12 Monetary Policy and the Phillips Curve

Question 1

What is the main tool of monetary policy?

Answer 1

The base rate (federal funds rate).

Question 2

Define federal funds rate

Answer 2

The interest rate paid from one bank to another for overnight loans.

Question 3

What is the structure of the Short-Run model? (MP, IS and Phillips curves)

Answer 3

Question 4

Why is the rate set by the Fed the rate that banks charge interest at?

i.e. what happens if the rate is above or below the Fed rate?

Answer 4

If the rate is higher than the Fed’s rate, then banks would borrow from or lend to the Fed, as it would be cheaper, therefore banks can’t really charge above it.

If the rate is lower, then other banks would borrow at the lower rate and lend back to the Fed - pure profit opportunity (arbitrage opportunity).

Question 5

Recall: how can we link nominal and real interest rates?

Answer 5

Therefore changes in nominal rate will change real rate as long as it is not offset by changes in inflation.

Question 6

What key assumption do we make?

Implication?

Answer 6

Sticky inflation assumption - Assume that the rate of inflation displays inertia, or stickiness, so that it adjusts slowly over time.

Meaning, in the very short run (e.g. 6 months), we assume that the rate of inflation does not respond directly to changes in monetary policy.

Question 7

MP curve diagrammatically

Answer 7

Question 8

What happens diagrammatically if the central bank wishes to increase the real interest rate?

Answer 8

Initially, real interest rate was equal to marginal product of capital r (bar). Economy was at potential so no AD shocks and a (bar) = 0.

Question 9

Suppose a housing bubble has just burst and there is fear that the economy will enter a recession.

Diagram?

Answer 9

Backward shift in IS, causing the equilibrium to shift from point A to B, resulting in output performing below potential.

Question 10

Suppose a housing bubble has just burst and there is fear that the economy will enter a recession.

What does the central bank do in response?

Answer 10

Lower nominal interest rates which, due to the stickiness of inflation assumption, lowers real interest rates.

Lowers MP

Question 11

Equation for inflation involving expectations.

Answer 11

Question 12

Equation for inflation based on contingent expectations

Answer 12

Question 13

What determines expected inflation?

Answer 13

Question 14

Diagram for the Phillips curve based on change in inflation

Answer 14

Question 15

Equation for infaltion involvingn price shocks

Answer 15

Question 16

Phillips curve for a sudden oil price increase

Answer 16

Question 17

How is the assumption of sticky inflation built into our Short-Run model?

Answer 17

Built into the MP curve, where we assume that changes in the nominal interest rate lead to changes in the real interest rate.

Also in Phillips curve → expected inflation adjusts slowly because actual inflation adjusts slowly, i.e., it is sticky.

Question 18

Cost-push inflation vs. demand-pull inflation

Answer 18

• Cost-push inflation*: caused by price shocks, as increased costs tend to push up the inflation rate.
• Demand-pull inflation*: caused by increases in aggregate demand in the economy which pull up the inflation rate.

Question 19

Disinflation

How could the classical dichotomy aid monetary policy? But, does it?

Answer 19

If it holds in the short run, then slowing the rate of money growth might slow the rate of inflation directly.

However, stickiness of inflation means it would have no effect (i.e. the classical dichotomy does not hold).

Question 20

How could a central bank reduce the inflation rate?

+ diagrams

Answer 20

Question 21

Three main reason for the Great Inflation during the 70s

Answer 21

1. Oil prices
2. Loose monetary policy
3. Information and potential output (confused the great slowdown for a recession - which was a change in potential output)

Question 22

70s mistaking the slowdown in potential for a recession diagram

Answer 22

Question 23

Short-run model curves linked (simplified)

Answer 23

Question 24

How is the Classical Dichotomy at odds with monetary policy? Implication?

Answer 24

Recall: classical dichotomy implies that changes in nominal variables only have nominal effects, so real variables only determined by real forces.

This implies that the classical dichotomy cannot hold, for the short-run at least.

Question 25

Reasons why the Classical Dichotomy may not hold in the Short-Run?

(4)

Answer 25

For the Classical Dichotomy to hold, all prices (incl. nominal wages and rental prices) in the economy must adjust in the same proportion immediately. There are:

• Costs of setting new prices associated with imperfect information and costly consumption.
• Contracts set prices and wages in nominal terms, rather than real terms.
• Bargaining costs
• Social norms about fairness

Question 26

What does the money illusion refer to?

Answer 26

The fact that people focus on nominal rather than real magnitudes.

Question 27

How do central banks control the nominal interest rate?

Answer 27

By supplying whatever money is demanded at that rate.

Question 28

If we assume sticky inflation, what does this mean for the quantity theory of money?

Answer 28

A change in the velocity of money is driven by a change in the nominal interest rate.

In particular, the nominal interest rate is the opportunity cost of holding money.

Question 29

Central banks setting and changing the nominal interest rate diagrammatically

Answer 29

Question 30

Federal Reserve’s three conventional tools for monetary policy

Answer 30

1. Fed funds rate
2. Reserve requirements
3. The discount rate

Question 31

Define reserve requirements

Answer 31

Banks are required to hold a certain fraction of their deposits in special accounts (“in reserve”) with the central bank. Special accounts are called reserves.

The fed can change this fraction (although rarely does) as part of monetary policy.

Question 32

Define discount rate

Answer 32

Interest rate charged by the Federal Reserve itself on loans that it makes to commercial banks and other financial institutions.

A bank that is short on reserves and cannot sort finance elsewhere can borrow from the central bank as the lender of last resort.

Question 33

How does the Fed control money supply?

Answer 33

Primarily through open market operations.

In which the central bank trades interest-bearing government bonds in exchange for currency reserves.