenience of
  money transactions.

• Zimbabwe Inflation Download

42
Causes of Extremely Rapid Inflation

• Government generates revenues by printing new
  money (referred to as seignorage).
• Government facing borrowing constraints may be
  forced to rely on inflation tax for deficit
  financing and real returns to owning money.
• Explain the link between deficits and inflation.

43
Israel 1970-1990
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Israel 1970-1990
45
A Bias toward Expansionary
monetary policy

1. Central Bank repeatedly expands the money supply
2. Inflation recurs
3. After a time, as inflation becomes expected it
   will cease to impact output even in the short
   run.

YP
P
5
4
3
P
2
SRAS'
1
AD'
SRAS
AD
Y
Inflationary Gap
46
Features of Inflation TargetingA medium term
communication strategy

• Commitment to price stability as goal of monetary
  policy.
• Clear statement of numerical target for inflation
  over the medium (1-2 year) term.
• Communication with public about current forecasts
  of inflation and policy actions used to achieve
  target.
• Central Bankers accountable for achieving goals.

47
Yield Curve

• The yield curve is the gap between the interest
  rate on long-term bonds and short-term bonds.
• When long-term interest rates are high relative
  to the short-term interest rates, the yield curve
  is steep.
• When short-term interest rates are relatively
  high, the yield curve is flat or inverted.

48
Monetary Policy and the Yield Curve

• Central bank expands the money supply and
  short-term interest rate will fall.
• Negative effect on long term real interest rate
  but
• Also likely to increase inflationary
  expectations raising nominal long-term interest
  rates.
• Yield Curve steepens when money supply expands
  and flattens when money supply contracts.

• Yield Curve Download

49
US Yield CurveSeptember 2007 Expansionary
Monetary Policy
50
Learning Outcome

• Calculate the impact of inflation on long-term
  nominal interest rates using the theory of the
  Fisher effect.
• Calculate real return on debt as a function of
  inflation and expected inflation.
• Calculate real return on money as a function of
  inflation.