Macroeconomics EC2065 CHAPTER 9 - INFLATION, EXPECTATION, AND MACROECONOMIC POLICY

EC2065 MACROECONOMICS
CHAPTER 9: INFLATION, EXPECTATION, AND MACROECONOMIC POLICY

Learning outcome:
By the end of the chapter, you will be able to address the following questions:
• Can a fiscal stimulus raise GDP by more than the extra government spending?
• Should central banks prioritise controlling inflation or focus on trying to stabilise
fluctuations in real GDP?
• What options do central banks have when nominal interest rates fall to zero?
• What is forward guidance, and how effective is it as a monetary policy tool?
• Should inflation targeting be reformed, or abandoned and replaced by targets for
the price level or nominal GDP?
Essential readings:
Williamson, Chapter 15.
Introduction:
This chapter considers the link between inflation and business-cycle fluctuations when
prices are neither completely sticky nor completely flexible. We will also explore the
important role of expectations in analysing macroeconomic policy and consider the
challenges faced by the central bank when monetary policy is constrained by a lower bound
on interest rates.
1. Inflation and The Phillips Curve
• This section introduces a model that links inflation to the business-cycle fluctuations
studied in Chapter 8.
• The basic new Keynesian model from the previous chapter assumes all goods prices
are completely rigid, so that model says nothing about how inflation is determined.
On the other hand, full price flexibility implies the economy’s real interest rate is at
its natural rate and its real GDP reaches its natural level.
• In that case, Chapter 6 showed how inflation depends on monetary policy and other
real and financial variables but there was only a very limited effect of monetary
policy on real variables for moderate inflation rates because of the absence of
nominal rigidity.
PREPARED BY CHEN AIDI 1

• We now consider a model with partial price adjustment to bridge the two extremes
above. This model also implies a close link between inflation and the state of the real
economy, the Phillips curve.
Firms’ Incentives to Adjust Prices
• As explained in Chapter 8, with monopolistic competition, each firm wants to set a

price where 𝑀𝑅𝑃𝑁 = 𝑤, i.e. the marginal revenue product of labour is equal to the
real wage. If 𝑀𝑅𝑃𝑁 < 𝑤, the price charged by a firm is too low and it would want to
raise its price and sell less. If 𝑀𝑅𝑃𝑁 > 𝑤, the firm’s price is too high, and it would
want to lower the price and sell more.
• To understand why prices are not always set so that 𝑀𝑅𝑃𝑁 = 𝑤, we assume there
are costs of price adjustment. These were discussed in Chapter 8 point 1 and include
‘menu costs’ and the managerial costs of making pricing decisions.
• Firms compare these costs with the benefits of price adjustment when deciding
whether to set a new price. The gains a firm would make by adjusting the price of its
product and the magnitude of the desired price adjustment both increase with the
size of the gap between 𝑀𝑅𝑃𝑁 𝑎𝑛𝑑 𝑤.
• We will not set up a precise comparison of the costs and benefits of price
adjustment here but, in the background, this trade-off is why firms will not change
their prices all the time, nor leave their prices constant forever.
Price Changes and Economic Activity
• We now link the incentives to adjust prices to economic activity as measured by real
GDP 𝑌. When GDP 𝑌 is at its natural level 𝑌*, firms employ workers up to the point 𝑁*
where 𝑀𝑅𝑃𝑁 = 𝑤, as shown in the figure below:

• Firms would have no desire to change prices in this case. If 𝑌 is below 𝑌*,
employment 𝑁 is below 𝑁* and the diagram shows that 𝑀𝑅𝑃𝑁 > 𝑤, so a price cut is
desired. If 𝑌 is above 𝑌*, then 𝑀𝑅𝑃𝑁 < 𝑤, so a price increase is desired. This is
because the marginal revenue product 𝑀𝑅𝑃𝑁 falls with employment (𝑀𝑅𝑃𝑁 is
downward sloping), while the real wage 𝑤 rises (𝑁 𝑠 is upward sloping).
• Moreover, a larger gap between 𝑌 and 𝑌* means that firms’ desired price change is
larger and more firms will prefer to adjust prices after taking account of the costs of
doing so.
• Intuitively, as output and employment increase, the marginal product of labour 𝑀𝑃𝑁
declines (as does 𝑀𝑅𝑃𝑁 ), which increases firms’ marginal cost of production. The
wage 𝑤 must also increase to raise the supply of labour, which additionally adds to
the cost of production. It follows that the direction and size of price changes
depends on the ‘output gap’ between actual GDP 𝑌 and its natural level 𝑌*.
• Inflation is defined as the rate of change of the price level 𝑃 over time. The notation
we will use in this chapter is that 𝜋 is the inflation rate between the past and current
time periods (note this is different from our earlier notation in Chapter 6) and 𝜋′ is
the inflation rate between the current and future time periods, i.e. 𝜋=(𝑃−𝑃̅)/𝑃̅ and
𝜋′=(𝑃′−𝑃)/𝑃, where 𝑃̅ is the past level of prices.
• Mechanically, inflation 𝜋 is positive when firms are increasing prices on average, or

equivalently, when newly set prices are higher than the average of past prices 𝑃̅. By
the same logic, future inflation 𝜋′ is expected to be positive when firms will set
higher prices than the current average 𝑃 in the future.
Expectations
• When there are costs of making price changes and firms do not expect to be
adjusting prices continually, they also need to consider future conditions when
setting current prices.
• If it is desirable to set higher prices in future time periods then expected future
inflation 𝛱 ′𝑒 will be positive. Hence, any firm adjusting its prices in current period
will choose a larger price increase when 𝛱 ′𝑒 is higher, so higher expected future
inflation 𝛱 ′𝑒 leads to more inflation 𝜋 in the current time period.
• The effect of 𝛱 ′𝑒 on 𝜋 is less than one-for-one because less weight is given to future
conditions than current conditions when setting prices now.

The Phillips Curve
• We have seen that our model of partial price adjustment predicts inflation 𝜋 is
positively related to the output gap between 𝑌 and 𝑌* because higher 𝑌 raises 𝑤
and lowers 𝑀𝑅𝑃𝑁 , leading firms to have a greater desire to make larger price
increases.
• Inflation is also positively related to expected future inflation 𝛱 ′𝑒 , capturing firms’

desire to raise prices pre-emptively in response to expected future economic
conditions.
• We refer to the relationship between inflation 𝜋 and the output gap 𝑌−𝑌* as the
‘Phillips curve’. This is the upward-sloping line or curve 𝑃C in the diagram below with 𝜋
on the vertical axis and real GDP 𝑌 on the horizontal axis:
• If no future inflation is expected (𝛱 ′𝑒 =0), the Phillips curve passes through the point
with 𝜋=0 when 𝑌 =𝑌* because there is no inflationary pressure when output is at its
natural level and no future inflation is expected. The Phillips curve shifts to the right
if the natural level of output 𝑌* rises and shifts upwards if expected future inflation
𝛱 ′𝑒 is higher.
• The gradient of the Phillips curve indicates how much inflation 𝜋 rises when output 𝑌
increases. The Phillips curve would be flatter if there is less inflationary pressure
because of more nominal rigidity, for example, fewer firms being willing to change
price because the costs of price adjustment are larger.
• The Phillips curve is also flatter if there is greater ‘real rigidity’.

• Real rigidity refers to firms’ desired prices being less sensitive to what happens to
real GDP 𝑌. For example, if the marginal product of labour curve 𝑀𝑃𝑁 is flatter (and
hence, also 𝑀𝑅𝑃𝑁 ) because returns to labour diminish less rapidly, then firms’ cost
of production rises by less with output, reducing inflationary pressure. This also
occurs if the labour supply curve 𝑁 𝑠 is flatter, so wages need to rise by less to induce
an increase in labour supply.
• Another source of real rigidity is the presence of efficiency wage concerns that
mean real wages are less sensitive to economic conditions, for example, when a
particular constant real wage level maximises the amount of effective labour input
per unit of wages paid.
Inflation and Unemployment
• Traditionally, the Phillips curve was viewed as a negative relationship between the
inflation rate and the unemployment rate.
• By adding efficiency wages to our analysis of the labour market, we immediately

obtain this negative inflation-unemployment relationship from the ‘Phillips curve’ in
terms of inflation and the output gap explained earlier.
• The logic is that, for a given natural rate of unemployment and natural level of
output 𝑌*, an increase in 𝑌 raises employment and reduces unemployment relative
to the natural rate of unemployment.
• Hence, if unemployment below its natural rate then output 𝑌 is above 𝑌*, which
increases inflationary pressure, while if unemployment above its natural rate then 𝑌
is below 𝑌*, which decreases inflationary pressure.
• The downward-sloping Phillips curve in terms of inflation and unemployment passes

through the natural rate of unemployment at 𝜋 =0 when 𝛱 ′𝑒 =0. This Phillips curve
shifts with changes in inflation expectations or changes in the natural rate of
unemployment.
2. Expectations and Aggregate Demand
• We have seen that expectations of future inflation are an important feature of the
Phillips curve that explains current inflationary pressure. Expectations about the
future are also relevant to the level of aggregate demand for goods and services,
which we represented using the output demand curve 𝑌 𝑑 derived in Chapter 3.

• First, inflation expectations affect the real interest rate that results from the nominal
interest rate set by the central bank. Inflation can therefore affect incentives to save
or borrow.
• Second, expectations of the future state of the economy influence current

consumption and investment demand. This is because households have a desire to
smooth consumption in response to expected changes in future income, and
investment demand depends on expectations of the amount of future employment
of labour.
Inflation Expectations and Real Interest Rates
• In Chapter 3, we saw that both consumption and investment demand depend on the
expected real interest rate between the current and future time periods. Here, with
our notation that distinguishes between actual and expected inflation, we denote
the ex-ante real interest rate by 𝑟 𝑒 .
𝑒
• The Fisher equation implies: 𝑟 𝑒 = ⅈ − 𝜋 ′ . Given a nominal interest rate ⅈ, higher
expected future inflation 𝛱 ′𝑒 reduces the expected real interest rate 𝑟 𝑒 . This means
there is less incentive to save and a greater incentive to borrow. With these
substitution effects, and ignoring income effects with a representative household as
explained in chapter 3 point 11, higher 𝛱 ′𝑒 leads to higher 𝐶 𝑑 . It also raises
investment demand 𝐼 𝑑 according to the model from Chapter 3 point 8. Output
demand 𝑌 𝑑 therefore depends positively on expected future inflation 𝛱 ′𝑒 .
Expectations of The Economy’s Future GDP
• The consumption choice model studied in Chapter 3 shows that households’ optimal
consumption plan satisfies 𝑀𝑅𝑆𝐶,𝐶 ′ = 1 + 𝑟 𝑒 , where 𝑀𝑅𝑆𝐶,𝐶 ′ is the marginal rate of
substitution between current and future consumption.
• If consumption in the future 𝐶′ is expected to be higher then 𝑀𝑅𝑆𝐶,𝐶 ′ rises. Hence,

for the same expected real interest rate 𝑟 𝑒 , current consumption 𝐶 must increase to
satisfy 𝑀𝑅𝑆𝐶,𝐶 ′ = 1 + 𝑟 𝑒 . This reflects that both 𝐶 and 𝐶′ are normal goods, so for a
given relative price of current and future consumption as determined by the real
interest rate, households want both 𝐶 and 𝐶′ to rise or fall together. This is the desire
for consumption smoothing discussed in Chapter 3. Therefore, the expectation of
higher consumption in future raises consumption demand 𝐶 𝑑 in the current period.

• The model of investment in Chapter 3 implies that firms invest in capital up to the
point where 𝑀𝑃𝑘 ′ − 𝑑= 𝑟 𝑒 . If expectations of future employment 𝑁’ increase, this
raises the expected future marginal product of capital 𝑀𝑃𝑘 ′ .
• Note that any neoclassical production function with capital and labour has the
feature that a greater employment of labour increases the marginal product of
capital. Therefore, for a given real interest rate, the expectation of higher future
employment raises current investment demand 𝐼 𝑑 .
• In summary, we conclude that the output demand curve 𝑌 𝑑 shifts to the right if
expectations of future inflation 𝛱 ′𝑒 increase, or there are higher expectations of
future consumption or future employment. To simplify matters, we suppose that
future consumption and employment are both positively related to future real GDP,
so 𝑌 𝑑 shifts to the right if expectations of future GDP 𝑌’ increase.
3. Aggregate Demand with Market Imperfections
• In analysing the effects of macroeconomic policy on aggregate demand, we will see

that it can be important to incorporate some of the insights of our study of credit-
market imperfections in Chapter 4 and imperfectly competitive markets in Chapter
8.
• For example, it is sometimes claimed that increasing aggregate demand through

extra government expenditure 𝐺 gives rise to a positive feedback loop – a
‘multiplier’. The argument is that higher demand raises output and income, and
consumption then rises with income, further increasing demand and so on.
• However, this multiplier did not feature in our analysis of the output demand curve
𝑌 𝑑 from the dynamic macroeconomic model of Chapter 3. There we emphasised
that higher government expenditure 𝐺 increases the tax burden, reducing the
amount of private consumption 𝐶 that is affordable. Income 𝑌𝑌 did increase but, as
seen in Box 4.2, that was the result of the decision of households to supply more
labour when faced with a higher tax burden. Higher GDP 𝑌 caused by higher 𝐺 did
not in itself make households better off.
Consumption and Aggregate Demand
• In the new Keynesian model from Chapter 8, the presence of imperfect competition
means the level of GDP is not efficient. As 𝑀𝑃𝑁 > 𝑀𝑅𝑆𝑙,𝐶 , households are made better
off when higher aggregate demand for goods increases employment.

• Higher income itself makes households better off because the extra ability to
consume is worth more to households than the extra time spent working. In
addition, real wages 𝑤 can rise with aggregate demand and employment in the new
Keynesian model because 𝑤 begins below the marginal product of labour 𝑀𝑃𝑁 ,
unlike in the standard dynamic macroeconomic model.
• The consequence of the market imperfections is that consumption demand 𝐶 𝑑 now

depends directly on aggregate demand and income 𝑌 in addition to other factors – it
is still necessary to consider the effect of higher government expenditure 𝐺 on the
tax burden. The sensitivity of 𝐶 𝑑 to higher 𝑌 is labelled the marginal propensity to
consume (MPC):
𝜕𝐶 𝑑
𝑀𝑃𝐶 =
𝜕𝑌
• The aggregate demand for output is 𝑌 𝑑 = 𝐶 𝑑 + 𝐼 𝑑 + 𝐺. Consumption demand 𝐶 𝑑 is

now a function of 𝑌, and in equilibrium, income is equal to aggregate demand (𝑌=
𝑌 𝑑 ). The diagram below plots the expenditure function 𝑌 𝑑 against aggregate output
and income 𝑌:
• The gradient of the expenditure 𝑌 𝑑 as a function of 𝑌 is given by marginal

𝜕𝐶 𝑑
propensity to consume . In equilibrium, 𝑌 = 𝑌 𝑑 , so the level of output demand
𝜕𝑌
must lie on the 45𝑜 line in the diagram. Any factors affecting aggregate expenditure
𝑌 𝑑 apart from 𝑌 itself cause shifts of the expenditure function.

• If aggregate expenditure 𝑌 𝑑 were to increase, for example, owing to higher 𝐺, the

expenditure function shifts vertically upwards by the same amount. By finding the
new point of intersection with the 45𝑜 line, we see that the overall effect on 𝑌 is
larger than the size of the shift of the 𝑌 𝑑 function. A marginal propensity to
consume between 0 and 1 (making the expenditure function upward sloping but less
steep than the 45𝑜 line) amplifies the effects of changes in output demand 𝑌 𝑑
because of a positive feedback loop working through income and consumption.
• The consequences of this for the output demand curve 𝑌 𝑑 (a relationship between
real GDP 𝑌 and the real interest rate 𝑟) derived in Chapter 3 point 12 is that the 𝑌 𝑑
curve becomes flatter, i.e. more sensitive to 𝑟 and shifts become larger than they
would be in the standard dynamic macroeconomic model of Chapter 3.
Consumption and Aggregate Demand with Credit Market Imperfections
• Even in the new Keynesian model, the multiplier effect described above is usually
not strong enough to offset the direct effect of the higher tax burden on
consumption when public expenditure is increased.
• However, a stronger multiplier is found with the credit-market imperfections that

were studied in Chapter 4. We assume some households face a binding borrowing
limit. They cannot generate enough income in the current period to pay for their
desired level of consumption and they cannot borrow against future income. It is
important to appreciate that not all households in the economy will be in this
position – some will be savers – so we are moving away from the usual assumption
of a representative household.
• As explained in Chapter 4 point 3, households who are credit-constrained have a

marginal propensity to consume of 1 from disposable income (assuming all
households are able to increase the amount they work when aggregate output 𝑌
rises). Moreover, their current consumption does not respond to future taxes, only
to current taxes through their impact on disposable income.
• In contrast, households who are not credit-constrained have a much smaller

response of consumption to 𝑌 and adjust consumption in response to the present
value of all current and future taxes.

• The economy’s overall marginal propensity to consume is a weighted average of the

𝑀PC=1 for credit-constrained households and the low 𝑀PC of unconstrained
households, the weights depending on how much of aggregate consumption
spending comes from the two groups of households. This overall 𝑀PC determines
the gradient of the expenditure function seen in the diagram below and the size of
the multiplier effect.
• If there are sufficiently many constrained households, we will see that the overall
𝑀PC can be high enough to offset the negative impact on current consumption of
the higher future tax burden when the government increases public expenditure.
Box 9.1: Multiplier and Crowding Out Effects of Fiscal Policy
• We now re-examine the effects of a fiscal stimulus. There are two important changes
compared to our earlier analysis in Box 4.2. First, some households are credit
constrained. Second, prices are sticky (completely sticky here for simplicity) and we
suppose monetary policy is accommodative in the sense that the central bank holds
the real interest rate 𝑟 constant throughout.
• Consider an increase in government expenditure 𝐺 that is financed by running a

larger budget deficit, so there is no rise in current taxes 𝑇, only future taxes. The
wealth effect from the higher tax burden reduces consumption demand 𝐶 𝑑 but only
for those households who are not credit constrained.

• Credit-constrained households consume their disposable income and so have a

marginal propensity to consume of one and their current consumption does not
respond to the higher future taxes. This means that 𝐶 𝑑 depends on disposable
income 𝑌− 𝑇, which rises with 𝑌. Ignoring the effects of the tax burden on
unconstrained households, the increase in 𝐺 raises 𝑌 𝑑 more than one-for-one
because of the multiplier effect working through the consumption of the constrained
households.
• Compared to Box 4.2, the presence of some credit-constrained households means

there is less crowding out of consumption from the higher tax burden and new
multiplier effect on consumption. With no constrained households, we know the
rightward shift of the output demand curve 𝑌 𝑑 is smaller than the increase in 𝐺. But
as the fraction of credit-constrained households rises, the shift of 𝑌 𝑑 becomes larger
and can exceed than the increase in 𝐺.
• The other difference compared to the analysis in Box 4.2 is that sticky prices imply
the real interest rate 𝑟 is determined by the intersection of the 𝑌 𝑑 curve and the
𝑀𝑀 line, not 𝑌 𝑑 and the output supply curve 𝑌 𝑠 . This is shown in the following
diagram:
• If monetary policy is accommodative with a horizontal 𝑀𝑀 line remaining in the

same position then the real interest rate 𝑟 does not rise, in contrast to what happens
in an economy with flexible prices.

• The constant 𝑟 reduces crowding out of private consumption and investment

expenditure when 𝐺 rises. The increase in real GDP 𝑌 is equal to the size of the
horizontal shift of 𝑌 𝑑 and we have seen that this can be larger than the increase in 𝐺
when there are sufficiently many credit-constrained households.
• It is therefore possible that ‘multiplier’ effects dominate ‘crowding-out’ effects and

GDP rises by more than a deficit-financed increase in government expenditure.
Box 9.2: Asset Prices and The Financial Accelerator
• Shocks to aggregate demand can also be amplified through financial markets. For
example, supposing a decline in GDP leads to a reduction in asset prices, this
tightens credit constraints if those assets are used as collateral for borrowing.
• The greater difficulty of borrowing this causes then further reduces aggregate
demand and GDP. A feedback loop of this type is known as a ‘financial accelerator’.
• We can illustrate the financial accelerator using the limited-commitment model of

borrowing constraints and house prices from Chapter 4 point 6. We add to the
earlier model a reason why lower aggregate demand and GDP reduces house prices,
for example, borrowing constraints linked to the incomes of those buying houses, or
complementarities between housing and consumption expenditure on durable
goods.
• We assume the collateral constraint in the limited-commitment model is binding,

which implies the consumption of existing homeowners is linked to house prices.
• Suppose a negative shock to the economy reduces GDP. This leads to lower house
prices and causes a reduction in consumption of credit-constrained homeowners,
which in turn reduces aggregate demand and GDP, and depresses house prices
further.
Box 9.3: The 2008 Financial Crisis
What are the links between the 2008 financial crisis in the USA and the severity of the
‘great recession’ that followed?
• Our analysis of credit-market imperfections from Chapter 4 allows us to identify a

number of channels through which a financial shock can have a large impact on
aggregate demand and GDP.

• First, falling house prices reduce the value of collateral available to support
borrowing. Using the limited-commitment model from Chapter 4 point 6, this
reduces the consumption demand 𝐶 𝑑 of credit-constrained households, causing
𝑌 𝑑 to shift to the left.
• A financial crisis also leads to expectations of more defaults on debts, which raises
interest-rate spreads through the asymmetric information mechanism explained in
Chapter 4 point 5. The consequences of the higher interest rates faced by borrowers
are analysed in Box 4.5 and result in lower 𝐶 𝑑 for borrower households and lower 𝐼 𝑑
for firms without sufficient internal funds to finance investment. These effects lead
to a further shift of 𝑌 𝑑 to the left.
• Furthermore, falling asset prices and defaults result in losses for banks, which
reduces bank capital. As explained in Chapter 7, this means that banks may need to
restrict lending and deposit creation to satisfy bank capital requirements. Overall,
these factors imply a large leftward shift of the output demand curve 𝑌 𝑑 as shown in
the following diagram:
• Finally, the Federal Reserve was unable fully to offset the large leftward shift of 𝑌 𝑑
by reducing interest rates and shifting down the 𝑀𝑀 line. This is because of the
lower bound on the nominal interest rate, an issue we will discuss further in Chapter
9 point 7. Assuming the nominal interest rate ⅈ cannot fall below zero, the lowest
𝑒
possible real interest rate was − 𝜋 ′ , the negative of expected future inflation, and
inflation expectations were relatively low during the 2000s.

4. Inflation, Aggregate Demand and Monetary Policy
• The Phillips curve derived in the start of Chapter 9 implies a link between economic
activity and inflation. We will now consider which point on the Phillips curve the
economy will reach, which depends on the output demand curve and monetary
policy.
• There is an interaction with monetary policy because the central bank may adjust
interest rates in response to changes in inflation, for example, if it uses an interest-
rate feedback rule such as the Taylor rule studied earlier on.
• We will summarise the 𝑌 𝑑 curve and the stance of monetary policy with a single
curve that can be drawn in the same diagram as the Phillips curve and the
intersection between the two determines inflation 𝜋 and real GDP 𝑌.
• Suppose the central bank sets the nominal interest rate ⅈ and increases ⅈ in response
to higher inflation 𝜋. The ‘Taylor principle’ suggests ⅈ should rise more than one-for-
one with 𝜋 (recall the Fisher equation). The central bank also increases ⅈ in response
to GDP 𝑌 being higher than 𝑌*, using the natural level of output 𝑌* as the notion of
‘potential output’. In Chapter 8 point 2, in the diagram with the 𝑌 𝑑 and 𝑀𝑀 curves,
the 𝑀𝑀 curve is now upward-sloping and shifts upwards when inflation 𝜋 increases.
r
MM’ due to rise in 𝛱
MM
𝑟1
𝑟𝑜
𝑌𝑑
Y
𝑌1 𝑌0 > Y*
• Higher inflation 𝜋 thus causes an upward shift of the 𝑀𝑀 curve. The higher real
interest rate induced by monetary policy causes a reduction in aggregate demand, a
movement up the 𝑌 𝑑 curve and 𝑌 is lower.

• Taking as given expectations of 𝜋′ and 𝑌 ′ , this implies a negative demand-side

relationship between inflation 𝜋 and real GDP 𝑌. We label this the 𝑌 𝑑 −𝑀𝑀 line,
coming from the combination of the output demand curve and the stance of
monetary policy.
• Putting this together with the upward-sloping Phillips curve that represents the
supply side of the economy, the intersection between 𝑌 𝑑 −𝑀𝑀 and 𝑃C determines
inflation 𝜋 and real GDP 𝑌. This is illustrated in the following diagram:
• The 𝑌 𝑑 −𝑀𝑀 curve shifts to the right for the same reasons that cause the output
demand curve 𝑌 𝑑 to shift to the right. It shifts to the left if there is an exogenous
increase in the tightness of monetary policy. Using the links between expectations of
the future and aggregate demand studied in Chapter 9 point 2, it also shifts to the
right with an increase in expected future inflation 𝜋′ or expected future GDP 𝑌 ′ .
5. The Costs of Inflation
• Our discussions of macroeconomic policy have focused on obtaining a desirable

outcome for real GDP 𝑌, for example, by closing the output gap between 𝑌 and 𝑌*.
But there are also costs of inflation that make control of inflation a legitimate
objective of policy in its own right.
• Some costs of high inflation, arising from money being a poor store of value, have
already been analysed in Chapter 6 point 10. However, the nominal rigidities and the
unit of account function of money studied in Chapter 8 and here give rise to further
costs of inflation. They also suggest the optimal inflation rate might be different
from what was found in Chapter 6.

Money Being a Poor Store of Value
• As explained in Chapter 6 point 10, for a given real interest rate on bonds, higher
inflation makes money a worse store of value. This leads to time and resources being
wasted in trying to economise on holding money or creating substitutes for money.
It also reduces production because money being a poor store of value is an implicit
tax on economic activity.
• Hence, money’s medium of exchange function suggests there are costs of inflation,
or to be precise, costs of anticipated inflation. The earlier analysis of the Friedman
rule indicates these costs are eliminated only when there is deflation at a rate equal
𝑒
to the real interest rate (𝛱 ′ = −𝑟 𝑒 <0). This suggests the optimal inflation rate is
negative.
Menu Costs and Relative- Price Distortions
• The nominal rigidities in the new Keynesian model imply there are additional costs of
inflation. Costs incurred by firms in adjusting prices, for example menu costs and
managerial time, are higher as inflation – or deflation – increases.
• Since price adjustments are not perfectly synchronised across different firms,
positive or negative inflation rates also affect the relative prices of different goods,
causing misallocation of spending.
• Costs of these kinds increase as inflation 𝜋 rises above or falls below zero and occur
for both anticipated and unanticipated inflation. These considerations suggest
aiming for a zero rate of inflation.
Inflation and Redistribution
• Another potential problem of unanticipated inflation is the redistribution between

creditors and debtors it causes. To see this, suppose savers hold nominal bonds
issued by borrowers.
• The ex-ante Fisher equation ⅈ= 𝑟 𝑒 + 𝛱 ′𝑒 implies that higher expected inflation 𝛱 ′𝑒

can result in higher ⅈ, leaving the expected real return 𝑟 𝑒 on nominal bonds
unchanged.
• The ex-post Fisher equation is 𝑟 = ⅈ− 𝜋′, which indicates the real return on bonds
depends on the realised inflation rate 𝜋′ but the nominal interest rate ⅈ cannot
adjust if this inflation is unexpected.

• This logic suggests inflation should be as predictable as possible but does not provide
specific guidance on what the optimal inflation rate is.
Box 9.4: Inflation Targeting
• In light of the costs of inflation, one widely used monetary policy strategy is to make
controlling inflation the primary goal of monetary policy.
• Inflation targeting is where the central bank uses its policy instruments to try to
achieve inflation 𝜋 = 𝜋*, where 𝜋* is the target rate of inflation.
• Inflation-targeting central banks typically have targets for 2 per cent or 3 per cent
inflation with some margin for error.
The Benefits of Price Stability in The New Keynesian Model
• Although real-world central banks typically have positive inflation targets, the
nominal rigidities of the standard new Keynesian model suggest a zero inflation
target 𝜋* =0 is best (we will consider later a reason for targeting a positive inflation
rate).
• The costs of inflation linked to nominal rigidity are minimised by ensuring inflation 𝜋
is kept close to zero.
But what about the consequences for the stability of real variables such as GDP of this
exclusive focus on inflation?
• Assume the inflation target 𝜋 = 𝜋* =0 is achieved (and this is expected to continue in

the future as well). The new Keynesian model with partial price adjustment implies
there is no inflation or deflation only if firms are on average happy with the existing
prices they have previously set.
• With imperfect competition, these firms have no desire to raise or lower prices when
their marginal revenue product of labour 𝑀𝑅𝑃𝑁 is equal to the real wage 𝑤𝑤. But if
𝑀𝑅𝑃𝑁 = 𝑤 then employment must be such that the resulting supply of output is on
𝑌 𝑠 curve because 𝑀𝑅𝑃𝑁 = 𝑤 is what occurs when prices are fully flexible.
• This argument indicates that aiming for price stability (zero inflation) in the new
Keynesian model should result in real GDP 𝑌 being at the intersection of the 𝑌 𝑑 and
𝑌 𝑠 curves, hence, equal to the natural level of output 𝑌*. This means there would be
no output gap and the real interest rate would be at the natural rate of interest 𝑟*.
The pursuit of price stability thus results in real economic outcomes that are the
same as if prices were completely flexible.

𝑒
• With 𝛱 ′ = 0, monetary policy needs to set a nominal interest rate ⅈ = 𝑟= 𝑟* to
achieve the zero inflation target. Interestingly, this is exactly the same monetary
policy as the optimal stabilisation policy from Chapter 8 point 6 where there was no
need for any concern about inflation because prices were completely sticky. Here,
we have added an inflation objective alongside the desire to close the output gap,
but the same monetary policy is able to achieve both objectives.
Flexible or Strict Inflation Targeting?
Should central banks interpret an inflation target strictly to the exclusion of other
objectives? Or should meeting the inflation target be ‘flexible’, allowing also for
stabilisation of fluctuations in real GDP and employment?
• In the standard new Keynesian model, we have seen that aiming for 𝜋 =0 strictly
means accepting real GDP 𝑌 = 𝑌*, which closes the output gap. This suggests a
‘strict’ inflation target is not necessarily bad.
• One concern might be that real GDP 𝑌* is inefficiently low because 𝑀𝑅𝑃𝑁 = 𝑤*=
𝑀𝑅𝑆𝑙,𝑐 implies 𝑀𝑃𝑁 > 𝑀𝑅𝑆𝑙,𝑐 (recalling that 𝑀𝑃𝑁 >𝑀𝑅𝑃𝑁 ). But as we will see in Box
9.5, aiming for 𝑌 systematically above 𝑌 ∗ risks an inflation bias.
Putting aside concerns that output 𝑌* is too low on average, what about fluctuations in 𝑌*
and, hence, in actual real GDP 𝑌 = 𝑌* when 𝜋 =0? Will a strict inflation target cause real
GDP to fluctuate too much?
• Let us consider this point after when efficiency wages are added to the new Keynesian
model. This means the level of employment 𝑁* associated with the natural level of
output 𝑌* is found where the efficiency wage 𝑤* equals 𝑀𝑅𝑃𝑁 , rather than where
̂ is
𝑀𝑅𝑃𝑁 intersects the labour supply curve 𝑁 𝑠 . The efficient level of employment 𝑁
where 𝑀𝑃𝑁 = 𝑀𝑅𝑆𝑙,𝑐 , which lies on the 𝑁 𝑠 curve as shown in the diagram below:

• Now consider a negative supply shock that shifts 𝑀𝑃𝑁 and 𝑀𝑅𝑃𝑁 to the left. As
seen in the figure, this shock causes employment 𝑁* and output Y* to fall too much
compared to what is efficient (𝑁 ̂ ). Rigidities such as efficiency wages can therefore
make the levels of employment and output too volatile if the central bank follows a
strict inflation target resulting in 𝑁 =𝑁* and 𝑌= 𝑌*.
• In these circumstances, a flexible inflation target generally performs better than a

strict inflation target. Following a temporary negative supply shock, allowing
inflation 𝜋 to rise means 𝑁 will be above 𝑁* (this is a movement along the Phillips
curve). This is a better outcome because employment drops too much if 𝜋 =0,
although there is a trade-off between the cost of the positive inflation rate and the
better outcome for real GDP.
6. Time Inconsistency
• Macroeconomic policies such as monetary and fiscal policy can have a direct impact
on the economy. But since expectations of the future matter for current economic
outcomes, expectations of future policies can also affect the economy today.
• Policymakers will be able to achieve more if they are able to influence expectations
as well as take direct action. However, announcements of future policies might not
be credible because of the problem of ‘time inconsistency’.
• A policy is said to be time inconsistent if the policymaker gains in the current period
when the announcement is believed but does not gain by implementing the policy
when the time comes in future – even if nothing fundamental has changed.
• A time-consistent policy is one where there is no incentive ex post to follow a

different policy from the one it was optimal to announce earlier.
• Without the ability to commit to future actions, people have no incentive to believe
a policymaker will follow a time-inconsistent policy because the announcement lacks
credibility.
What makes some policies time inconsistent?
• Since expectations of the future influence the economy in the present, the
policymaker can achieve more in the current period if announcements of future
policy are believed and change expectations today.

• But that benefit lies in the past when the time comes in the future actually to
implement the announcement, so the policy that is now optimal to the policymaker
is different.
• For example, consider the announcement that tax rates on capital or capital income
will be low. If this is believed, it encourages investment and raises the capital stock.
Since building up new capital takes some time, it is expected future tax rates that
matters for investment decisions. But once capital is accumulated, the government
has an incentive to implement a ‘one-off’ capital levy to raise tax revenue.
• Another example is announcing a target for a low rate of inflation. If this is believed,
it reduces the nominal interest rate and money becomes seen as a better store of
value, which encourages economic activity.
• Note that it is expected future inflation that matters for the interest rate on nominal
bonds and decisions about holding money. However, ex post, the government has an
incentive to tolerate a ‘one-off’ burst of inflation to reduce the real value of
government liabilities through an inflation tax.
Box 9.5: The Inflation Bias Problem
• In the new Keynesian model, the central bank is able to raise real GDP 𝑌 by lowering
the real interest rate 𝑟. We saw in Chapter 8 point 6 and Box 9.4 how this makes it
possible for the central bank to pursue stabilisation policy that aims to close the
output gap between real GDP 𝑌 and the natural level of output 𝑌*, as well as achieve
price stability.
• However, the natural level of output 𝑌* is itself inefficiently low, with 𝑀𝑃𝑁 > 𝑀𝑅𝑆𝑙,𝑐
even at 𝑌= 𝑌* because 𝑀𝑃𝑁 = w= 𝑀𝑅𝑆𝑙,𝑐 and 𝑀𝑃𝑁 > 𝑀𝑅𝑃𝑁 . This inefficiency of 𝑌*
arises owing to distortions present in the economy in addition to the problem of
nominal rigidity that the stabilisation policy and inflation targeting are able to
mitigate.
• The basic source of distortions is the imperfect competition in the goods market that
leads firms to produce too little as a way of boosting profits. But other distortions
such as ‘efficiency wages’ or taxes that reduce the incentive to work also worsen the
inefficiency of the natural level of output.

In light of GDP being inefficiently low, should monetary policy aim to provide additional
stimulus even when 𝑌 = 𝑌*?
• Suppose monetary policy reduces the real interest rate below the natural interest
rate 𝑟* to push real GDP above its natural level 𝑌*. Taking as given inflation
expectations 𝛱 ′𝑒 , this policy moves the economy along a Phillips curve with output 𝑌
and inflation 𝜋 both rising. This seems to improve the outcome for real GDP, albeit at
the cost of some inflation.
• However, this policy is not a response to a shock but to economic activity being
judged systematically too low. Hence, the higher inflation that results from it can be
anticipated. This causes inflation expectations to rise, which shifts the Phillips curve
upwards.
• The upward shift of the Phillips curve worsens the combinations of inflation and real
GDP that can be attained by the central bank. Now, an even higher rate of inflation is
required to achieve a given target for the level of real GDP, and when that is
anticipated, this leads to even higher expected inflation.
• Eventually, inflation expectations stop rising when further inflation would be too
costly for the central bank to tolerate.
• These adverse shifts of the Phillips curve mean that there is higher inflation with only
a limited (or no) gain in terms of real GDP.
• Monetary policy therefore suffers from an ‘inflation bias’. The freedom to use
monetary policy to aim for the efficient level of real GDP leads to higher inflation,
but fails to achieve its original goal. It results in higher costs of inflation, without
gaining much or anything by way of a better outcome for real GDP.
• If the central bank were to announce it would target a lower rate of inflation and
inflation expectations fell, the Phillips curve would be in a more favourable position.
But then there would be a temptation to pursue an expansionary monetary policy to
raise 𝑌 above 𝑌*. This points to the time inconsistency of announcing a goal of lower
inflation.
• Owing to the time inconsistency problem, an announcement that the central bank
will pursue low inflation is not credible. But there would be gains from being able to
reduce inflation expectations and obtain a Phillips curve in a more favourable
position if the central bank were able to commit itself to a low-inflation monetary
policy.

What institutional mechanisms might enable the central bank to do this?
1. Giving the central bank independence might insulate it from political pressure to aim
for real GDP 𝑌 above 𝑌*.
2. Establishing a framework for monetary policy where the central bank is given the
primary task of controlling inflation and is judged by the public on how well it
performs in this might shift the focus of monetary policy away from the level of real
GDP.
• An independent central bank given the job of meeting an inflation target is the
current consensus on how best to achieve this.
• The central bank is usually allowed to interpret its inflation target ‘flexibly’ and
consider business-cycle fluctuations in real GDP in its policy deliberations but to
focus only on inflation in the long run.
7. Unconventional Monetary Policy at The Interest Rate Lower Bound
• An important obstacle to using monetary policy to stabilise the economy in the way
described in Chapter 8 point 6 is the interest-rate lower bound.
• It was argued the central bank could close the output gap and obtain 𝑌= 𝑌* by
setting the nominal interest rate ⅈ so that the implied real interest rate 𝑟 equals
natural rate of interest 𝑟∗.
• But as Chapter 6 point 13 explains, there is a limit on how far the nominal interest
rate ⅈ can be reduced by the central bank. This limit used to be seen as zero but is
now thought to be slightly negative (see Chapter 6 point 14 for one reason why).
• The ex-ante Fisher equation implies the real interest rate is 𝑟= ⅈ− 𝛱 ′𝑒 . Taking as given
inflation expectations 𝛱 ′𝑒 , if there is a lower bound ⅈ ≥0 on the nominal interest rate
(taken to be zero here) then the real interest rate is subject to the lower bound 𝑟 ≥−
𝛱 ′𝑒 . The real interest rate cannot fall below the negative of the rate of inflation that
is expected.

• The problem is that a large shock to the economy may reduce the natural rate of
interest 𝑟* below −𝛱 ′𝑒 , meaning that it is not feasible to get to 𝑟 = 𝑟* by lowering ⅈ.
This challenge for monetary policy is illustrated in the following diagram:
• The inability to use conventional monetary policy to stabilise the economy once the
interest-rate lower bound is reached has led central banks to use or consider using
unconventional monetary policies instead, such as:
1. Quantitative easing
2. Forward guidance
3. Negative interest rates.
Quantitative Easing:
If the central bank cannot reduce the nominal interest rate ⅈ, can it stimulate the economy
by increasing the money supply instead?
• Policies of this type are known as quantitative easing (QE).
• Suppose the central bank creates more money and purchases short-term nominal
government bonds. Since the interest-rate lower bound has been reached, these
short-term nominal government bonds have yield ⅈ =0.
• But as Chapter 6 point 13 has explained, at the interest-rate lower bound, the
demand for money becomes perfectly interest elastic because money and risk-free
nominal bonds are perfect substitutes at the margin – the ‘liquidity trap’.

• As shown in the diagram below, this additional money would be passively absorbed
into money demand but there would be no change in interest rates, prices, or real
GDP:
Can quantitative easing be adapted so that expansions of the money supply do have an
effect on the economy? What needs to be done differently?
• It is implicit in the example from the diagram above that the expansion of the money
supply is only temporary and would be reversed once the interest-rate lower bound
ceases to bind and QE is no longer needed.
• As explained in Box 6.3, the effects of a permanent expansion of the money supply
would be quite different, causing an increase in prices and inflation, and leading here
to a movement along the Phillips curve with higher economic activity. Hence, a
commitment to maintain a monetary expansion even in normal times in the future
might in principle be a more effective form of QE, although it may suffer from a
time-inconsistency problem and lack credibility if people think the central bank will
change course in the future.
• Another proposal is a ‘helicopter drop’ of money, where a monetary expansion is

transferred to the government and given away in the form of lower taxes or
increased transfer payments for households.
• In principle, this is very similar to the permanent expansion of the money supply
described above – which would deliver a fiscal gain to the government from reducing
the real value of existing money and nominal debt, and ultimately show up as lower
taxes.

• But one important difference is that it would be more difficult to reverse because
the central bank has given the money away and does not hold any additional assets
that could be used to buy back the money.
• While this policy might be more effective, it is widely seen as setting a dangerous
precedent and blurring the lines between monetary and fiscal policy.
• Rather than claim monetary expansions will be permanent, real-world central banks’
QE has instead attempted to get around the liquidity trap problem by making
purchases of long-term government bonds with a positive yield, or private-sector
assets such as corporate bonds or mortgage-backed securities. These assets share
the feature that they are risky, unlike short-term government bonds.
• Private-sector assets are subject to default risk and even long-term government
bonds are risky for those not holding them until maturity (see Box 7.5). These risky
assets are not perfect substitutes for money, unlike short-term government bonds at
interest-rate lower bound.
• We can use the model of portfolio choice from Chapter 7 point 8 to analyse the
effects of purchases of risky assets by the central bank. Central-bank purchases of
risky assets require in equilibrium that private investors hold a smaller fraction of
risky assets and a larger fraction of risk-free assets (the money the central bank
creates) in their portfolios.
• As shown in the diagram below, a lower risk premium is needed for this portfolio to
be chosen, so central-bank purchases result in a decline in risk premiums. This is
known as the ‘portfolio balance effect’. This then helps an economy at the lower
bound by reducing the cost of credit for risky borrowers, or those borrowing over
long periods.

Forward Guidance
• The term ‘forward guidance’ refers to an announcement made by the central bank
about the future path of interest rates.
• When the current nominal interest rate is at its lower bound, the central bank is still
able to give an indication of what it will do with future interest rates, at least to the
extent that future interest rates are not already themselves expected to be at the
lower bound.
• For example, there could be an announcement that interest rates will remain ‘lower
for longer’, i.e. the central bank will not raise interest rates as quickly as is currently
expected.
• If interest rates can be lowered in future periods then this would be expected to
raise future output 𝑌’ and future inflation 𝜋’. Higher expectations of 𝜋′ and 𝑌’ both
increase output demand in the current period through the channels explained in
Chapter 9 point 2 even though there is no immediate change in interest rates. Thus,
forward guidance might work through manipulating expectations of the future in a
way that improves current economic outcomes.
• However, the policy is not a ‘free lunch’ because future outcomes are worse if future
interest rates are set at an inappropriate level for the conditions then prevailing.
• This also points to a potential problem with the credibility of forward guidance. Once
the future period is reached, the central bank may not want to keep interest rates
too low.
• The benefit of announcing this was better economic outcomes in the past but that is
now a bygone, while the cost is worse current economic outcomes. This time-
inconsistency problem can undermine the credibility of a forward guidance
announcement.
• For people to believe the announcement, the central bank needs to make a binding
commitment but lacks any straightforward way to tie its hands.

Box 9.6: Inflation Targeting and The Interest Rate Lower Bound Problem
If the lower bound on nominal interest rates jeopardises macroeconomic stability and
unconventional monetary policies are seen as ineffective or costly are there any reforms
to economic policy that would mitigate the lower bound problem? For example, should
the existing framework of inflation targeting that is used in many countries be changed or
abandoned?
• Below we explore a number of alternatives:

1. Raising the inflation target
2. Average inflation targeting
3. Price level targeting or nominal GDP targeting
Raising the inflation target:
• Suppose a higher target 𝜋* for inflation is chosen. The Fisher equation with the real
interest rate at its natural rate 𝑟* in the long run implies ⅈ = 𝑟*+𝜋*. A higher inflation
target 𝜋* thus means a higher nominal interest rate ⅈ on average, which gives a
larger cushion to adjust ⅈ downwards.
• With 𝛱 ′𝑒 ≈ 𝜋* and a lower bound of zero on the nominal interest rate ⅈ, the real
interest rate can be reduced to −𝜋*, which is lower when 𝜋* is higher.
• Therefore, if inflation targets were raised, monetary policy can shift the 𝑀𝑀 line
further downwards. This gives the central bank a greater ability to offset larger
negative demand shocks. However, there are costs of having higher 𝜋 on average as
discussed earlier on.
Average Inflation Targeting:
• It would also be possible to replace the standard form of inflation targeting with
what is called ‘average inflation targeting’. This has the central bank aim for a target
based on the inflation rate averaged over a number of years.
• Average inflation targeting was adopted by the US Federal Reserve in August 2020.
• Consider an example of this policy where the target is for inflation averaged over
two periods. If this is credible, people expect that an average of current inflation 𝜋
and future inflation 𝜋′ will remain stable even if 𝜋 does not.
• Suppose 𝜋 falls because of a negative demand shock that the central bank cannot
offset because of the interest-rate lower bound.

• Under this policy, there is then an increase in expectations of 𝜋′ – assuming

monetary policy is not also constrained in the future period.
• As explained in Chapter 9 point 2, higher 𝛱 ′𝑒 reduces the real interest rate and
boosts demand in the current period.
Price-Level Targeting or Nominal GDP Targeting:
• Following a similar logic to average inflation targeting, targets for the level of prices
𝑃 have also been suggested.
• Price-level targeting is equivalent to a target for the inflation rate averaged over a
long period. Lower inflation now causes expected future inflation to rise so that the
future price level can return to its target level or path.
• Another alternative policy with some similar features is a target for the level of
nominal GDP.
• If credible, low inflation now means expectation of higher future inflation or higher
future real GDP, and expectations of higher 𝜋′ or 𝑌’ boost current demand.
Box 9.7: Forward Guidance and Confidence
• Central banks have increasingly used ‘forward guidance’ when nominal interest rates
are at their lower bound.
• With forward guidance, the central bank provides information about future path of
interest rates.
But how is that information interpreted by people in the economy?
• In Chapter 9 point 7, we described one interpretation, where people believe the

central bank will keep interest rates lower in future when it is not constrained by the
lower bound problem and that interest rates will be lower than future economic
conditions warrant.
• This future stimulus raises expectations of 𝜋′ and 𝑌′, which boosts the current level
of demand. In this case, forward guidance is interpreted as a commitment to keep
monetary policy excessively loose in the future.

• But another way people might interpret the forward guidance announcement is that
the central bank is more pessimistic about the economy. Hearing the forward
guidance announcement, they think the central bank must believe prospects for the
economy have become weaker if it is predicting future interest rates will be lower
than before.
• If the private sector revises its own beliefs after hearing the announcement then
confidence about the future declines. This leads to lower expectations of 𝜋′ and 𝑌′,
which reduce demand through the channels explained in Chapter 9 point 2, the
opposite of what the central bank intended if it was trying to make a commitment.
Box 9.8: Negative Interest Rate Policies
• We saw in Chapter 6 point 14 that it is possible for a central bank to reduce the
nominal interest rate ⅈ below zero. But there is still a lower bound −ℎ while physical
cash remains available, where ℎ is the proportional holding cost of cash taking
account of the need for secure storage.
• With interest rate lower bound ⅈ ≥−ℎ, the central bank can lower the real interest
rate 𝑟 =ⅈ −𝛱 ′𝑒 to −𝛱 ′𝑒 −ℎ at most.
• As shown in the diagram below, this gives further scope for monetary stimulus,
which can be effective through the usual channels:
• By setting negative nominal interest rates, the central bank can shift the 𝑀𝑀 line
further downwards along the 𝑌 𝑑 curve, which allows it to stabilise the economy for a
larger range of negative demand shocks.

• However, there may be costs of this negative interest rate policy. First, there can be
an inefficiently large use of cash to avoid negative rates, which wastes resources on
security and storage costs (see Chapter 6 point 14).
• Negative interest rates also mean banks cannot break even without negative interest
rates charged on deposits. But if households and firms were to switch from using
bank deposits to using cash as money then this would eliminate the benefits of
financial intermediation provided by banks (see Chapter 7 point 10).

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EC2065 MACROECONOMICS

CHAPTER 9: INFLATION, EXPECTATION, AND MACROECONOMIC POLICY

Williamson, Chapter 15.

1. Inflation and The Phillips Curve

PREPARED BY CHEN AIDI 1

Firms’ Incentives to Adjust Prices

• As explained in Chapter 8, with monopolistic competition, each firm wants to set a

Price Changes and Economic Activity

PREPARED BY CHEN AIDI 2

• Mechanically, inflation 𝜋 is positive when firms are increasing prices on average, or

PREPARED BY CHEN AIDI 3

The Phillips Curve

• Inflation is also positively related to expected future inflation 𝛱 ′𝑒 , capturing firms’

• The Phillips curve is also flatter if there is greater ‘real rigidity’.

PREPARED BY CHEN AIDI 4

Inflation and Unemployment

• By adding efficiency wages to our analysis of the labour market, we immediately

• The downward-sloping Phillips curve in terms of inflation and unemployment passes

2. Expectations and Aggregate Demand

PREPARED BY CHEN AIDI 5

• Second, expectations of the future state of the economy influence current

Inflation Expectations and Real Interest Rates

Expectations of The Economy’s Future GDP

• If consumption in the future 𝐶′ is expected to be higher then 𝑀𝑅𝑆𝐶,𝐶 ′ rises. Hence,

PREPARED BY CHEN AIDI 6

3. Aggregate Demand with Market Imperfections

• In analysing the effects of macroeconomic policy on aggregate demand, we will see

• For example, it is sometimes claimed that increasing aggregate demand through

Consumption and Aggregate Demand

PREPARED BY CHEN AIDI 7

• The consequence of the market imperfections is that consumption demand 𝐶 𝑑 now

• The aggregate demand for output is 𝑌 𝑑 = 𝐶 𝑑 + 𝐼 𝑑 + 𝐺. Consumption demand 𝐶 𝑑 is

• The gradient of the expenditure 𝑌 𝑑 as a function of 𝑌 is given by marginal

PREPARED BY CHEN AIDI 8

• If aggregate expenditure 𝑌 𝑑 were to increase, for example, owing to higher 𝐺, the

Consumption and Aggregate Demand with Credit Market Imperfections

• However, a stronger multiplier is found with the credit-market imperfections that

• As explained in Chapter 4 point 3, households who are credit-constrained have a

• In contrast, households who are not credit-constrained have a much smaller

PREPARED BY CHEN AIDI 9

• The economy’s overall marginal propensity to consume is a weighted average of the

Box 9.1: Multiplier and Crowding Out Effects of Fiscal Policy

• Consider an increase in government expenditure 𝐺 that is financed by running a

PREPARED BY CHEN AIDI 10

• Credit-constrained households consume their disposable income and so have a

• Compared to Box 4.2, the presence of some credit-constrained households means

• If monetary policy is accommodative with a horizontal 𝑀𝑀 line remaining in the

PREPARED BY CHEN AIDI 11

• The constant 𝑟 reduces crowding out of private consumption and investment

• It is therefore possible that ‘multiplier’ effects dominate ‘crowding-out’ effects and

Box 9.2: Asset Prices and The Financial Accelerator

• We can illustrate the financial accelerator using the limited-commitment model of

• We assume the collateral constraint in the limited-commitment model is binding,

Box 9.3: The 2008 Financial Crisis

• Our analysis of credit-market imperfections from Chapter 4 allows us to identify a

PREPARED BY CHEN AIDI 12

PREPARED BY CHEN AIDI 13

4. Inflation, Aggregate Demand and Monetary Policy

PREPARED BY CHEN AIDI 14

• Taking as given expectations of 𝜋′ and 𝑌 ′ , this implies a negative demand-side

5. The Costs of Inflation

• Our discussions of macroeconomic policy have focused on obtaining a desirable

PREPARED BY CHEN AIDI 15