NK Model With Inflation Flashcards
The Fisher equation states that:
R = r + i. Thus: real interest rates (r) fall as inflation (I) increases. Nominal interest rate (R) has a 1:1 effect on r. Therefore the CB can directly change alter r by adjusting R.
Supply Side states that:
Supply SIde = NKPC (gives way for inflation). NKPC = i = bi’+a(Y - Ym). Through the NKPC output can directly affect inflation. Thus: alterations in R have 1:1 affect on r. r directly affects Y, Y directly affects i.
Demand Side states that:
Demand Side = Y - Ym = -a(r - r*). Shows how a change in r directly affects Y. r and Y have a negative relationship: if r increases then Y decreases, this is since increased r defers borrowing but promotes saving: reducing C and I. Given: AD = C + I + G, decrease to C/I correlates directly to decreased Y.
How can CB overcome ZLB?
Standard MP is insufficient when optimal MP - via TR - suggests that R must fall below ZLB to optimise Y. CB can however increase i by promising increased i’. A rise in i must mean r falls (negative relationship). A fall in r given R=r+i, has 1:1 affect on R, thus R decrease by the same amount. In future periods CB may opt not to set i’ at promised rate as economy was stabilised in past periods. Essentially, through the promise of increased i’, CB can optimise i and r in current periods (optimal policy).
How can CB affect inflation?
CB can alter the inflation rate (i) through alterations in the nominal interest rate (R). CB choose R, Given the fisher equation R=r+i (and the fact inflation is fixed), R has a 1:1 effect on the real interest rate (r). Via the output equation: Y-Ym= -α(r-r*), the real interest rate directly affects output. Through the NKPC, we can see how output directly affects the inflation rate (i).
What is divine coincidence?
The ability for CB to stabilise the output gap and the inflation rate around its targets. This is possible in the NK model with inflation, as CB can control the output (thus inflation via the NKPC) through adjusting R which adjusts r.
What does the NK with inflation Model support?
Allows for inflation within the model as it is now an endogenous variable. Shows how via the NKPC CB can indirectly affect inflation (I) - through alteration of R.
