Monetary Economics I

Lecture 12:

Monetary Theory I: Monetary Policy Theory

Faculty of Economics and Business

Universitas Gadjah Mada

2022
LEARNING OBJECTIVES

▪ STUDENTS UNDERSTAND HOW MONETARY POLICY CAN BE

INCORPORATED INTO SHORT RUN MACROECONOMIC MODEL

▪ STUDENTS UNDERSTAND HOW MONETARY POLICY CURVE IS

DERIVED

▪ STUDENTS CAN USE THE IS-MP AND AD-AS MODELS TO ANALYZE

THE EFFECT OF MONETARY POLICY
Monetary Policy (MP) Theory

Analytical Framework for MP Theory

Monetary Policy and IS-MP-PC Model

Monetary Policy and AD-AS Model

Monetary Policy (MP) Theory

Analytical Framework for MP Theory

Monetary Policy and IS-MP-PC Model

Monetary Policy and AD-AS Model

Central Bank and Monetary Policy
Recall the last meeting’s discussion, by conducting monetary policy, a central banks plays a
pivotal role in the aggregate economic activities.

CENTRAL BANK

MONETARY
TOOLS OF THE POLICY INTERMEDIATE GOALS
POLICY
CENTRAL BANK INSTRUMENTS TARGETS
Central Bank and Monetary Policy
Recall the last meeting’s discussion, by conducting monetary policy, a central banks plays a
pivotal role in the aggregate economic activities.

CENTRAL BANK

MONETARY
TOOLS OF THE POLICY INTERMEDIATE GOALS
POLICY
CENTRAL BANK INSTRUMENTS TARGETS

Short-term Interest Rates s Short-term and long-term

Open market operations Price Stability
(such as BI7DRR) interest rates

In recent (normal) years, monetary policy works as follows:

▪ Using open market operations, central bank changes the target for the policy rate, which causes a change in the long-term real
interest rate.
▪ A change in the long-term real interest rate affects the components of aggregate expenditure, thereby changing the output gap
and the inflation rate.
Central Bank and Monetary Policy
Recall the last meeting’s discussion, by conducting monetary policy, a central banks plays a
pivotal role in the aggregate economic activities.

CENTRAL BANK

MONETARY
TOOLS OF THE POLICY INTERMEDIATE GOALS
POLICY
CENTRAL BANK INSTRUMENTS TARGETS
Transmission Mechanism
The monetary transmission mechanism examines the ways in which monetary policy affects
and the economy.
TRANSMISSION CHANNELS AGGREGATE DEMAND PRICE LEVEL

INTEREST RATE
CHANNEL Nominal
INVESTMENT
CENTRAL BANK interest rate Cash flow Moral hazard,
DOMESTIC
adverse selection
EXPECTATIONS Real interest DEMAND
CONSUMPTION
rate

MONETARY ASSET PRICE Tobins’ q

POLICY Stock prices GOALS
CHANNEL PRICE
Financial Lending activity LEVEL
wealth

INFLATION
POLICY RATE
LENDING Bank RATE
Bank loan
CHANNEL deposits Financial Distress

IMPORT
NET EXPORT PRICE

EXCHANGE Exchange
RATE CHANNEL rate
NET EXTERNAL
DEMAND
Monetary Policy and the Economy

▪ Monetary policy is part of

macroeconomic policy to stabilize
the economy.
▪ Most economists see the fluctuations
in the economy as resulting from the
response of households and firms to
macroeconomic shocks.
Macroeconomic Shocks

MACROECONOMIC SHOCK SOURCE OF SHOCK

▪ Macroeconomic shock is an unexpected Economists call exogenous events that shift
exogenous event that has a significant these curves shocks to the economy:
effect on an important sector of the
▪ Demand shock: a shock that shifts the
economy or on the economy as a whole.
aggregate demand curve
▪ Examples of macroeconomic shocks:
▪ Supply shock: a shock that shifts the
(1) financial crisis, (2) the collapse of a
aggregate supply curve
housing bubble, (3) a significant
innovation in information technology, (4) a
significant unexpected increase in oil
prices, or an (5) unexpected change in
monetary or fiscal policy.
Should Policy Be Active or Passive?
There are two views regarding stabilization policy:

ACTIVE POLICY PASSIVE POLICY

▪ Advocates of active policy view the ▪ Advocates of passive policy argue that
economy as subject to frequent shocks because monetary and fiscal policies
that will lead to unnecessary fluctuations work with long and variable lags,
in output and employment unless attempts to stabilize the economy are
monetary or fiscal policy responds. likely to end up being destabilizing.
▪ Many believe that economic policy has ▪ In addition, they believe that our present
been successful in stabilizing the understanding of the economy is too
economy. limited to be useful in formulating
successful stabilization policy and that
inept policy is a frequent source of
economic fluctuations.
The Framework of Short-run
Macroeconomic Analysis

Goods IS
Market Curve

IS-MP Aggregate Aggregate Wage-Price Labour

Model Demand Supply Determination Market
Financial MP
Market Curve

Model of Aggregate
Demand and Aggregate
Supply

Macroeconomists derive the model of short run macroeconomic analysis, which will help us to understand why economic
fluctuations occur and how policymakers use monetary policy and fiscal policy to help reduce the severity of recessions.
Monetary Policy (MP) Theory

Analytical Framework for MP Theory

Monetary Policy and IS-MP-PC Model

Monetary Policy and AD-AS Model

IS-MP-PC Model

In this section, we’d like to focus on deriving

different types of MP Curve:
The IS-MP-PC model is valuable not
▪ MP Curve in Close Economy Setting
only because it can be used in
economic forecasting, but also ▪ MP Curve in Open Economy with Fixed
because it provides a deeper Exchange Rate Regime
understanding on how government
▪ MP Curve in Open Economy with Flexible
policy can affect aggregate
Exchange Rate Regime
economic activity.

However, we start the discussion with IS curve

determination to give the economic intuition of
the IS-MP-PC Model
Deriving IS Curve: Goods Market

Goods IS
Market Curve
IS-
Aggregate Aggregate Wage-Price Labour
LM/MP Demand Supply Determination Market
Model
Financial LM/MP
Market Curve

Model of Aggregate
Demand and Aggregate
Supply
Deriving IS Curve: Goods Market

Goods
Market
Goods and Services
for investment FIRMS
GOVERNMENT &
CENTRAL BANK
Government
purchases
GOODS AND FINANCIAL LABOR
SERVICES
MARKET MARKET MARKET

HOUSEHOLDS
Payment for Goods
and services

Goods and Services

for consumption
Goods Market Equilibrium

Supply Side Demand Side

GOODS-SERVICES
PRODUCTION MARKET EXPENDITURE
𝒀 = 𝒇 𝑲, 𝑳 𝑨𝑬 = 𝑪 + 𝑰 + 𝑮 + 𝑵𝑿
An economy’s output of goods and
If we want to understand what determines the
services (Y) depends on:
demand for goods, it makes sense to look at
1. The quantity of inputs/the factors of the aggregate expenditure (AE) on real GDP.
production (i.e. Capital, Labor)
2. The ability to turn inputs into output
(the production function).
Deriving IS Curve from Goods Market

Supply Side Demand Side

GOODS-SERVICES
PRODUCTION MARKET EXPENDITURE
𝒀 = 𝒇 𝑲, 𝑳 𝑨𝑬 = 𝑪 + 𝑰 + 𝑮 + 𝑵𝑿

Consumption (𝑪) is a function of disposable income (𝑌𝐷 ):

𝐶 = 𝑐0 + 𝑐1 𝑌𝐷
▪ 𝑐0 is what people would consume if their disposable
income equals zero with 𝑐0 > 0
▪ 𝑐1 is the marginal propensity to consume (MPC), or the
effect of an additional dollar of disposable income on
consumption with 0 < 𝑐1 < 1
Deriving IS Curve from Goods Market

Supply Side Demand Side

GOODS-SERVICES
PRODUCTION MARKET EXPENDITURE
𝒀 = 𝒇 𝑲, 𝑳 𝑨𝑬 = 𝑪 + 𝑰 + 𝑮 + 𝑵𝑿

Consumption (𝑪) is a function of disposable

income (𝑌𝐷 ):
𝐶 = 𝑐0 + 𝑐1 𝑌𝐷
Because 𝑌𝐷 = 𝑌 + 𝑇𝑅 − 𝑇
𝐶 = 𝑐0 + 𝑐1 (𝑌 + 𝑇𝑅 − 𝑇)
Deriving IS Curve from Goods Market

Supply Side Demand Side

GOODS-SERVICES
PRODUCTION MARKET EXPENDITURE
𝒀 = 𝒇 𝑲, 𝑳 𝑨𝑬 = 𝑪 + 𝑰 + 𝑮 + 𝑵𝑿

▪ In this lecture, we assume that we take

investment and government spending as
given to keep our model simple.
𝑰 = ത𝑰
ഥ
𝑮=𝑮
▪ In addition, we also assume that the economy is
a closed economy (𝑿 = 𝑴 = 𝟎).
Deriving IS Curve from Goods Market

Supply Side Demand Side

GOODS-SERVICES
PRODUCTION MARKET EXPENDITURE
𝒀 = 𝒇 𝑲, 𝑳 𝑨𝑬 = 𝑪 + 𝑰 + 𝑮 + 𝑵𝑿

The equilibrium condition in the goods markets :

𝒀 = 𝑨𝑬
ത + 𝐼 ҧ + 𝐺ҧ
𝑌 = 𝑐0 + 𝑐1 (𝑌 + 𝑇𝑅 − 𝑇)
Deriving IS Curve

Having constructed a model, we can solve it to look at what determines the level of output
in goods market.

𝑌 = 𝑐0 + 𝑐1 𝑌 + 𝑇𝑅 − 𝑇ത + 𝐼 ҧ + 𝐺ҧ
𝑌 = 𝑐0 + 𝑐1 𝑌 + 𝑐1 𝑇𝑅 − 𝑐1 𝑇ത + 𝐼 ҧ + 𝐺ҧ
𝑌 − 𝑐1 𝑌 = 𝑐0 + +𝑐1 𝑇𝑅 − 𝑐1 𝑇ത + 𝐼 ҧ + 𝐺ҧ
𝑌(1 − 𝑐1 ) = 𝑐0 + +𝑐1 𝑇𝑅 − 𝑐1 𝑇ത + 𝐼 ҧ + 𝐺ҧ

1
𝑌= 𝑐0 + 𝐼 ҧ + 𝐺ҧ + 𝑐1 𝑇𝑅 − 𝑐1 𝑇ത
1 − 𝑐1
Deriving IS Curve

Steps to characterize the equilibrium

graphically:
𝑌 1. Plot production as a function of output.
Because production equals output, their
relation is the 45-degree line
2. Plot demand as a function of output
𝐴𝐸 = 𝐶 + 𝐼 + 𝐺 + 𝑁𝑋

In equilibrium point: production equals

aggregate expenditure.
𝑌 = 𝐴𝐸
Deriving IS Curve

𝑌
𝑌

1. A decline in
investment spending
shifts the AE line down

2…result in a larger
decline in equilibrium
real GDP

The decline in output is larger than the initial shift in demand, by a factor equal to the multiplier (i.e. the multiplier depends
on the propensity to consume, which can be estimated using econometrics)
Deriving IS Curve: Graphical Analysis

Goods IS
Market Curve
IS-
Aggregate Aggregate Wage-Price Labour
LM/MP Demand Supply Determination Market
Model
Financial LM/MP
Market Curve

Model of Aggregate
Demand and Aggregate
Supply
Deriving IS Curve: Graphical Analysis
Constructing the IS Curve Aggregate
Expenditure
Equilibrium in the Goods Market

𝑨𝑬(𝒓𝟏 )

𝑨𝑬(𝒓𝟐 ) a) An increase in the interest rate reduces

investment
b) A decrease in investment shifts the
aggregate demand downward and
thereby reduces output/income

The Investment Function

c) The IS curve summarizing this
The IS Curve
relationship between the interest rate
and income: the higher the interest rate,
the lower the level of income.

The IS curve is therefore downward sloping

IS Curve: Positive Shock

(a) The effect of a demand shock on aggregate expenditure (b) The effect of a demand shock on the IS curve

3. …the IS Curve
shifts to the right

1. A positive demand
shock shifts the AE
curve up and….

2. …cause equilibrium
real GDP to increase
from Y1 to Y2, so
IS Curve: Negative Shock

(a) The effect of a demand shock on aggregate expenditure (b) The effect of a demand shock on the IS curve

3. …the IS Curve
shifts to the left

1. A negative demand
shock shifts the AE
curve down and….

2. …cause equilibrium
real GDP to decrease
from Y1 to Y2, so
IS Curve and Output Gap

▪ The graph shows the output gap, rather than

the level of real GDP, on the horizontal axis.
▪ Values to the left of zero on the horizontal axis
represent negative values for the output
gap—periods during which real GDP is below
potential GDP—and values to the right of zero
on the horizontal axis represent positive
values for the output gap—periods during
which real GDP is above potential GDP.
▪ The vertical line, is also the point where the
output gap is zero
Deriving MP Curve: Financial Market

Goods IS
Market Curve

IS-MP Aggregate Aggregate Wage-Price Labour

Model Demand Supply Determination Market
Financial MP
Market Curve

Model of Aggregate
Demand and Aggregate
Supply
Deriving MP Curve: Financial Market

FINANCIAL
MARKET
Financial
Market
MONEY CAPITAL
MARKET MARKET
Financial markets are crucial to
promoting a greater economic
efficiency by channeling funds
from people who do not have a
productive use for them to those
who do
Deriving MP Curve: Financial Market

Supply Side Demand Side

FINANCIAL MARKET
Money Supply Money Demand
ഥ
𝑀𝑠 = 𝑀 𝑀𝑑 = 𝑓 𝑃𝑌, 𝐿 𝑖
To simplify the analysis, we assume that Money demand is a function of nominal
the only money in the economy is currency income and interest rate:
and it is supplied by central bank (i.e. fixed
supply of money).
The equation implies:
1. the demand for money increases in
proportion to nominal income
2. the demand for money depends
negatively on the interest rate
Deriving MP Curve: Financial Market

Supply Side Demand Side

FINANCIAL MARKET
Money Supply Money Demand
ഥ
𝑀𝑠 = 𝑀 𝑀𝑑 = 𝑓 𝑃𝑌, 𝐿 𝑖

Equilibrium in financial markets requires that money supply

equals money demand:
𝑀 𝑠 = 𝑀𝑑
𝑀 = 𝑓 𝑃𝑌, 𝐿 𝑖
𝑀
= 𝑓 𝑌, 𝐿 𝑖
𝑃

This equilibrium relation is called the Liquidity – Money

(LM) relation
Deriving MP Curve: Financial Market

The interest rate must be such

that the supply of money (which
is independent of the interest
rate) is equal to the demand for
money (which does depend on
the interest rate).
Deriving MP Curve: Financial Market

Goods IS
Market Curve
IS-
Aggregate Aggregate Wage-Price Labour
LM/MP Demand Supply Determination Market
Model
Financial MP
Market Curve

Model of Aggregate
Demand and Aggregate
Supply
Monetary Policy (MP) Curve

▪ Central bank conducts monetary policy by managing the money

supply and interest rates to pursue macroeconomic policy objectives
such as price stability, high employment, and high rates of growth.
▪ During the past several decades, most central banks, has focused its
monetary policy actions on interest rates.
▪ Therefore, we call the curve showing the effect of the real interest rate
on the output gap the monetary policy, or MP, curve.
Deriving MP Curve
(a) The central bank adjusts the money supply (b) The MP curve

4..the long-term real

interest rate remains
3..Central Bank increases constant at r
the money supply from
MS1 to MS2

2..the demand for money

shifts to the right from
MD1 to MD2
1. The output
gap changes
Deriving MP Curve

When Central bank increases

the target interest rate, the
MP curve shifts up
▪ The MP curve shows the long-
term real interest rate.
▪ It is called MP curve because
monetary policy is one of the
factors that affects the real
interest rate
▪ Therefore, the MP curve is
When Central bank decreases
the target interest rate, the MP
curve shifts down
useful because it is the simplest
way to start thinking about
monetary policy
IS-MP Model in a Closed Economy

Goods IS
Market Curve

IS-MP
Model
Financial MP
Market Curve

The economy is in equilibrium where MP and IS curves intersect

at point A, with real GDP equal to potential GDP, so the output gap
equals 0.
Monetary Policy in a Closed Economy
The MP Curve shifts upward
▪ An increase in the target interest rate

▪ An increase in the short-term ▪ Long-term real interest

interest rate investors expect in the
rates will increase and
future

▪ An increase in the term premium ▪ Consumption and

investors require on long-term investment will decrease
bonds

▪ An increase in the default risk

premium

The MP Curve shifts downward

▪ Long-term real interest

rates will decrease
An increase in the expected
inflation rate ▪ Consumption and
investment will increase
IS-MP Model in an Open Economy

▪ No economy today is completely closed,

although a few countries, such as North Korea,
Goods IS have very limited economic interactions with
Market Curve other countries.
IS-MP ▪ To see how the choice of an exchange-rate
Model system affects monetary and fiscal policy, we
Financial MP need to modify the IS–MP model from the
Market Curve
closed economy to account for the effect of real
interest rates on the nominal exchange rate and
net exports.
IS-MP Model in an Open Economy
IS RELATION
To derive the IS in open economy, we look at each of it
components in detail:
Goods IS
Market Curve
𝐶 = 𝑐0 + 𝑐1 𝑌 + 𝑇𝑅 − 𝑇ത

IS-MP 𝐼 = 𝐼ҧ
Model
Financial MP
𝐺 = 𝐺ҧ
Market Curve
𝑁𝑋 = 𝑁𝑋0 − 𝑥𝑟 − 𝑚𝑌 Net exports are positively related to
autonomous net exports (𝑁𝑋0 )
and are negatively related to the
level of real interest rates (𝑟) and
income (𝑌)
IS Curve in an Open Economy
IS RELATION
The IS curve traces out the combinations of the real interest rate
and aggregate output at which the goods market is in equilibrium.
Goods IS 𝑌 = 𝐶 + 𝐼 + 𝐺 + 𝑁𝑋
Market Curve
𝑌 = 𝑐0 + 𝑐1 𝑌 + 𝑇𝑅 − 𝑇ത + 𝐼 ҧ + 𝐺ҧ + 𝑁𝑋0 − 𝑥𝑟 − 𝑚𝑌
IS-MP
Model 1 𝑥 𝑟
𝑌= 𝑐0 + 𝐼 ҧ + 𝐺ҧ + 𝑐1 𝑇𝑅 + 𝑁𝑋0 − 𝑐1 𝑇ത −
Financial MP 1 − 𝑐1 + 𝑚 1 − 𝑐1 + 𝑚
Market Curve

The effect of real interest rates on net exports provides us with an

additional reason for thinking that real interest rates affect real
GDP and the output gap.
IS Curve in an Open Economy
IS RELATION
The IS curve shifts to the right when there is
1 𝑥 𝑟
𝑌= ഥ ↑ +𝒄𝟏 𝑻𝑹 ↑ +𝑵𝑿𝟎 ↑ −𝒄𝟏 𝑻
𝒄𝟎 ↑ +𝑰ത ↑ +𝑮 ഥ↓ −
Goods IS 1 − 𝑐1 + 𝑚 1 − 𝑐1 + 𝑚
Market Curve
1) a rise in autonomous consumption, 4) a rise in gov. transfer
IS-MP 2) a rise in investment, 5) a rise in autonomous net exports
Model 3) a rise in government purchases 6) a fall in taxes
Financial MP
Market Curve
Movements of these six factors in the opposite direction will shift
the IS curve to the left.
MP Curve in an Open Economy

MP RELATION
▪ Taking into account the response of central banks to inflation,
Goods IS the MP curve should slope upward, which means that central
Market Curve banks tend to increase the real interest rate as the output gap
increases.
IS-MP
Model ▪ Higher inflation results in higher real interest rates, represented
Financial MP by upward movements along the monetary policy curve.
Market Curve
𝑟 = 𝑟ҧ + 𝜆𝜋
where 𝑟ҧ is the autonomous (exogenous) component of the real interest rate
set by the monetary policy authorities, which is unrelated to the current
level of the inflation rate or any other variable in the model, and 𝜆 is the
responsiveness of the real interest rate to the inflation rate.
MP Curve under
Flexible Exchange Rate System
MP RELATION
The MP Curve and Changes in the
Target Inflation Rate
Goods IS
▪ The MP curve slopes upward to
Market Curve reflect the tendency of central banks
to increase real interest rates as
IS-MP output increases.
Model
▪ A decrease in the target inflation rate
Financial MP causes the MP curve to shift to the
Market Curve left, and an increase in the target
inflation rate causes the MP curve to
shift to the right.
MP Curve under
Fixed Exchange Rate System
MP RELATION
The MP curve under a fixed exchange- The MP curve when the inflation
rate system target changes
Goods IS
Market Curve

IS-MP
Model
Financial MP
Market Curve

At low levels of output, the MP curve is horizontal An increase in the inflation target shifts the MP
but then begins to rise, just like it does under a curve to the right, and a decrease in the inflation
floating exchange-rate system. target shifts the MP curve to the left.
IS-MP Model Equilibrium in
Flexible Exchange Rate
IS MP

IS MP

Equilibrium occurs in point A where the IS and MP curves

intersect. The MP curve slopes upward to allow for the In a country with floating exchange rates, an
tendency of central banks to increase real interest rates expansionary monetary policy would lead to decrease in
as output increases. the real interest rate.
IS-MP Model Equilibrium in
Fixed Exchange Rate
IS MP

IS MP

Equilibrium occurs in panel (a),where the IS and MP curves

intersect. The MP curve is horizontal when the real interest rate If the real interest rate is already at the lower bound of r, then the
decreases to but it then slopes upward to allow for the tendency of central bank cannot use an increase in the inflation target to
central banks to increase real interest rates as output increases. simultaneously increase output and maintain the fixed exchange rate.
Monetary Policy (MP) Theory

Analytical Framework for MP Theory

Monetary Policy and IS-MP-PC Model

Monetary Policy and AD-AS Model

Aggregate Demand and Supply

We build an aggregate demand and aggregate supply model,

which explicitly incorporates the central bank’s use of a
monetary policy rule.
▪ Aggregate demand is the level of planned aggregate
expenditure in the economy.
▪ Aggregate supply is the total quantity of goods and services
that firms are willing to supply.
 Deriving Aggregate Demand
IS-MP Curve
Real Interest rate

The AD curve tells us what happens to the

quantity of real GDP demanded if the inflation
rate increases, holding everything else constant.
▪ A change in the inflation rate causes a
movement along a particular AD curve.
AD Curve ▪ If a factor that would affect the demand for
Price

goods and services other than the inflation rate

changes, the AD curve will shift either to the
right or to the left.
Deriving Aggregate Supply
PC Curve

▪ We now consider the aggregate supply (AS)

curve, which shows the total quantity of
output, or real GDP, that firms are willing
and able to supply at a given inflation rate.
▪ This definition of the AS curve is similar to the
definition of the Phillips curve.
▪ There are three sources of inflationary
pressure in the short run, (1) changes in the AS Curve

Price
expected inflation rate (𝜋𝑡𝑒 ), (2) demand
shocks (𝑦𝑡 ≠ 𝑦 𝑝 ), and (3) supply shocks (𝑠𝑡 ).
Therefore, we can derive AS equation as
follows:
𝜋𝑡 = 𝜋𝑡𝑒 + 𝛼 𝑦𝑡 − 𝑦 𝑝 − 𝑠𝑡
 Equilibrium in the AD-AS Model
PC Curve
IS-MP Curve
Real Interest rate

Equilibrium in the Aggregate Demand

and Aggregate Supply Model

Price
AD Curve AS Curve

Price
Price
 Equilibrium in the AD-AS Model
Equilibrium in the Aggregate Demand and
Aggregate Supply Model
The aggregate demand and
Inflation rate (𝝅) aggregate supply (AD–AS) model
explains short-run fluctuations in the
output gap and in the inflation rate.
𝑨𝑺

The economy is in long-run

equilibrium when:
𝝅𝟏 = 𝝅𝒆𝟏 = 𝝅𝑻𝒂𝒓𝒈𝒆𝒕 A 1. Real GDP equals potential GDP.
2. The inflation rate equals both the
central bank’s target inflation
rate and the expected inflation
𝑨𝑫 rate.
෡𝟏 = 𝟎
𝒀 ෡)
Output gap (𝒀
 Change in the Monetary Policy Rule

The AD–AS model includes a

Inflation rate (𝝅)
monetary policy rule so that we
can better understand how
𝑨𝑺𝟏 monetary policy reduces the
severity of economic fluctuations.
1. From an initial long-run
equilibrium at point A.
𝝅𝟏 = 𝝅𝒆𝟏 = 𝝅𝑻𝒂𝒓𝒈𝒆𝒕 A

𝑨𝑫𝟏

෡𝟏 = 𝟎
𝒀 ෡)
Output gap (𝒀
 Change in the Monetary Policy Rule

The AD–AS model includes a

Inflation rate (𝝅)
monetary policy rule so that we
can better understand how
𝑨𝑺𝟏 monetary policy reduces the
severity of economic fluctuations.
B
𝝅𝟐
1. From an initial long-run
equilibrium at point A.
𝝅𝟏 = 𝝅𝒆𝟏 = 𝝅𝑻𝒂𝒓𝒈𝒆𝒕 A 2. Central bank decides to
increase the target inflation
𝑨𝑫𝟐 rate by lowering the real
interest rate, which shifts the
𝑨𝑫𝟏 AD curve to the right.
෡𝟏 = 𝟎
𝒀 ෡𝟐
𝒀 ෡)
Output gap (𝒀
 Change in the Monetary Policy Rule

The AD–AS model includes a

Inflation rate (𝝅)
monetary policy rule so that we
can better understand how
𝑨𝑺𝟏 monetary policy reduces the
severity of economic fluctuations.
B
𝝅𝟐
3. As a result, the economy
moves to a new short-run
𝝅𝟏 = 𝝅𝒆𝟏 = 𝝅𝑻𝒂𝒓𝒈𝒆𝒕 A
equilibrium at point B, with a
higher inflation rate, increased
real GDP, and a lower
𝑨𝑫𝟐
unemployment rate: There is a
𝑨𝑫𝟏
short-run trade-off between
inflation and unemployment.
෡𝟏 = 𝟎
𝒀 ෡𝟐
𝒀 ෡)
Output gap (𝒀
 Change in the Monetary Policy Rule

𝑨𝑺𝟐 The AD–AS model includes a

Inflation rate (𝝅)
monetary policy rule so that we can
better understand how monetary
𝑨𝑺𝟏 policy reduces the severity of
C
𝝅𝟑 = 𝝅𝒆𝟑 = 𝝅′𝑻𝒂𝒓𝒈𝒆𝒕
economic fluctuations.
B 4. Eventually, the expected
𝝅𝟐 inflation rate increases, which
causes the AS curve to shift up.
𝝅𝟏 = 𝝅𝒆𝟏 = 𝝅𝑻𝒂𝒓𝒈𝒆𝒕 A
5. The economy returns to long-
run equilibrium at point C, with
𝑨𝑫𝟐
real GDP equal to potential
GDP, so the output gap equals
𝑨𝑫𝟏
zero.
෡𝟏 = 𝟎
𝒀 ෡𝟐
𝒀 ෡)
Output gap (𝒀
 Change in the Monetary Policy Rule

𝑨𝑺𝟐 The AD–AS model includes a

Inflation rate (𝝅)
monetary policy rule so that we can
better understand how monetary
policy reduces the severity of
C 𝑨𝑺𝟏 economic fluctuations.
𝝅𝟑 = 𝝅𝒆𝟑 = 𝝅′𝑻𝒂𝒓𝒈𝒆𝒕
6. At point C, the inflation rate
B
𝝅𝟐
equals the new higher target
inflation rate.
𝝅𝟏 = 𝝅𝒆𝟏 = 𝝅𝑻𝒂𝒓𝒈𝒆𝒕 A 7. The result is a higher inflation
rate and no change in
unemployment: The trade-off
𝑨𝑫𝟐 between inflation and
unemployment disappears in the
𝑨𝑫𝟏 long run.
෡𝟏 = 𝟎
𝒀 ෡𝟐
𝒀 ෡)
Output gap (𝒀
Recap on Monetary Policy Rule

▪ The previous graph shows that a central bank can temporarily increase
real GDP and decrease the unemployment rate by announcing a higher
inflation target.
▪ The model makes another important point: In the short run, the central
bank can achieve a higher level of real GDP and a lower
unemployment rate by tolerating a higher inflation rate.
▪ However, once the expected inflation rate adjusts, real GDP will return
to potential GDP, and the unemployment rate will increase back to its
initial level.
Recap on Monetary Policy Rule

▪ The previous prediction (i.e. the central bank can increase real GDP
and employment temporarily) assumed that expectations are adaptive.
▪ If expectations are rational and monetary policy is anticipated,
households and firms adjust their pricing decisions as soon as they
learn about a change in policy.
▪ As a result, monetary policy does not affect real GDP but only affects
the inflation rate (i.e. Economists call this outcome the policy
ineffectiveness proposition).
Recap on Monetary Policy Rule

▪ The policy ineffectiveness proposition does not apply to unanticipated

changes in monetary policy.
▪ The proposition may also not hold if it is costly for firms to adjust prices
or if households and firms can accurately forecast the effects of
changes in monetary policy.
THANK YOU