THE CENTRAL BANK &
THE ECONOMY
Policymakers Model
of the Economy
Economy
Monetary
Transmission
Mechanism
Trade
Balance
Consumption
Investment
Financial
Markets
Money Market Rates
Interbank
Interest Rate
Inventories
Output Gap
• Disequilibrium in labor market (caused by wage stickiness
and job-search frictions) causes swings in unemployment.
• Potential output is the hypothetical level of output when
labor markets are in equilibrium.
• The output gap is the percentage deviation between
potential real GDP and real GDP.
Yt  Yt P
Output Gapt 
P
Yt
AS-AD Model
• Inflation and the output gap are jointly determined by the
intersection of aggregate expenditure and production
decisions.
• Negative relationship between inflation and expenditure
on goods and services.
• High inflation reduces competitiveness of exports
• High inflation reduces spending power of nominal assets (money)
• (Temporary) positive relationship between inflation and
producers willing to provide goods.
• Wages tend to be locked in by inflation expectations. When inflation
is ahead of expectation, firms will hire more workers.
AD Curve
• Negative relationship between inflation stems from
• Accelerating inflation makes exports less competitive and imports
more.
• Inflation reduces spending power of nominal assets (like money)
• Policy response of central bank (more later)
• AD curve may shift due to external shocks, fiscal policy,
exchange rates, asset prices, interest rates and but
importantly confidence about the future.
Short Run Aggregate Supply Curve
• Some wages and prices will be pre-set based on price-
setters 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 and wages.
• Over time, inflation expectations will adjust to actual
market outcomes.
AS-AD Model
When inflation equals
inflation expectations,
output is equal to
potential and Gap is
zero.
π
YP
AD
AS

π*
πE
Y*
Y
Gap
Inflation sets to clear supply equal to
demand. 
Recessionary Cycle
YP
π
Self-correction AD
process occurs
through the
adjustment of
expectations
AD
AS’

π*

In new
equilibrium,
inflation
continues to
fall but
output gap
falls
AS

Gap*
πE
Economy
begins in
equilibrium.
Demand contracts
for some reason.
Economy finds
new equilibrium
with slowing
inflation and a
negative output
gap.
Inflation
expectations
ratchet
Y
downwards in
response to low
inflation and
supply shifts
out as wage
demands
moderate
Monetary Policy Transmission Mechanism
π
Temporary
business cycle AD
expansion with
higher inflation
Inflation
expectations
accelerate until
they catch up
with actual
inflation
YP
AS’
AD
AS
Central bank
engages in
expansionary
monetary policy
πE

Aggregate
Demand
shifts out.

πE

Y
Gap*
Monetary Policy has no long-term effect on output gap
Aggregate
Supply Shifts
up
New longterm
equilibrium
with zero gap
and higher
inflation
Simple Macroeconomics
• Monetary policy primarily affects the demand through
various channels. Cutting interest rates shifts demand out;
raising interest rates shifts demand inward.
• In the face of an unstable demand curve (driven by
external shocks or animal spirits) counter-cyclical
monetary policy can simultaneously stabilize both inflation
and output.
• In the face of an unstable supply curve (driven by cost or
productivity shocks), the central bank faces a trade-off
between unstable inflation or unstable
π
YP
AS
AD
AD
RECESSIONARY
DEMAND SHOCK
CUT POLICY RATE
π*

 
πE
INFLATION AND
OUTPUT GAP
STABILIZED
Gap*
Recession with Counter-cyclical policy
Y
π
AD
AD
YP



SUPPLY SHOCK
RAISES COSTS
AND INFLATION
AS
AD
B. CUT
POLICY
RATES
AS

OUTPUT
STABILIZES
BUT
INFLATION
RISES
Trade-off w/ Supply Shocks
MONETARY
POLICY CHOICE:
A. RAISE POLICY
RATE
πE
INFLATION
STABILIZES BUT
OUTPUT GAP IS
DEEPER
Gap
Difficult Dynamics
• A number of factors related to the fact that the economy is
evolving over time make monetary policy more difficult.
1. Long and variable lags – Interest rate changes affect
economic decisions but inertia among firms and
consumers means this does not occur right away.
Today’s monetary policy must be set for future economic
conditions. Central bank must forecast the future and take
that into account.
Lags
• Data Lag – Measurement of the economy
• Recognition Lag – Time for data to cohere into actionabl
pattern.
• Legislative Lag
• Implementation Lag – Time for policymakers to take
action.
• Effectiveness Lag – Time for changes in policy to affect
economic outcome. Most important for monetary policy.
Difficult Dynamics pt. II
2. Asset prices and LT interest rates depend on market
expectations of future interest rates and strength of
impact on monetary policy.
Central bank controls only the overnight rate directly.
Central bank influences most rates and asset prices
through market expectations. The central bank must
communicate direction of policy with markets to enhance
effect on economy. Further, credibility of central bank
stabilization policies reduces financial market uncertainty
being a source of shocks to demand curve.
Asset Prices are function of the future
path of interest rates.
• Assets entitle the owner to a stream of future payments,
{DIV1 , DIV2 , DIV3 , DIV4 ,.....}
• Present value of stream of payments is sum of payments
discounted by the interest rate.
DIV3
DIV1 DIV2
DIV4
PV 



 .....
2
3
4
1  i (1  i2 ) (1  i3 ) (1  i4 )
• Asset prices anchored by fundamental value
Difficult Dynamics Part III
3. Current demand driven by consumers’ and firms’
expectations of future economic conditions.
Expectations channel an important part of economic
stabilization. Uncertainty about central bank commitment to
future stabilization policies could be a source of demand
shocks. Long-term credibility of monetary policy framework
as important to stabilization as current decisions.
Real Interest Rates and Demand
• Components of aggregate demand are sensitive to the
real interest rate in a negative way.
• Consumer Durables
• Residential Housing
• Corporate Investment
20
Example of the Policy Mechanism
Taylor Principle
•Real interest rate impacts demand for goods.
•Real interest rate is rt = it - E[πt+1]
•When E[πt+1] rises, central bank should increase it
more than 1-for-1 to raise real interest rate, limit
demand and limit inflation.
•When E[πt+1] falls, central bank should reduce it
more than 1-for-1 to drop real interest rate, raise
demand and avoid deflation.
Forward Looking Aggregate Demand
Equation
• Current theories of aggregate demand suggest that
spending is determined as a trade-off with future spending
with the real interest rate determining the balance of the
trade-off
• New Keynesian Aggregate Demand
Yt D  a  rt  b  Yt D1
b 1
Forward Looking Demand
Yt D  a  rt  b  Yt D1  .....
Yt D1  a  rt 1  b  Yt D2  .....
Yt D  a   rt  b  rt 1   b 2  Yt D2 .....
Yt D2  a  rt  2  b  Yt D3  .....
Current demand is determined by the path of future real interest rates
Yt 
D
a   rt  b  rt 1  b 2 rt  2  b3  Yt D3
......
Yt D3  a  rt 3  b  Yt D4  .....
Yt D  a   rt  b  rt 1  b 2 rt  2  b3rt 3  b 4 rt  4  b5 rt 5  ......
Difficult Dynamics pt. 4
4. Worker’s wage demands driven by inflation expectations.
Unstable inflation expectations can be a source of instability
in supply curve and may be responsible for a wage price
spiral.
“Thirty years ago, the public's expectations of inflation were not well
anchored. With little confidence that the Fed would keep inflation low and
stable, the public at that time reacted to the oil price increases by
anticipating that inflation would rise still further. A destabilizing wage-price
spiral ensued as firms and workers competed to "keep up" with inflation.
… The episode highlights the crucial importance of keeping inflation
expectations low and stable, which can be done only if inflation itself is
low and stable.” Bernanke, 2006
π
YP
AD
AS
AS
AD
If
central
bank
tries to
close
output
gap,
they
need to
ratify
inflation
expecta
tions.
Wage
demands
and firms
costs rise
Leads to 
stagflation

Wage Price Spiral

Workers
inflation
expectations
rise
πE
Implications
• Avoid monetary policy surprises since they can destabilize
the aggregate demand curve. Further, instability of
expectations of future monetary policy path can
destabilize financial markets and aggregate demand.
• Monetary policymakers need to communicate policy path
in order to have full effect on demand. Communication
policy should indicate future policy should move in a
stabilizing direction.
• Monetary policy must have credible commitment to a
stable, future inflation path.