Advanced Macroeconomics: Lecture 8 - MP 2 Shocks

Question 1

When and Why? A Rise in Inflation.

Answer 1

CB decisions process throughout stages of a shock:

T = -1: Pre-shock. Inflation is at normal figure e.g. 2%. Ye and Rs as well.

T = 0: External supply shock happens. π0 > πT. Thus inflation expectations for next period also up (CB knows PC will shift left in period 1). They must hike rates from Rs to R0 to try and cool down Y1. (Remember, in any given period, the only thing the CB can control is Y in the NEXT period)

T = 1: Y1 now results in π1 (lower inflation but still higher than πT). CB know PC will shift right (but only halfway back to original PC). Y1 is lower than Ye (as they intended), but must now lower rates to ensure that y1 < y2 < ye (that is, that output in the next period is closer to equilibrium than it was in this period.)

T = 2: Repeat of last period: CB must slowly keep lowering rates to ensure output increases as we move back towards equilibrium.

Question 2

Degree of inflation aversion by the CB

Answer 2

Question 3

Degree of inflation aversion by the CB cont.

Answer 3

Whichever axis the circle is “stretched” towards is the factor that CB are more averse to.

MR line also becomes flatter when CB is inflation averse. Intuition is that they are willing to sacrifice more output to tackle inflation when they are really inflation averse.

Question 4

Critiques of the NCM approach

Answer 4

1. Ignores the possibility of hysteresis after a shock / very restrictive CB policy
2. Fiscal policy is neglected due to crowding out, when in the real world we see it has a positive multiplier effect
3. No recognition of the role of the credit market, assumes a single interest rate for all borrowers which is not the case in reality
4. Suggests that contractionary MP is the only tool the fed have to fight inflation and asset bubbles, but contractionary MP is a “shotgun not a sniper” and sort of kills everything
5. Model assumes central bank can accurately forecast inflation (they can’t, lol).

Question 5

Summary of MP Shocks

Answer 5

CBs inflation averse when Beta > 1. MR curve also flattens as an inflation-averse CB are willing to sacrifice proportionally more output to tackle inflation.

Assuming CBs are inflation averse is probably a fair assumption wrt the real world. We see the fed being very hawkish and willing to pull a Volcker and nuke the economy to handle inflation.

Greater sensitivity of inflation to output i.e. greater “a” in intertial PC: π1 = π0 + a(y1 - ye) makes inflation more responsive to output. i.e. a smaller cut in output is necessary to tackle the same level of inflation.