Monetary Policy

Expectations Theory

For an investment of $1
it = today's interest rate on a one-period bond
ite1 = interest rate on a one-period bond expected for next period
i2t = today's interest rate on the two-period bond
Expectations Theory (cont’d)

Expected return over the two periods from investing $1 in the

two-period bond and holding it for the two periods
(1 + i2t )(1 + i2t )  1
 1  2i2t  (i2t ) 2  1
 2i2t  (i2t ) 2
Since (i2t ) 2 is very small
the expected return for holding the two-period bond for two periods is
2i2t
Expectations Theory (cont’d)

If two one-period bonds are bought with the $1 investment

e
(1  it )(1  i )  1
t 1
e e
1  it  i  it (i )  1
t 1 t 1

it  ite1  it (ite1 )
it (ite1 ) is extremely small
Simplifying we get
it  ite1
 The Aggregate Expenditure Curve
• The aggregate expenditure (AE) curve also
known as the IS curve depicts the negative
short-run relationship between the real
interest rate and output
• Output can be above or below potential
output, depending on the interest rate
The Aggregate Expenditure Curve
 Equilibrium Output
• The central bank’s choice of a nominal
interest rate determines the real rate of
interest
• The real rate corresponds to a certain amount
of aggregate expenditure on the AE curve
• Depending on the real interest rate, aggregate
expenditure can be above or below potential
output
Equilibrium Output
 Supply Shocks and the Phillips Curve
• Equation for Phillips curve
π = πe + α (Y – Y*)/Y* + ν
• If there is no shock ν = 0. If ν = 2% the shock
increases inflation by 2%
• The adaptive expectations version of the Phillips
curve shows that changes in inflation occur if there is
an output gap or a supply shock
π – π(–1 ) = α (Y – Y*)/Y* + ν
 The Complete Economy
• The aggregate expenditure and Phillips curves
together determine output and inflation
• The central bank chooses the real interest
rate, which determines output on the AE
curve
• The level of output relative to potential
determines the inflation rate on the Phillips
curve
 An Expenditure Shock
• Assume a positive expenditure shock, such as
a tax cut or increase in consumer confidence,
that shifts AE to the right
• If the real interest rate is constant, the shock
increases output and inflation
An Expenditure Shock
An Expenditure Shock
 Lags in the Phillips Curve
• Monetary policy affects inflation with a long
lag: one year to affect output and another
year to affect inflation
• Firms adjust prices slowly, often changing
prices once or twice a year
• Firms may be reluctant to change prices until
competitors do, slowing the adjustment of
prices
Time Lags and the Effects of Policy
• To include the effects of time lags assume the
following:
– For the AE curve, output is determined by the
interest rate 1 year ago r(–1)
– For the Phillips curve, inflation depends on output
1 year earlier Y(–1)
– Expected inflation equals last year’s inflation rate,
π(–1)
 A Disinflation
• Assume the central bank increases the real
interest rate for 2 years to reduce inflation
• Due to the lag effect on output, the decrease
of output begins 1 year later and occurs for 2
years
• Now it takes 2 years for inflation to fall
• The overall result is the same as with no lags,
but the timing changes with lags
A Disinflation with Time Lags
 Countercyclical Policy
• With no time lags, a countercyclical policy eliminates
the effects of expenditure shocks
• With time lags, expenditure shocks affect output and
inflation even if the central bank acts immediately
• Assume a temporary expenditure shock increases
output for 1 year
• The central bank knows the shock is temporary and
increases the real interest rate for 1 year
Countercyclical Policy with Time Lags
Countercyclical Policy with Time Lags
(cont.)
Countercyclical Policy with Time Lags
(cont.)
 Countercyclical Policy
• In the year of the expenditure shock, output is unaffected by
the increased real interest rate, as it is determined by the
previous year’s rate, so output increases above the natural
rate
• In the second year the previous year’s interest rate increase
lowers output below the natural rate
• Inflation increases 1 year after output increases and returns
to its original level 1 year after output falls below the natural
rate
• The expenditure shock has no long-run effects, but volatility
increases in the short run
• If the central bank did nothing, the increase in inflation
following the boom year would be permanent