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

Macroeconomic equilibrium in the short run: the Money market

2013

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

• 1. The big picture

The big picture

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

TR curve IS-TR Model

Outline

1.

Recall: IS curve

2.

Deriving the TR curve

1.

Money demand

2.

Money supply

3.

Taylor Rule

4.

The slope of the TR curve

5.

Shifts of the TR curve

3.

Macroeconomic equilibrium

1.

Demand shocks

2.

Change in monetary policy

3.

Policy mix

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  Supply adjusts to demand  Keynesian Cross

 If i ↓ investment ↑ (DD ↑)  Y ↑

 

 

 

*

, , , , Y C Y T I q i G PCA Y Y       

• 1. IS curve

 i

From DD to IS

 Equilibrium on the goods market: Y = desired demand  IS curve derived by finding Y’s for all i’s that lead to Y = DD Desired demand Output Interest rate Output

 DD i ( ) DD i ( ) DD

Y  DD  Y Y  Y

A

IS Y=DD i

B A  i i B

 

 

 

*

, , , , Y C Y T I q i G PCA Y Y       

• 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 ↑

 downward sloping  Right of IS: excess supply  Left of IS: excess demand

Interest rate IS

All combinations of i andY for which total supply of goods equals total demand of goods (for a given price level)

Output

• 1. IS curve

 IS curve: IS curve shifts, when any of the exogenous parameters

change: Ω, T, q, G, Y*, σ (“More”  right, “Less”  left, except: T + σ)

Shift in the IS curve

Desired demand Output Interest rate Output

( ) DD G ,i 

B A

DD  Y Y  Y

IS´ Y=DD

i

A

IS

B

( ) DD G,i DD Y

 

 

 

*

, , , , Y C Y T I q i G PCA Y Y       

• 1. IS 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. Deriving the TR curve

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 Real money stock Nominal interest rate 2.1. Money demand If output increases from Y to Y‘: money demand increases from k(i)Y to k(i)Y‘

k(i)Y k(i)Y‘

Deriving the TR curve

 money supply (Ms)

 real money supply = M/P  If P constant  M/P constant  controlled by the central

bank (M0)

 CB can choose any point on

the money demand curve

 Inflation targeting: CB fixes the

interest rate

must provide as much M0s as is

demanded at that rate

M/P

Interbank rate

2.2. Money supply Real money

TR curve and money market equilibrium

Figure 10.9 (a): Animation 1

Y  Y‘ : increases money demand from k(i)Y to k(i)Y‘

Real Money Nominal interest rate i k(i)Y k(i)Y‘ M/P M/P*

At interest rate i, money market equilibrium holds if the CB supplies (M/P)*

i‘ M/P‘

 The higher interest rate i‘ reduces money demand. New money market equilibrium: at (M/P)‘ and i‘ CB raises the interest rate from i to i‘ in reaction to the output increase How does the CB decides on i‘? 2.2. Money supply

The Taylor rule

 Taylor rule

 : trend GDP  : inflation target  : natural nominal interest rate, the rate CB would want if both π and Y

are at their trend values.

 a and b: weights of the respective objectives

 Short run: prices are fixed, inflation = 0

 If Y  (above trend GDP)  i   If Y  (below trend GDP)  i 

Y Y Y b a i i      ) (  

Output stability Price stability

i

Y Y Y b i i   



Y

2.3. Taylor Rule

The Slope of the TR Curve: TR0

A D

Y

Y

TR0 Nominal interest rate

i

Output Real money

MS

M/P

D A k(i)Y k(i)Y‘ Y‘ > Y

Higher output Y‘ increases money demand. But: TR0 implies a totally elastic money supply curve MS

• 0. (slope of zero)

i

 The slope of TR depends on b:  Scenario 1: b= 0  TR0: CB holds interest rate constant

Y Y Y b i i   

M/P‘

2.4. The slope of the TR curve

The Slope of the TR Curve: TR1

A C

Y

Y

TR1 Nominal interest rate

i

Output Real money MS

1

M/P C A k(i)Y k(i)Y‘ Higher output Y‘ increases money demand. TR1 implies a positive slope

• f money supply curve MS

1.

i‘1 i‘1

i

 Scenario 2: central bank responds to output increase by

raising interest rates moderately.

 b > 0  TR1

M/P‘

2.4. The slope of the TR curve

Y Y Y b i i   

The Slope of the TR Curve: TR2

A

B

Y Y

TR2

Nominal interest rate i‘2

i

Output Real money

i‘2 MS

2

M/P B

A k(i)Y k(i)Y‘

i

TR2 implies a totally inelastic money supply curve MS2.

Y‘ > Y

 Scenario 3: central bank responds to output increase by

raising interest rates strongly.

 b ≫ 0  TR2: CB keeps money supply fixed. 2.4. The slope of the TR curve

TR1 TR2 (LM) TR3

MS MS

2

Summary of the TR curve

 TR always goes through A.  The slope of TR depends on the weight b the central bank

puts on the output gap.

Real money supply Output

A B B

Nominal interest rate Nominal interest rate

D D C C F A

Y Y Y b i i   

M/P MS

1

Y i i Y

F

k(i)Y‘ k(i)Y

2.4. The slope of the TR curve

TR0

Example of the Taylor rule schedule

 Example:

 Inflation = 0  inflation target =0  Natural interest rate = 3%  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 TR1 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

Y Y Y b i i   

2.4. The slope of the TR curve

Shifts of the TR curve

 TR curve:

 For the TR curve to shift: If

change in

 the target for Y or for π  or the natural interest rate  or change in π (Ch. 13)

 Ex: Change in monetary

policy:

 CB increases the natural

interest rate to  TR shifts up (left) Output

TR

Nominal interest rate

TR´

i Y

A B

i

2.5. Shifts of the TR curve

Y Y Y b a i i      ) (  

i

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, shifts 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

• 2. Deriving the TR curve

Macroeconomic equilibrium

 In the IS-TR framework, the macroeconomic equilibrium

• ccurs 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

i

Y

Interest rate Output

A

• 3. Macroeconomic equilibrium

Figure 10.13 (b): Animation 1

TR B Nominal interest rate Output A IS‘ IS Y‘ i‘ i

In response to output expansion, the central bank raises the interest rate. New equilbrium: point B

IS-TR equilibrium: demand shock

 Positive demand shock: increase in demand  IS shifts to

the right

Y

3.1. Demand shocks in the macroeconomic equilibrium

Ms Si

i

D

IS-TR equilibrium

 TR curve with a slope >0  Outward Shift of IS  Y, i , M/P  Real money supply Output

A

Nominal interest rate Nominal interest rate

TR

Y i

IS IS´ D´

B A B

Exogenous increase in demand

Y

C C

3.1. Demand shocks in the macroeconomic equilibrium

The economics behind IS-TR

 Example: IS curve shifts because of an increase in G  Goods market (Keynesian cross):

 Desired demand(C+I+G+PCA) increases  supply of goods

will follow

 Total production rises and thus income rises also: Y  Multiplier effect: A-C (the new equilbrium would be C)

 Money market:

 Increase in Y leads to a higher money demand for a given i  Taylor rule tells CB how to set the interest rate in case that Y

is above the trend value (here the case!)  expansionary monetary policy

 CB will increase money supply and i (depending on b)  i 

(A  B)

3.1. Demand shocks in the macroeconomic equilibrium

 The action of the CB has again an impact on the real

economy:

 Goods market:

 Higher i reduces investment planned investement , DD   This drop in investment partially offsets the positive effect of

the increase in G on Y. (C-B)

• New equilibrium: point B
• higher i, higher Y, but Y lower then predicted by the

Keynesian cross. That’s because of the interaction with the money market!

• No money neutrality here!

The economics behind IS-TR

3.1. Demand shocks in the macroeconomic equilibrium

Figure 10.13 (b): Animation 1

TR C Nominal interest rate Output A IS IS‘‘ Y‘‘ i i‘‘

In response to output contraction, the central bank lowers the interest rate.

IS-TR equilibrium: demand shock

 Negative demand shock: decrease in demand  IS shifts

to the left

Question: Can you find what happens in the money market? Question: How does the money market influences the goods market?

Y

3.1. Demand shocks in the macroeconomic equilibrium

Figure 10.13 (d): Animation 2

TR D Nominal interest rate Output A IS Y‘ i i‘ TR‘

IS-TR equilibrium: TR shocks

 Expansionary monetary policy shock: decrease in the

natural interest rate  TR shifts to the right

NOTE: According to the Taylor rule monetary policy is automatically expansionary if Y < (contractionary if Y > ) Shift of TR-curve only if decrease/increase in i for ALL levels of Y (also )  change in one of the parameters of the TR!

Y

Y Y Y

3.2. Monetary policy changes the macroeconomic equilibrium

IS

IS-TR equilibrium

 Policy mix: new equilibrium in D same Y, M/P , i ↘

TR IS‘

i

Y

TR´

Interest rate Output

A D

Combination of exogenous changes in demand and monetary policy

3.2. Monetary policy changes the macroeconomic equilibrium

Short-Term Interest Rates, 1990-2011

3.2. Monetary policy changes the macroeconomic equilibrium

Find the mistake!

Real money supply Output

A A F H

Nominal nterest rate Nominal nterest rate

B

M

Si F B

TR

i

TR´

H C C

IS IS´ D´ D

Y