Macroeconomic equilibrium in the short run: the Money market 2013 - PowerPoint PPT Presentation

Macroeconomic equilibrium in the short run: the Money market 2013

1. The big picture Overview Previous lecture  How can we explain short run fluctuations in GDP?  Key assumption: sticky prices  Equilibrium of the goods market  IS curve Today  Equilibirum of the Money market  TR-curve  Macroeconomic equilibrium  IS-TR

Introduction The big picture IS-TR Model TR curve IS-TR today AS-AD: lecture AS: next notes (+ IS-TR with Monday parts of capital flows: Ch 12 Ch 13) Wednesday

Outline Recall: IS curve 1. Deriving the TR curve 2. Money demand 1. Money supply 2. Taylor Rule 3. The slope of the TR curve 4. Shifts of the TR curve 5. Macroeconomic equilibrium 3. Demand shocks 1. Change in monetary policy 2. Policy mix 3.

1. IS curve IS curve: equilibrium on the goods market  IS-curve  graphs all combinations of i and Y that result in goods market equilibrium  Goods market equilbrium  Aggregate supply of domestic goods and services = aggregate demand  Aggregate supply: Y  Aggregate demand (desired demand DD ): C + G + I + PCA             PCA Y Y  * Y C Y T I q i G , , , ,  Supply adjusts to demand  Keynesian Cross  If i ↓  investment ↑ (DD ↑)  Y ↑

1. IS curve From DD to IS  Equilibrium on the goods market: Y = desired demand             PCA Y Y  * Y C Y T I q i G , , , ,  IS curve derived by finding Y ’ s for all i ’ s that lead to Y = DD Y=DD IS Desired demand Interest rate A  i DD i ( )  B DD  i i DD i ( ) B  i DD A   Y Y Y Output Y Output

1. IS curve IS curve: equilibrium on the goods market  IS-curve  graphs all combinations of i and Y that result in goods market equilibrium  actual output = planned expenditure (desired demand: DD )  If i ↓  investment ↑ (DD ↑)  Y ↑ Interest rate  downward sloping  Right of IS: excess supply  Left of IS: excess demand All combinations of i and Y for which total supply of goods IS equals total demand of goods (for a given price level) Output

1. IS curve Shift in the IS curve             PCA Y Y   IS curve: * Y C , Y T I q i , G , ,  IS curve shifts, when any of the exogenous parameters change: Ω, T, q, G, Y*, σ ( “More”  right, “Less”  left, except: T + σ ) Y=DD Desired demand IS ´ Interest rate IS  DD G ,i ( ) B DD  DD G,i ( ) A B i DD A   Y Y Y Y Output Output

2. Deriving the TR curve Money market equilibrium  TR curve  represents the equilibrium in the money market  i.e. the combinations of the interest rate i and the income level Y where money demand equals money supply  Prices are fixed  Upward sloping  CB sets the interest rate  money supply endogenous  Interest rate set according to the Taylor rule to ensure price stability ( inflation targeting )

2.1. Money demand Deriving the TR curve  money demand  Money demand = k(i)PY  People are interested in the purchasing power of money  Real money demand with fixed prices: k(i)PY  k(i)Y Nominal interest rate If output increases from Y to Y ‘: money demand increases from k(i)Y to k(i)Y‘ k(i)Y ‘ k(i)Y Real money stock

2.2. Money supply Deriving the TR curve  money supply (M s )  real money supply = M/P  If P constant  M/P constant  controlled by the central bank (M0)  CB can choose any point on Interbank rate the money demand curve  Inflation targeting: CB fixes the interest rate  must provide as much M0 s as is demanded at that rate Real money M/P

2.2. Money supply TR curve and money market equilibrium Y  Y‘ : increases money demand from k(i)Y to k(i)Y‘ k(i)Y ‘ At interest rate i , money market k(i)Y Nominal interest rate equilibrium holds if the CB i‘ supplies (M/P)* CB raises the interest rate from i to i‘ in reaction to the output increase i  The higher interest rate i‘ reduces money demand. New money market equilibrium: at (M/P)‘ and i‘ M/P ‘ M/P M/P* Real How does the CB decides on i‘? Money Figure 10.9 (a): Animation 1

2.3. Taylor Rule The Taylor rule Output stability  Taylor rule Price stability  Y Y       i i a ( ) b Y  : trend GDP Y   : inflation target  : natural nominal interest rate, the rate CB would want if both π and Y i are at their trend values.  a and b: weights of the respective objectives  Short run: prices are fixed, inflation = 0  Y Y   i i b Y  If Y  (above trend GDP)  i   If Y  (below trend GDP)  i 

2.4. The slope of the TR curve The Slope of the TR Curve: TR 0  Y Y  The slope of TR depends on b :   i i b Y  Scenario 1 : b = 0  TR 0 : CB holds interest rate constant Nominal interest rate k(i)Y‘ Higher output Y‘ increases money demand. Y‘ > Y k(i)Y But: TR 0 implies a totally elastic money supply curve M S 0 . (slope of zero) D i M S TR 0 i 0 A D A Y  Real money M/P ‘ Y M/P Output

2.4. The slope of the TR curve The Slope of the TR Curve: TR 1  Scenario 2 : central bank responds to output increase by raising interest rates moderately .  b > 0  TR 1  Y Y   i i b Higher output Y‘ increases Y money demand. k(i)Y‘ TR 1 implies a positive slope Nominal interest rate k(i)Y of money supply curve M S 1 . M S TR 1 1 C i‘ 1 i‘ 1 C i i A A Y  Y Real money M/P ‘ M/P Output

2.4. The slope of the TR curve The Slope of the TR Curve: TR 2  Scenario 3 : central bank responds to output increase by raising interest rates strongly .  b ≫ 0  TR 2 : CB keeps money supply fixed. TR 2 implies a totally M S inelastic money 2 TR 2 k(i)Y‘ supply curve MS 2 . Nominal interest rate B B i‘ 2 i‘ 2 k(i)Y i i A A Y‘ > Y Y  Y Real money M/P Output

2.4. The slope of the TR curve Summary of the TR curve  Y Y   i i b  TR always goes through A . Y  The slope of TR depends on the weight b the central bank puts on the output gap. TR 3 Nominal interest rate Nominal interest rate M S 2 F F TR 2 (LM) M S 1 B TR 1 B C C D A i i M S TR 0 A 0 D k(i)Y‘ k(i)Y Y  Y Real money Output M/P supply

2.4. The slope of the TR curve Example of the Taylor rule schedule  Example:  Inflation = 0  inflation target =0  Y Y  Natural interest rate = 3%   i i b Y  Output gap = 4% 1. scenario: CB reacts only little to a change in Y: b= 0.4  i=0.03 + 0.4*0.04=0.046 (ex.: Curve TR 1 in previous slide) 2. scenario: CB reacts stronger to a change in Y: b=0.5  i=0.03 + 0.5*0.04= 0.05  Money supply increases less than in scenario 1

2.5. Shifts of the TR curve Shifts of the TR curve  Y Y  TR curve:       i i a ( ) b Y  For the TR curve to shift: If TR ´ Nominal interest rate change in  the target for Y or for π  or the natural interest rate i  B TR  or change in π (Ch. 13)  Ex: Change in monetary i policy: A  CB increases the natural i  interest rate to  TR shifts up (left) Y Output

2. Deriving the TR curve Summary of the TR curve  TR curve  represents the equilibrium in the money market  i.e. the combinations of the interest rate i and the income level Y where money demand equals money supply  Upward sloping  Slope depends on b, s hifts due to exogenous changes in monetary policy  Central bank: inflation targeting  CB can choose any interest rate it wants, but has to provide the amount of money demanded at that interest rate  If Taylor rule is followed: once the CB has decided on a , b and the inflation target, i is determined by this equation  Money market always in equilibrium

3. Macroeconomic equilibrium Macroeconomic equilibrium  In the IS-TR framework, the macroeconomic equilibrium occurs when both the goods and the money market are in equilibrium  no excess demand/supply either for goods or for money (general equilibrium)  IS-TR  We will consider three policy experiments:  Exogenous increase in demand  Exogenous change in monetary policy  Policy mix

3. Macroeconomic equilibrium IS - TR equilibrium TR IS Interest rate A i Y Output

3.1. Demand shocks in the macroeconomic equilibrium IS - TR equilibrium: demand shock  Positive demand shock : increase in demand  IS shifts to the right TR In response to output Nominal interest rate expansion, the central B bank raises the interest i‘ rate. A i New equilbrium: point B IS‘ IS Y‘ Y Output Figure 10.13 (b): Animation 1

3.1. Demand shocks in the macroeconomic equilibrium IS-TR equilibrium  TR curve with a slope >0  Outward Shift of IS  Y  , i  , M/P  Exogenous increase in demand Nominal interest rate Nominal interest rate TR M s B B A i i S i C A C IS ´ D ´ D IS Y  Y Real money Output supply