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The Monetary Policy and Aggregate Demand Curves

The Monetary Policy and Aggregate Demand Curves

The and Aggregate Curves

The conducts monetary policy by setting the policy —the 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.

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Figure: The Monetary Policy Curve

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The Monetary Policy and Curves

• The monetary policy (MP) curve shows how monetary policy, measured by the real , reacts to the 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

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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  

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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 )

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Figure: Shifts in the Monetary Policy Curve

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Figure: The Inflation Rate and the , 2007–2010

SuSe 2013 Monetary Policy and EMU: The AS AD Model 7 The Aggregate

The aggregate demand curve represents the relationship between the inflation rate and aggregate demand when the is in equilibrium

The aggregate demand curve is central to aggregate demand and analysis, which allows us to explain short-run fluctuations in both aggregate 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 rises, so that spending and equilibrium aggregate output fall

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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 expenditure  Autonomous spending  purchases   Autonomous  Financial frictions

• Any factor that shifts the IS curve shifts the aggregate demand curve in the same direction

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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

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Figure: Shift in the AD Curve from Autonomous Monetary Policy Tightening

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Aggregate Demand and Supply Analysis Aggregate Demand

• Aggregate demand is made up of four component parts:  consumption expenditure (C), the total demand for consumer  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

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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 )

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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 analysis.

• If velocity stays constant, a constant implies constant nominal aggregate spending, and a decrease in the level is matched with an increase in aggregate demand.

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Figure: Leftward Shift in the Aggregate Demand

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Figure: Rightward Shift in the Aggregate Demand

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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

• An increase in spending from any of the components C, I, G, NX, will also shift AD to the right

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Table: Factors That Shift the Aggregate Demand Curve

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Aggregate Demand and Supply Analysis

• 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

• Short-run aggregate supply curve  and are sticky  Generates an upward sloping SRAS as firms attempt to take advantage of short-run profitability when price level rises

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Figure: Long- and Short-Run Aggregate Supply Curves

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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

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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

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Table: Factors That Shift the Short- Run Aggregate Supply Curve

A persistent

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Figure: Shift in the Short-Run Aggregate Supply Curve from Changes in Expected Inflation and Price Shocks

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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 *

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Figure: Short-Run Equilibrium

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Figure: Adjustment to Long-Run Equilibrium in Aggregate 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.

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Figure: Positive Demand

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 as a negative (or unfavorable) supply shock, and it results in a rise in 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. In the long run, however, output and inflation will be unchanged (holding the aggregate demand curve constant)

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Figure: Temporary Negative Supply Shock

SuSe 2013 Monetary Policy and EMU: The AS AD Model 39 Permanent Supply Shocks and Real Theory

• A permanent negative supply shock—such as an increase in ill-advised regulations that causes the economy to be less efficient, thereby reducing supply—would decrease and shift the long-run aggregate supply curve to the left

• Because the permanent supply shock will result in higher prices, there will be an immediate rise in inflation and so the short-run aggregate supply curve will shift up and to the left

• One group of , led by Edward Prescott of Arizona State University, believe that business cycle fluctuations result from permanent supply shocks alone and their theory of aggregate economic fluctuations is called real business cycle theory SuSe 2013 Monetary Policy and EMU: The AS AD Model 40

Figure: Permanent Negative Supply Shock

SuSe 2013 Monetary Policy and EMU: The AS AD Model 41 Conclusions Aggregate demand and supply analysis yields the following conclusions:

1. A shift in the aggregate demand curve affects output only in the short run and has no effect in the long run

2. A temporary supply shock affects output and inflation only in the short run and has no effect in the long run (holding the aggregate demand curve constant)

3. A permanent supply shock affects output and inflation both in the short and the long run

4. The economy has a self-correcting mechanism that returns it to potential output and the natural rate of unemployment over time

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Response of Monetary Policy to Shocks

• Monetary policy should try to minimize the difference between inflation and the inflation target (inflation gap)

• In the case of both demand shocks and permanent supply shocks, policy makers can simultaneously pursue and stability in economic activity

• Following a temporary supply shock, however, policy makers can achieve either price stability or economic activity stability, but not both. This tradeoff poses a dilemma for central banks with dual mandates

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Response to an Aggregate

• Policy makers can respond to this shock in two possible ways:  No policy response  Policy stabilizes economic activity and inflation in the short run

• In the case of aggregate demand shocks, there is no tradeoff between the pursuit of price stability and economic activity stability

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Figure: Aggregate Demand Shock: No Policy Response

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Figure: Aggregate Demand Shock: Policy Stabilizes Output and Inflation in the Short Run

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APPLICATION Quantitative (Credit) Easing to Respond to the Global

• Sometimes the negative aggregate demand shock is so large that at some point the central bank cannot lower the real interest rate further because the nominal interest rate hits a floor of zero, as occurred after the Lehman Brothers bankruptcy in late 2008

• In this situation when the zero-lower-bound problem arises, the central bank must turn to nonconventional monetary policy

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APPLICATION Quantitative (Credit) Easing to Respond to the Global Financial Crisis

• Though the Fed took action, the negative aggregate demand shock to the economy from the global financial crisis was so great that the Fed’s quantitative (credit) easing was insufficient to overcome it, and the Fed was unable to shift the aggregate demand curve all the way back and the economy still suffered a severe

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Response to a Permanent Supply Shock

• There are two possible policy responses to a permanent supply shock: -No policy response -Policy stabilizes inflation

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Figure: Permanent Supply Shock: No Policy Response

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Figure: Permanent Supply Shock: Policy Stabilizes Inflation

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Response to a Temporary Supply Shock

• When a supply shock is temporary, policymakers face a short-run tradeoff between stabilizing inflation and economic activity

• Policymakers can respond to the temporary supply shock in three possible ways:  No policy response  Policy stabilizes inflation in the short run  Policy stabilizes economic activity in the short run

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Figure: Temporary Aggregate Supply Shock: No Policy Response

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Figure: Temporary Aggregate Supply Shock: Short-Run Inflation Stabilization

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Figure: Temporary Aggregate Supply Shock: Short-Run Output Stabilization

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The Bottom Line: The Relationship Between Stabilizing Inflation and Stabilizing Economic Activity

We can draw the following conclusions from this analysis:

1. If most shocks to the economy are aggregate demand shocks or permanent aggregate supply shocks, then policy that stabilizes inflation will also stabilize economic activity, even in the short run. 2. If temporary supply shocks are more common, then a central bank must choose between the two stabilization objectives in the short run. 3. In the long run there is no conflict between stabilizing inflation and economic activity in response to shocks.

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How Actively Should Policy Makers Try to Stabilize Economic Activity?

• All economists have similar policy goals (to promote high employment and price stability), yet they often disagree on the best approach to achieve those goals

• Nonactivists believe government action is unnecessary to eliminate unemployment

• Activists see the need for the government to pursue active policy to eliminate high unemployment when it develops

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Figure: Monetary Expansion

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Figure: Monetary Expansion over time

SuSe 2013 Monetary Policy and EMU: The AS AD Model 59 Inflation: Always and Everywhere a Monetary Phenomenon

• This is supported by our aggregate demand and supply analysis because it shows that monetary policy makers can target any inflation rate in the long run by shifting the aggregate demand curve with autonomous monetary policy

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Figure: A Rise in the Inflation Target

SuSe 2013 Monetary Policy and EMU: The AS AD Model 63 Causes of Inflationary Monetary Policy

• High Employment Targets and Inflation

 Cost-push inflation results either from a temporary negative supply shock or a push by workers for hikes beyond what productivity gains can justify  Demand-pull inflation results from policy makers pursuing policies that increase aggregate demand

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