Chapter 12

Monetary Policy and the

Phillips Curve
12.1 Introduction
In this chapter, we learn
• how the central bank effectively sets the real
interest rate in the short run.
• This rate is the MP curve in our short-run model.
• that the Phillips curve describes how firms set their
prices over time, pinning down the inflation rate.
• how the IS curve, the MP curve, and the Phillips
curve make up our short-run model.
• how to analyze the evolution of the macroeconomy
in response to changes in policy or economic
shocks.
Introduction
The federal funds rate
• Overnight lending rate between banks
The short-run model summary:

Through the…

MP curve The nominal interest rate determines the real

interest rate.
IS curve The real interest rate influences short-run GDP.

Phillips curve The relationship between short-run GDP and

inflation is shown.
The Structure of the Short-Run Model
12.2 The MP Curve
Banks borrowing from each other must match the
central bank lending rate.
• Banks cannot charge a higher rate.
• Everyone would use the central bank.
• Banks cannot charge a lower rate.
• Everyone would borrow at the lower rate and
lend it back to the central bank at a higher rate
(arbitrage).
• The lender would run out of resources quickly.
The Federal Funds Rate
From Nominal to Real Interest Rates
Fisher equation:

Nominal Real Inflation

interest interest
rate rate
From Real to Nominal Interest Rates
Sticky inflation assumption
In the short run, inflation
• displays inertia, or stickiness.
• adjusts slowly over time.
• does not respond directly to monetary policy.
Central banks can set the real interest rate in the short
run.
Case Study: Ex Ante and Ex Post Real Interest Rates
Sophisticated version of the Fisher equation:

where is the expected rate of inflation.

The rate relevant for investment decisions:

The actual real interest rate

The IS-MP Diagram—1
The MP curve
• Illustrates the central bank’s ability to set the real
interest rate at a particular value (horizontal line)
The IS curve
• Recall: Illustrates the negative relationship between
interest rates and short-run output
The MP Curve in the IS-MP Diagram
The IS-MP Diagram—2
The economy is at potential when
• Real interest rate = MPK
• No aggregate demand shocks
• Short-run output = 0
If the central bank raises the interest rate above the
MPK

Real
Inflation is Investment
interest rate
sticky ↓
↑
Raising the Interest Rate in the IS-MP Diagram
The End of a Housing Bubble

Housing
• Then, a shock occurs
prices ↑

Housing
prices ↓ • AD parameter ↓

• In response,
IS curve
the central
shifts left
bank
↓ • Since
Nominal inflation is
interest sticky
rate
↓ Real
interest
rate
Stabilizing the Economy after a Housing Bubble

B A B A
r MP r MP

C
R MP
IS IS

IS IS
2% 0 2% 0
(a) (b)
Case Study: The Term Structure of Interest Rates
Interest rates on investments of different lengths of
time should yield the same return.

When the Fed changes the overnight rate,

• financial markets expect the change will persist.
• it signals information about likely changes in the
future.
• interest rates at longer magnitudes change.
Case Study: The Term Structure of Interest Rates
12.3 The Phillips Curve
Recall: The inflation rate is the percent change in the
overall price level.

Firms set their prices on the basis of

• their expectations of the economy-wide inflation
rate.
• the state of demand for their product.
The Phillips Curve—1
Expected inflation

• where represents demand conditions

Adaptive expectations
• Firms expect next year’s inflation rate to be the
same as this year’s inflation rate.
• Firms adjust their forecasts of inflation slowly.
• Embodies the sticky inflation assumption
The Phillips Curve—2
The Phillips curve
• Describes how inflation evolves over time as a
function of short-run output

If output is below potential, prices rise more slowly

than usual.
If output is above potential, prices rise more rapidly
than usual.
The Phillips Curve—3
Using the equations:

Therefore, the Phillips curve can be expressed as:

The Phillips Curve—4

Phillips curve

Slumping economy Booming economy

Price Shocks and the Phillips Curve
We can add shocks to the Phillips curve:

Rewrite:

Inflation depends on:

• Expectations of inflation
• Demand conditions
• Shocks to inflation
Oil Price Shock
Temporary upward shift in the Phillips curve
Cost-Push and Demand-Pull Inflation
Price shocks to an input in production
• Cost-push inflation
• Tends to push the inflation rate up
Changes in short-run output
• Demand-pull inflation
• Increases in AD pull up the inflation rate.
Case Study: The Phillips Curve and the Quantity Theory
The quantity theory:
• An ↑ in the growth rate of real GDP would ↓ inflation.
The Phillips curve:
• An ↑ in GDP causes the rate of inflation to ↑.
Which one is correct?
The quantity theory:
• Long-run model
The Phillips curve:
• Part of our short-run model
12.4 Using the Short-Run Model
Disinflation
• Sustained lower and stable rate of inflation
The Great Inflation of the 1970s
• Misinterpreting the productivity slowdown
contributed to rising inflation.
Inflation in the United States
The Volcker Disinflation—1
In the long run, reducing the level of inflation requires tight
monetary policy.
• A sharp reduction in the rate of money growth
Since inflation is sticky,
• The classical dichotomy is unlikely to hold in the short
run.
• A decrease in the money growth rate may not slow
inflation.
The real interest rate increase induces a recession.
• The recession causes negative changes in inflation.
• As demand falls, firms raise their prices slower to sell
more.
Tightening Monetary Policy

B
MP’

A
MP

IS
A Recession and Falling Inflation

Phillips curve

B
The Volcker Disinflation—2
Lowering the inflation rate
• At the cost of a slumping economy
• High unemployment and lost output
Once inflation has declined sufficiently
• Real interest rate can be raised back to MPK,
allowing output to rise back to potential
The Disinflation over Time
The Great Inflation of the 1970s—1
Inflation rose in the 1970s for three reasons:
• OPEC coordinated oil price increases: Oil shock
• U.S. monetary policy was too loose.
• Policymakers thought that reducing inflation
required permanent increases in unemployment.
• In reality, disinflation requires only a temporary
recession.
The Great Inflation of the 1970s—2
Inflation rose in the 1970s for three reasons:
• The Federal Reserve did not have perfect
information.
• Thought the productivity slowdown was a
recession
• The Fed lowered interest, which increased output
above potential and generated more inflation.
• However, the slowdown was a change in potential
output.
Mistaking a Slowdown in Potential for a Recession
The Short-Run Model in a Nutshell
Case Study: The 2001 Recession
12.5 Microfoundations: Understanding Sticky Inflation
The short-run model
• Changes in the nominal interest rate affect the real
interest rate.
The classical dichotomy
• Changes in nominal variables have only nominal
effects.
• If monetary policy affects real variables, the classical
dichotomy fails in the short run.
The Classical Dichotomy in the Short Run—1
Can the classical dichotomy hold at all points in time?
• All prices, including wages and rental prices, must
adjust in the same proportion immediately.
The Classical Dichotomy in the Short Run—2
Reasons that the classical dichotomy fails in the short
run:
• Imperfect information
• Costs of setting prices
• Contracts set prices and wages in nominal terms
• Bargaining costs
• Social norms and money illusion
Case Study: The Lender of Last Resort
Central banks ensure a stable financial system by
• Making and enforcing rules, including reserve
requirements
• Acting as the lender of last resort
• Lending money when banks experience financial
distress
• Having deposit insurance, although this can increase
risky behavior
12.6 Microfoundations: How Central Banks Control Nominal Interest Rates

The central bank controls the level of the nominal

interest rate by supplying the money that is demanded
at that rate.

The nominal interest rate

• The opportunity cost of holding money
Quantity demanded of money is negatively related to
the nominal interest rate.
How the Central Bank Sets the Nominal Interest Rate

Ms

Md
Money Supply and Demand
The demand for money
• Decreasing function of the nominal interest rate
• Downward sloping
The supply of money
• The level of money the central bank provides
• Vertical line
Changing the Interest Rate
To raise the interest rate

New
equilibriu
↓ MS QMD>QMS ↑i ↓ QMD m
Higher i
Raising the Nominal Interest Rate
Why it instead of Mt?—1
The interest rate is crucial even when central banks
focus on the money supply.
The money demand curve is subject to many shocks,
which shift the curve.
• Changes in price level
• Changes in output
If the money supply is constant,
• the nominal interest rate fluctuates, resulting in
changes in output.
Why it instead of Mt?— 2
The money supply schedule is effectively horizontal at
a targeted interest rate.
An expansionary (loosening) monetary policy
• Increases the money supply
• Lowers the nominal interest rate
A contractionary (tightening) monetary policy
• Reduces the money supply
• Increases the nominal interest rate
Targeting the Nominal Interest Rate
12.7 Inside the Federal Reserve
Reserves
• Deposits held in accounts with the central bank
• Pay no interest
Reserve requirements
• Banks required to hold a certain fraction of their
deposits
Discount rate
• Interest rate charged by the Federal Reserve on
loans made to commercial banks
Open-Market Operations
Open-market operations
• The central bank trades interest-bearing
government bonds in exchange for currency or non-
interest-bearing reserves.
To increase the money supply, the Fed buys
government bonds in exchange for currency or
reserves.
• The price at which the bond sells determines the
nominal interest rate.
12.8 Conclusion
Policymakers exploit the stickiness of inflation.
• Changes in the nominal interest rate change the real
interest rate.
Through the Phillips curve, booms and recessions alter
the evolution of inflation.
Because inflation evolves gradually, the only way to
reduce it is to slow the economy.
Additional Figures for Worked Exercises: The Great Inflation—1
The Great Inflation—2
Clicker Question 1
Why does the classical dichotomy fail to hold in the
short run?
a. Firms have imperfect information.
b. Unions negotiate contracts that set wages for long
periods of time.
c. Sometimes people think it is unfair to lower
nominal wages.
d. All of these choices are correct.
Clicker Question 1 – Answer
Why does the classical dichotomy fail to hold in the
short run?
a. Firms have imperfect information.
b. Unions negotiate contracts that set wages for long
periods of time.
c. Sometimes people think it is unfair to lower
nominal wages.
d. All of these choices are correct.
Clicker Question 2
The Federal Reserve will lower short-run output by
a. lowering the nominal interest rate.
b. lowering the real interest rate.
c. decreasing the money supply.
d. increasing the money supply.
Clicker Question 2 – Answer
The Federal Reserve will lower short-run output by
a. lowering the nominal interest rate.
b. lowering the real interest rate.
c. decreasing the money supply.
d. increasing the money supply.
Clicker Question 3
Misperceiving a long-lasting slowdown in labor
productivity as a recession will result in
a. an increase in inflation.
b. a decrease in inflation.
c. actual output equaling potential output.
d. actual output being below potential output.
Clicker Question 3 – Answer
Misperceiving a long-lasting slowdown in labor
productivity as a recession will result in
a. an increase in inflation.
b. a decrease in inflation.
c. actual output equaling potential output.
d. actual output being below potential output.
Clicker Question 4
If the aggregate demand parameter increases and the
central bank wishes to stabilize output at potential, it
should
a. raise the nominal interest rate.
b. lower the nominal interest rate.
c. buy government bonds.
d. expand the money supply.
Clicker Question 4 – Answer
If the aggregate demand parameter increases and the
central bank wishes to stabilize output at potential, it
should
a. raise the nominal interest rate.
b. lower the nominal interest rate.
c. buy government bonds.
d. expand the money supply.
Clicker Question 5
a. The mission of the Federal Reserve is to
a. preserve price stability.
b. foster maximum sustainable growth in output and
employment.
c. promote a stable and efficient financial system.
d. All of these choices are correct.
Clicker Question 5 – Answer
The mission of the Federal Reserve is to
a. preserve price stability.
b. foster maximum sustainable growth in output and
employment.
c. promote a stable and efficient financial system.
d. All of these choices are correct.
Clicker Question 6
Price-setting behaviors become more sensitive to
demand conditions. This results in
a. a larger recession occurring to change the
inflation rate by a given amount.
b. a smaller recession occurring to change the
inflation rate by a given amount.
c. the IS curve becoming steeper.
d. the IS curve becoming flatter.
Clicker Question 6 – Answer
Price-setting behaviors become more sensitive to
demand conditions. This results in
a. a larger recession occurring to change the
inflation rate by a given amount.
b. a smaller recession occurring to change the
inflation rate by a given amount.
c. the IS curve becoming steeper.
d. the IS curve becoming flatter.
Clicker Question 7
Suppose prices adjust immediately because there is no
sticky inflation. Then, monetary policy will
a. have only real effects.
b. have only nominal effects.
c. have both real and nominal effects.
d. have no effect.
Clicker Question 7 – Answer
Suppose prices adjust immediately because there is no
sticky inflation. Then, monetary policy will
a. have only real effects.
b. have only nominal effects.
c. have both real and nominal effects.
d. have no effect.
Clicker Question 8
An economy starts at its long-run values. A recession
will then cause
a. the inflation rate to increase, because firms seek
to sell more.
b. the inflation rate to increase, because firms seek
to sell less.
c. the inflation rate to decrease, because firms seek
to sell more.
d. the inflation rate to decrease, because firms seek
to sell less.
Clicker Question 8 – Answer
An economy starts at its long-run values. A recession
will then cause
a. the inflation rate to increase, because firms seek
to sell more.
b. the inflation rate to increase, because firms seek
to sell less.
c. the inflation rate to decrease, because firms
seek to sell more.
d. the inflation rate to decrease, because firms seek
to sell less.
Clicker Question 9
To create disinflation, the Federal Reserve must lower
the nominal interest rate.
a. true
b. false
Clicker Question 9 – Answer
To create disinflation, the Federal Reserve must lower
the nominal interest rate.
a. true
b. false
Clicker Question 10
An implication of adaptive expectations and sticky
inflation is that the Federal Reserve must push output
below potential to lower inflation.
a. true
b. false
Clicker Question 10 – Answer
An implication of adaptive expectations and sticky
inflation is that the Federal Reserve must push output
below potential to lower inflation.
a. true
b. false
Clicker Question 11
At the interest rate targeted by the central bank, the
money supply is horizontal.
a. true
b. false
Clicker Question 11 – Answer
At the interest rate targeted by the central bank, the
money supply is horizontal.
a. true
b. false
Clicker Question 12
Suppose that a shock to the economy increases the
bargaining power of labor unions. The Phillips curve
will shift upward.
a. true
b. false
Clicker Question 12 – Answer
Suppose that a shock to the economy increases the
bargaining power of labor unions. The Phillips curve
will shift upward.
a. true
b. false
Clicker Question 13
A tight monetary policy by the European Central Bank
will result in an increase in the nominal interest rate.
a. true
b. false
Clicker Question 13 – Answer
A tight monetary policy by the European Central Bank
will result in an increase in the nominal interest rate.
a. true
b. false
Clicker Question 14
Unlike fiscal policy, which often takes months to have
substantial effects on the economy, the effect on
economic activity of monetary policy is instantaneous.
a. true
b. false
Clicker Question 14 – Answer
Unlike fiscal policy, which often takes months to have
substantial effects on the economy, the effect on
economic activity of monetary policy is instantaneous.
a. true
b. false
Clicker Question 15
Economists today believe that the Phillips curve
demonstrates that the level of inflation is related to
economic activity and that there is a permanent trade-
off between inflation and economic performance.
a. true
b. false
Clicker Question 15 – Answer
Economists today believe that the Phillips curve
demonstrates that the level of inflation is related to
economic activity and that there is a permanent trade-
off between inflation and economic performance.
a. true
b. false
Clicker Question 16
Last year you invested $100 in a savings account
earning interest of 9 percent per year. If over the past
year the overall price level in the economy decreased
by 2 percent, what was the real interest rate during
this period?
a. 2 percent
b. 7 percent
c. 9 percent
d. 11 percent
Clicker Question 16 – Answer
Last year you invested $100 in a savings account
earning interest of 9 percent per year. If over the past
year the overall price level in the economy decreased
by 2 percent, what was the real interest rate during
this period?
a. 2 percent
b. 7 percent
c. 9 percent
d. 11 percent
Clicker Question 17

a. higher; firms are producing less than potential

b. lower; firms are producing more than potential
c. higher; firms are producing more than potential
d. lower; firms are producing less than potential
Clicker Question 17 – Answer

a. higher; firms are producing less than potential

b. lower; firms are producing more than potential
c. higher; firms are producing more than potential
d. lower; firms are producing less than potential
Clicker Question 18

a. 4
b. 0.25
c. 1.5
d. 0.66
Clicker Question 18 – Answer

a. 4
b. 0.25
c. 1.5
d. 0.66
Clicker Question 19

a. $4; 4.00 percent

b. $4; 4.17 percent
c. 4.00 percent; $4
d. 4.17 percent; $4
Clicker Question 19 – Answer

a. $4; 4.00 percent

b. $4; 4.17 percent
c. 4.00 percent; $4
d. 4.17 percent; $4
Clicker Question 20
In the IS-LM model, the choice variable is the __________,
while in the IS-MP model the choice variable is the
__________.
a. consumption, exports
b. interest rate, money supply
c. taxes, government spending
d. none of the above
Clicker Question 20 – Answer
In the IS-LM model, the choice variable is the __________,
while in the IS-MP model the choice variable is the
__________.
a. consumption, exports
b. interest rate, money supply
c. taxes, government spending
d. none of the above
Clicker Question 21
Many people believe that the recession of 2001 was
caused by the attacks on the WTC. When we look at the
data, we find by the time of the attacks, the recession
was __________, and real GDP growth was already
__________.
a. starting, declining
b. growing, declining
c. nearly over, returning
d. none of the above
Clicker Question 21 – Answer
Many people believe that the recession of 2001 was
caused by the attacks on the World Trade Center. When
we look at the data, we find that the recession was
__________, and real GDP growth was already __________.
a. starting, declining
b. growing, declining
c. nearly over, returning
d. none of the above
Credits
This concludes the Lecture PowerPoint presentation for Chapter 12, Monetary Policy and the Phillips Curve, of
Macroeconomics, 5e by Charles I. Jones
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