7th: Modern monetary theory

Question 1

The Real Business Cycle Theory (RBC)? .4

Answer 1

Real business cycle theory is a theory that suggests that business cycles are a result of technological changes and the availability of resources, both of which influence productivity and cause changes in the long-run aggregate supply.

Three key elements:
1. The efficiency of business cycles: role of exogenous factors with perfect competition & frictionless markets, in contrast to Keynesian economics (1936)
2. The importance of technology shocks as the main exogenous shocks driving business cycle fluctuations
3. The limited role of monetary factors: no reference to monetary factors & no monetary sector (permanent money neutrality)

Question 2

!!! The New Keynesian Model (NLM) features? .4 and .5

Answer 2

-Monopolistic competition: goods & services prices set by private agents seeking to maximize their utility function
—(Main difference to know!!!Nominal rigidities: firms subject to constraints on price changes frequency & same for workers given sticky wages (as a worker you wouldn’t accept a wage decrease)
-Short-term non-neutrality of monetary policy: due to the presence of nominal rigidities, changes in short-term nominal interest rates are not fully matched by changes in expected inflation => consumption & investment changes => output & employment changes. In the long-term, all prices & wages adjust as the economy converges to its natural equilibrium (natural level of output) and money neutrality fully applies

Changes in aggregate demand result from the optimization functions of households and firms.

Therefore, the NKM leaves room for government/central bank interventionist policy in the short-term.

—Temporary price rigidities provide frictions that give rise to non-neutral effects of
monetary policy.
—Changes in aggregate demand result from the optimization behaviour of households
and firms (intertemporal consumption/ investment problem).
=> Current economic behavior depends also on expectations of the future course of monetary policy.

Question 3

He talks about past concept: Philips curve. What does Philips curve imply?

Answer 3

Low employment leads to slower wage increase, thus slower price increase, thus lower inflation

High employment leads to high inflation, since workers will be attracted by increase in wages, thus higher prices, thus higher inflation

Question 4

Aggregate supply?

Answer 4

Aggregate supply represents the total amount of goods and services that producers in an economy are willing and able to supply at a given overall price level, during a certain time period

Question 5

IS curve?

Answer 5

The IS (Investment-Saving) curve is a graphical representation showing the negative relationship between interest rates and the level of economic output (GDP) that equates the goods market. It suggests that higher interest rates reduce investment and savings, leading to lower economic output, while lower interest rates encourage borrowing, increase investment and consumption, and thus raise output. The IS curve is a fundamental concept in macroeconomic analysis, particularly in Keynesian economics

Question 6

Price stability = absence of inflation? .7

Answer 6

Price stability is not defined as the absence of inflation but as the inflation rate at which inflation is no longer of a concern : (1% < x < 3%)

Question 7

Taylor principle?

Answer 7

Whenever inflation exceeds targets, central bank needs to raise nominal rates more then proportionally to stabilise inflation

Question 8

Optimal Monetary Policy without Commitment?
Extreme inflation targeting is optimal under 2 circumstances?
Alpha?
Taylor principle?

Answer 8

The central bank retains the flexibility to respond to economic changes on a case-by-case basis.

Extreme inflation targeting is optimal under 2 circumstances: 1) cost push inflation is absent 2) there is no concern for output deviations (alpha = 0)

The parameter “α” in the context of monetary policy typically represents the sensitivity of the central bank’s actions to the output gap, which is the difference between actual and potential economic output. When “α” is set to zero, it indicates that the central bank is not considering the output gap when adjusting its policy. This means the bank would solely focus on inflation control, disregarding short-term variations in economic production. Such a stance could be optimal if the central bank aims to target inflation aggressively without concern for the immediate impact on economic growth or employment levels

Under the optimal policy, in response to a rise in expected inflation, nominal rates should rise sufficiently to increase real rates. Put differently, in the optimal rule for the nominal rate, the coefficient on expected inflation should exceed unity (=the Taylor Principle)

CB should adjust the interest rate in response to a demand shock. However nominal rates must stay constant by mere productivity shocks

Question 9

Indexation?

Answer 9

Indexation in economic terms refers to the adjustment of various figures – like income, prices, or investment returns – to maintain purchasing power and reflect changes in the cost of living, usually due to inflation. This practice is often applied to salaries, pensions, tax brackets, and interest rates on savings accounts to ensure that the real value does not decrease