Macroeconomics

Lecture 11

Monetary Policy and the Phillips Curve

Kriti Khanna
Plaksha University
MP Curve
Nominal Interest rate set by the central
bank determines the real interest rate

IS Curve
Real interest rate influences GDP in the
short run

Phillips Curve
How booms and recessions effect
evolution of inflation
 How Does the RBI set nominal interest rates?
RBI controls nominal interest rates by controlling the supply of money

• Repo Rate & Reverse Repo Rate:

Repo Rate or Repurchase Rate is the rate at which the RBI lends funds to commercial banks
and other financial institutions within the country.
Reverse Repo Rate is the rate at which the RBI borrows money from the commercial banks and
other financial institutions within the country.

• Reserve Ratios: CRR and SLR

CRR (Cash Reserve Ratio) - Banks are required to set aside this portion in cash with the RBI.
The bank can neither lend it to anyone nor can it earn any interest rate or profit on CRR.
Statutory Liquidity Ratio (SLR) - Banks are required to set aside this portion in liquid assets
such as gold or RBI approved securities such as government securities. Banks are allowed to
earn interest on these securities, however it is very low.
 How Does the RBI set nominal interest
rates?
• Open Market Operations:
In order to control money supply, the RBI buys and sells government
securities in the open market. These operations conducted by the
Central Bank in the open market are referred to as Open Market
Operations. When the RBI sells government securities, the liquidity is
sucked from the market, and the exact opposite happens when RBI
buys securities. The latter is done to control inflation.
From Nominal Interest Rates to Real Interest
Rates
• Changes in nominal interest rate will lead
to changes in real interest rate as long as
they are not offset by corresponding
changes in inflation

• Sticky inflation assumption: The rate of

inflation displays inertia, or stickiness, so
that it adjusts slowly over time. In the
very short run—say within 6 months or
so—we assume that rate of inflation
does not respond directly to changes in
monetary policy

• Central banks have the ability to set the

real interest rate in the short run.
 The IS-MP Diagram

Central banks set the real interest rate at a particular value: the MP curve is represented by
a horizontal line
What happens when central bank raises interest rates?

Because inflation is slow to

adjust, an increase in the
nominal interest rate raises the
real interest rate. Since the real
interest rate is now above the
marginal product of capital,
firms and households cut back
on their investment, and
output declines.
Example: End of a Housing Bubble
Suppose housing prices had
been rising, but then they fall
sharply.

- The aggregate demand

parameter declines (a falls)
- The IS curve shifts left

If the central bank lowers the

nominal interest rate in
response:

- The real interest rate falls as

well because inflation is
sticky
- The economy will not have a
decline in output.
 The Phillips Curve

Expected Inflation: the inflation rate that firms think will prevail in the rest of the economy over the
coming year
 Adaptive Expectations
• Under adaptive expectations firms adjust their forecasts of inflation
slowly. Firms expect next year’s inflation rate to be the same as this
year’s inflation rate.

• Expected inflation embodies the sticky inflation assumption.

The Phillips Curve
The Phillips Curve

The Phillips curve describes

how the state of the economy
—short-run output— drives
changes in inflation. When the
economy booms, inflation
rises. When the economy
slumps, inflation falls.

The parameter measures how

sensitive inflation is to demand
conditions
Price shocks and the Phillips Curve
Price of oil rises
 Cost-Push and Demand-Pull Inflation
Cost Push Inflation
Inflation because of price shocks- increases in cost of inputs tends to
push inflation rate up

Demand Pull inflation

Increases in aggregate demand in the economy raise (pull up) the
inflation rate
The short-run model – IS-MP + Phillips
Curve
The US Inflation Rate
 The Volker Disinflation
Paul Volcker was appointed to chair the Federal Reserve Board of Governors
in 1979. In part because of the oil shocks of 1974 and 1979 and in part
because of an excessively loose monetary policy in previous years, inflation
in 1979 exceeded 10 percent and appeared to be headed even higher.
Volcker’s job was to bring it back under control. Over the next several years,
inflation did decline.

How do we explain this decline with the short-run model?

The Volker Disinflation - FED increases short term nominal rates
The Effect of higher interest rates on the Phillips Curve
The Effect of higher interest rates on the Phillips Curve
The Great Inflation on 1970s
The mistake of the FED in the 1970’s
The short-run model in a Nutshell
 Market for Money
Nominal interest rate is the opportunity
cost of holding money—
the amount you give up by holding the
money instead of keeping it in a savings
account

Demand for Money

- Is a decreasing function of the nominal
interest rate
- Is downward sloping

Supply of Money
is simply a vertical line at whatever level
of money the central bank chooses to
provide.
The nominal interest rate is pinned down by the equilibrium in the money market, where households are willing to hold just
the amount of currency that the central bank supplies. If the nominal interest rate is higher than i *, then households would
want to hold their wealth in savings accounts rather than currency, so money supply would exceed money demand. This
puts pressure on the nominal interest rate to fall. Alternatively, if the interest rate is lower than i*, money demand would
exceed money supply, leading the nominal interest rate to rise.