lecture 11 Flashcards
The equation system of the New Keynesian model explains deviations of the variables from their steady state values. Explain the response of the economy to a technology shock.
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Why do central banks aim at keeping inflation low?
It is generally agreed that inflation is costly
- one reason is that inflation creates costs of proce adjustment when prices have to change
- for households, inflation makes holding money more costly
- surveys show that people do not like inflation
Which level of output should the central bank target?
the best strategy that monetary policy can follow is to commit to stabilize actual output around the natural level.
repeatedly trying to stimulate the economy above the natural level of output to move towards the efficient level will utimately lead to inflation higher than the target but to output at the natural level.
this is because the price setters will anticipate the higher inflation.
this is the equation for the natural real interest rate. What is the economic intutition behind it?
Why is it not sufficient to set the interest rate at the natural interest rate?
- there may be self-fulfilling fluctuations in output and prices
- this means that if everybody beleives the will be higher inflation and output, then there will indeed be higher output and ifnlation, even though all equilibrium conditions are satisfied.
- such beliefs can be triggered by some even that everbody observes, such as a bank collapse, animlar spirits or even changes in the number of spots on the sun’s surface
What is the divine coincidence?
- a policy, where both inflation and output are stabilized and there is no trade-off or conflict of goals.
- Both goals, clsoing the output gap and keeping inflation at its target are achieved by setting the nominal interest rate at the natural rate of interest and by promising to react to any fluctuations in inflation and output gap that could arise.
