June 2010

Prof. Ester Faia (Institute)

Monetary Policy and Aggregate Demand, Chapter 17

June 2010

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Keynes versus the classics

The classical economists. If only market forces are allowed to work, economic activity will quickly adjust to its natural rate determined by the supply side. No need for government intervention. After the Great Depression Keynes claimed that aggregate demand played an important role Nowadays economists believed that economic activity in the short to medium run is determined by both aggregate demand and aggregate supply

Prof. Ester Faia (Institute)

Monetary Policy and Aggregate Demand, Chapter 17

June 2010

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Conditions for good market equilibrium

Y = C + I +G

Where D=C+I is private demand

Prof. Ester Faia (Institute)

Monetary Policy and Aggregate Demand, Chapter 17

June 2010

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Conditions for good market equilibrium

Consumption demand

Prof. Ester Faia (Institute)

Monetary Policy and Aggregate Demand, Chapter 17

June 2010

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The Good Market From (1) through (3) we get the equilibrium in the good market

Properties of the aggregate demand

Prof. Ester Faia (Institute)

Monetary Policy and Aggregate Demand, Chapter 17

June 2010

5 / 17

Log-linear approximation of the aggregate demand Long run equilibrium

Totally di¤erentiating and divide both sides by Y and write right-hand side as products of (semi-)elasticities and percent deviations from steady-state

Prof. Ester Faia (Institute)

Monetary Policy and Aggregate Demand, Chapter 17

June 2010

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The Money Market

Equilibrium in the money market

Money demand function: notice that i is the short term interest rate controlled by the central bank

Money supply determined by constant money growth rule

Prof. Ester Faia (Institute)

Monetary Policy and Aggregate Demand, Chapter 17

June 2010

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Determination of interest rate

Money demand equals money supply

If η is close to 1 and β is close to zero

A constant rate of growth of M will then ensure a stable growth in aggregate money income PY.

Prof. Ester Faia (Institute)

Monetary Policy and Aggregate Demand, Chapter 17

June 2010

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Money growth targeting Assume that we have long run equilibrium in the previous period

Taking logarithms in (1) and (2) and using the approximations

ln(1+µ) ~ µ and ln(1+π) ~ π , we get Substitution of (3) into (4) yields:

Prof. Ester Faia (Institute)

Monetary Policy and Aggregate Demand, Chapter 17

June 2010

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Taylor Rule

A stable growth in total money income cannot be achieved if the parameters η and β change in an unpredictable way (for example through …nancial innovations) Taylor rule:

Equilibrium determinacy is achieved when the target on in‡ation is above 1

Prof. Ester Faia (Institute)

Monetary Policy and Aggregate Demand, Chapter 17

June 2010

10 / 17

Estimated interest rate reaction functions of four central banks

Prof. Ester Faia (Institute)

Monetary Policy and Aggregate Demand, Chapter 17

June 2010

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Three-month interest rate and the estimated Taylor rate in the euro area

Prof. Ester Faia (Institute)

Monetary Policy and Aggregate Demand, Chapter 17

June 2010

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Deriving the Aggregate Demand Curve

Use above equations to obtain:

Prof. Ester Faia (Institute)

Monetary Policy and Aggregate Demand, Chapter 17

June 2010

13 / 17

Aggregate Demand

The AD curve has a negative slope: higher in‡ation induces the central bank to raise the interest rate, causing aggregate demand to fall The AD curve is ‡atter, the more weight the central bank attaches to stable in‡ation compared to output stability The AD curve shifts upwards in case of optimistic growth expectations in the private sector or in case of an expansionary …scal policy The AD curve shifts downwards if the central bank reduces its in‡ation target

Prof. Ester Faia (Institute)

Monetary Policy and Aggregate Demand, Chapter 17

June 2010

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Aggregate Demand

The aggregate demand curve under alternative monetary policy regimes Prof. Ester Faia (Institute)

Monetary Policy and Aggregate Demand, Chapter 17

June 2010

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Term structure of interest rates

The problem: the central bank may control the short-term interest rate, but aggregate demand mainly depends on the long-term interest rate. Assumption: Short-term and long-term bonds are perfect substitutes. Hence by arbitrage:

Taking logs on both sides and using the approximation ln(1+i) ~ i,

Prof. Ester Faia (Institute)

Monetary Policy and Aggregate Demand, Chapter 17

June 2010

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Conditions for good market equilibrium Monetary policy can only have a signi…cant impact on long-term interest rates by in‡uencing the expected future short-term interest rates A change in the current short-term rate which is expected to be temporary will only have a very limited impact on the long-term interest rate When the market expects a future tightening of monetary policy, the yield curve is rising If the market expects a future relaxation of monetary policy, the yield curve is falling The yield curve is ‡at when market participants have static interest rate expectations

Prof. Ester Faia (Institute)

Monetary Policy and Aggregate Demand, Chapter 17

June 2010

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