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The Monetary Policy and Aggregate Demand Curves

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The Monetary Policy and Aggregate Demand Curves The Monetary Policy and Aggregate Demand Curves The central bank conducts monetary policy by setting the policy rate—the interest rate at which banks lend to each other. When the central bank lowers the policy rate, real interest rates fall; and when the central bank raises the policy rate, real interest rates rise. SuSe 2013 Monetary Policy and EMU: The AS AD Model 1 Figure: The Monetary Policy Curve SuSe 2013 Monetary Policy and EMU: The AS AD Model 2 The Monetary Policy and Aggregate Demand Curves • The monetary policy (MP) curve shows how monetary policy, measured by the real interest rate, reacts to the inflation rate, : rr where rr autonomous component of responsiveness of r to inflation • The MP curve is upward sloping: real interest rates rise when the inflation rate rises SuSe 2013 Monetary Policy and EMU: The AS AD Model 3 The Monetary Policy and Aggregate Demand Curves • The key reason for an upward sloping MP curve is that central banks seek to keep inflation stable • Taylor principle: To stabilize inflation, central banks must raise nominal interest rates by more than any rise in expected inflation, so that r rises when rises • Schematically, if a central bank allows r to fall when rises, then ( Y ad =AD) : r Yad r Y ad SuSe 2013 Monetary Policy and EMU: The AS AD Model 4 Shifts in the MP Curve Two types of monetary policy actions that affect interest rates: • Automatic (Taylor principle) changes as reflected by movements along the MP curve • Autonomous changes that shift the MP curve Autonomous tightening of monetary policy that shifts the MP curve upward (in order to reduce inflation) Autonomous easing of monetary policy that shifts the MP curve downward (in order to stimulate the economy) SuSe 2013 Monetary Policy and EMU: The AS AD Model 5 Figure: Shifts in the Monetary Policy Curve SuSe 2013 Monetary Policy and EMU: The AS AD Model 6 Figure: The Inflation Rate and the Federal Funds Rate, 2007–2010 SuSe 2013 Monetary Policy and EMU: The AS AD Model 7 The Aggregate Demand Curve The aggregate demand curve represents the relationship between the inflation rate and aggregate demand when the goods market is in equilibrium The aggregate demand curve is central to aggregate demand and supply analysis, which allows us to explain short-run fluctuations in both aggregate output and inflation SuSe 2013 Monetary Policy and EMU: The AS AD Model 8 Deriving the Aggregate Demand Curve Graphically • The AD curve is derived from: The MP curve The IS curve • The AD curve has a downward slope: As inflation rises, the real interest rate rises, so that spending and equilibrium aggregate output fall SuSe 2013 Monetary Policy and EMU: The AS AD Model 9 Figure: Deriving the AD Curve SuSe 2013 Monetary Policy and EMU: The AS AD Model 10 Factors that Shift the Aggregate Demand Curve • Shifts in the IS curve Autonomous consumption expenditure Autonomous investment spending Government purchases Taxes Autonomous net exports Financial frictions • Any factor that shifts the IS curve shifts the aggregate demand curve in the same direction SuSe 2013 Monetary Policy and EMU: The AS AD Model 11 Figure: Shift in the AD Curve From Shifts in the IS Curve SuSe 2013 Monetary Policy and EMU: The AS AD Model 12 Factors that Shift the Aggregate Demand Curve (cont’d) • Shifts in the MP curve An autonomous tightening of monetary policy, that is a rise in real interest rate at any given inflation rate, shifts the aggregate demand curve to the left Similarly, an autonomous easing of monetary policy shifts the aggregate demand curve to the right SuSe 2013 Monetary Policy and EMU: The AS AD Model 13 Figure: Shift in the AD Curve from Autonomous Monetary Policy Tightening SuSe 2013 Monetary Policy and EMU: The AS AD Model 14 Aggregate Demand and Supply Analysis Aggregate Demand • Aggregate demand is made up of four component parts: consumption expenditure (C), the total demand for consumer goods and services planned investment spending (I), the total planned spending by business firms on new machines, factories, and other capital goods, plus planned spending on new homes government purchases (G), spending by all levels of government (federal, state, and local) on goods and services net exports (NX), the net foreign spending on domestic goods and services SuSe 2013 Monetary Policy and EMU: The AS AD Model 15 Aggregate Demand and Supply Analysis Aggregate Demand Y ad C I G NX The aggregate demand curve is downward sloping because r I Y ad (You might have seen the following version, it is indeed the same story!) (P M / P i I Y ad ) (P M / P i E NX Y ad ) SuSe 2013 Monetary Policy and EMU: The AS AD Model 16 Aggregate Demand and Supply Analysis Aggregate Demand • The fact that the aggregate demand curve is downward sloping can also be derived from the quantity theory of money analysis. • If velocity stays constant, a constant money supply implies constant nominal aggregate spending, and a decrease in the price level is matched with an increase in aggregate demand. SuSe 2013 Monetary Policy and EMU: The AS AD Model 17 Figure: Leftward Shift in the Aggregate Demand SuSe 2013 Monetary Policy and EMU: The AS AD Model 18 Figure: Rightward Shift in the Aggregate Demand SuSe 2013 Monetary Policy and EMU: The AS AD Model 19 Factors that Shift the Aggregate Demand Curve • An increase in the money supply shifts AD to the right: holding velocity constant, an increase in the money supply increases the quantity of aggregate demand at each price level • An increase in spending from any of the components C, I, G, NX, will also shift AD to the right SuSe 2013 Monetary Policy and EMU: The AS AD Model 20 Table: Factors That Shift the Aggregate Demand Curve SuSe 2013 Monetary Policy and EMU: The AS AD Model 21 Aggregate Demand and Supply Analysis Aggregate Supply • Long-run aggregate supply curve Determined by amount of capital and labor and the available technology Vertical at the natural rate of output generated by the natural rate of unemployment • Short-run aggregate supply curve Wages and prices are sticky Generates an upward sloping SRAS as firms attempt to take advantage of short-run profitability when price level rises SuSe 2013 Monetary Policy and EMU: The AS AD Model 22 Figure: Long- and Short-Run Aggregate Supply Curves SuSe 2013 Monetary Policy and EMU: The AS AD Model 23 Aggregate Demand and Supply Analysis Shifts in the Aggregate Supply Curves • Shifts in the long run aggregate supply curve The long-run aggregate supply curve shifts to the right from when there is 1) an increase in the total amount of capital in the economy, 2) an increase in the total amount of labor supplied in the economy, 3) an increase in the available technology, or 4) a decline in the natural rate of unemployment An opposite movement in these variables shifts the LRAS curve to the left SuSe 2013 Monetary Policy and EMU: The AS AD Model 24 Figure: Shift in the Long-Run Aggregate Supply Curve SuSe 2013 Monetary Policy and EMU: The AS AD Model 25 Shifts in the Short-Run Aggregate Supply Curve • There are three factors that can shift the short-run aggregate supply curve: expected inflation price shocks a persistent output gap SuSe 2013 Monetary Policy and EMU: The AS AD Model 26 Table: Factors That Shift the Short- Run Aggregate Supply Curve A persistent SuSe 2013 Monetary Policy and EMU: The AS AD Model 27 Figure: Shift in the Short-Run Aggregate Supply Curve from Changes in Expected Inflation and Price Shocks SuSe 2013 Monetary Policy and EMU: The AS AD Model 28 Figure: Shift in the Short-Run Aggregate Supply Curve from a Persistent Positive Output Gap SuSe 2013 Monetary Policy and EMU: The AS AD Model 29 Equilibrium in Aggregate Demand and Supply Analysis • We can now put the aggregate demand and supply curves together to describe general equilibrium in the economy, when all markets are simultaneously in equilibrium at the point where the quantity of aggregate output demanded equals the quantity of aggregate output supplied SuSe 2013 Monetary Policy and EMU: The AS AD Model 30 Short-Run Equilibrium • The following Figure illustrates a short-run equilibrium in which the quantity of aggregate output demanded equals the quantity of output supplied • In the next Figure, the short-run aggregate demand curve AD and the short-run aggregate supply curve AS intersect at point E with an equilibrium level of aggregate output at Y * and an equilibrium inflation rate at * SuSe 2013 Monetary Policy and EMU: The AS AD Model 31 Figure: Short-Run Equilibrium SuSe 2013 Monetary Policy and EMU: The AS AD Model 32 Figure: Adjustment to Long-Run Equilibrium in Aggregate Supply and Demand Analysis SuSe 2013 Monetary Policy and EMU: The AS AD Model 33 Self-Correcting Mechanism • Regardless of where output is initially, it returns eventually to the natural rate • Slow Wages are inflexible, particularly downward Need for active government policy • Rapid Wages and prices are flexible Less need for government intervention SuSe 2013 Monetary Policy and EMU: The AS AD Model 34 Changes in Equilibrium: Aggregate Demand Shocks • With an understanding of the distinction between the short- run and long-run equilibria, you are now ready to analyze what happens when there are demand shocks, shocks that cause the aggregate demand curve to shift. SuSe 2013 Monetary Policy and EMU: The AS AD Model 35 Figure: Positive Demand Shock SuSe 2013 Monetary Policy and EMU: The AS AD Model 36 Changes in Equilibrium: Aggregate Supply (Price) Shocks • The aggregate supply curve can shift from temporary supply (price) shocks in which the long-run aggregate supply curve does not shift, or from permanent supply shocks in which the long-run aggregate supply curve does shift SuSe 2013 Monetary Policy and EMU: The AS AD Model 37 Changes in Equilibrium: Aggregate Supply (Price) Shocks Temporary Supply Shocks: • When the temporary shock involves a restriction in supply, we refer to this type of supply shock as a negative (or unfavorable) supply shock, and it results in a rise in commodity prices • A temporary negative supply shock shifts the short-run aggregate supply curve upward and to the left, leading initially to a rise in inflation and a fall in output.
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