Economy
Money Market Rates
Interbank
Interest Rate
Inventories
Trade
Balance
Investment
Consumption

• How does the central bank gauge whether the current monetary policy is effective in guiding the economy toward its goals?
• If it is not, how do they choose the level of the operating target in order to guide the economy toward its goals?

• Components of aggregate demand are sensitive to the real interest rate in a negative way.
•
• Consumer Durables
Residential Housing
• Corporate Investment
• High interest rates means an exchange rate appreciation which hurts the trade balance.

r
• Expenditure is negatively related to the real interest rate.
AE
Y

• But other factors r like consumer or business confidence, fiscal policy, or foreign demand factors will shift spending at any given interest rate.
AE’
AE
AE’’
Y

The central bank stabilizes inflation using the interest rate target.
•
• If inflation is above target, π TGT , central bank will raise interest rate
If inflation is below target, π TGT , central bank will cut interest rate
Under Taylor Principle, inflation above target is associated with rising real rates.
r t r
* b

  t
 TGT
 r * - Neutral real interest target b – inflation sensitivity

• Real interest rate is an increasing r function of the interest rate r*
Monetary Policy Reaction Curve
MPR
π TGT
π

• The reaction of monetary policy to inflation exacerbates the effect of inflation on
AD.
Increasing π →Increasing r → Decreasing AD
π
• The more sharply that monetary policy responds to inflation, the more sharply demand responds to inflation.
Aggregate Demand Curve
AD
Y

Relationship between inflation and aggregate demand depends on how sensitive MPC is to inflation r
Sensitive
MPR
π
Insensitive
AD
Insensitive
MPR
Sensitive
AD
π
Y

• Some wages and prices will be pre-set based on pricesetters inflation expectations. When inflation is accelerating ahead of expectations, firms will respond with extra production (ex. McDonalds).
• Potential output is an efficient level of production when inflation expectations match actual inflation. Associated with an economy with flexible prices.
•
• The output gap is the percentage deviation between potential real GDP and real GDP.
Output Gap t

Y t

Y t
P
Y t
P

π E
π
SRAS
Y
Y P

• Various events may shift demand out for goods at any given interest rate
• Household consumption may increase because of optimism or wealth effect
• Corporate investment may increase because of optimism
• Government Deficit
Spending
Rise in Household-Business Confidence\Stock-
Real Estate Market Booms\Expansionary Fiscal policy The AD Curve Shifts Out
π
AD'
AD
Y

π
Expansion Short –run Demand Shifts Up
Y P
2
1
Inflationary Output Gap
SRAS
Y
AD
AD ′

π
Recession Short –run Demand Shifts Down
Y P
1
2
SRAS
Recessionary Output Gap
AD ′
AD
Y

• Adaptive Expectations: Inflation expectations adjust to actual inflation
•  E t
 E t-1
=  [  t
 E t-1
]
• The SRAS adjusts to self-correct the output gap.
• Eventually, inflation expectations catch up with inflation.

π
Inflation Expectations Shift Upward
Y P
3
2
1
SRAS
Y
AD
AD ′
Inflationary Output Gap

•
π
The more sensitive is monetary policy, the flatter is the AD curve.
• The flatter the
AD curve, the less that inflation will need to decline to return the economy to potential output .
2b
2a
Y P
1
SRAS
AD
Sensitive
AD
Insensitive
Y

• Under inflation targeting, central bank is sensitive to the inflation rate in setting the interest rate, raising interest rates in response to increasing inflation, cutting interest rates
• A benefit of this approach is not only stable inflation and inflation expectations, but also more stability of output and shorter duration business cycles in the face of demand shocks.

21
Japan
3
2
1
-8 -6 -4 -2
0
0
-1
2 4 6
-2
-3
Output Gap
• When output gap is negative, inflation tends to be decelerating.
Stabilizing inflation can also stabilize the business cycle
Inflation Acceleration =
Inflation
Today

Inflation
LastYear

• Inflation itself may be subject to cost-push shocks such as energy prices etc.
• A monetary policy committee which strives to maintain a fixed inflation target with a very sensitive MPR will face a relatively large decline in output to maintain the target.
• Central bank often adjusts the inflation target to supply side conditions

π
2
Y P
Supply Shock
Stagflation
SRAS ′
1
SRAS
Y
AD

π B
A
Y P
SRAS
SRAS
AD
Sensitive
AD
Insensitive
Y

• Remember in HK, the nominal interest rate is equal to the
US$ interest rate.
• Again, assume that inflation expectations respond to actual inflation
 t
E

1
  t
 r t
HK  i t
HK  r t
HK  r t
US 


USA
 t
 t
HK


E ,
,

1
• In HK, as inflation rises, real interest rate falls!

Negative Relationship between inflation and real interest rate with fixed exchange rates r
MPR HK
π

Under fixed exchange rate, domestic interest rate & demand may be insensitive to domestic inflation r
Sensitive
MPR
π
Fixed S
AD
Fixed S
MPR
Sensitive
AD
π
Y