Notes Inflation and Interest Rates in the Medium Run Point of the class Math • manipulating an equation algebraically • manipulating graphs Model building • Using previous models to develop insight Economic concepts and intuition • Determination of output, inflation and unemployment in the short‐run and the medium‐run Definitions • Sacrifice ratio • Point years of excess unemployment • credibility • Staggered wage contracts Homework Problems • On the webpage. Facts [M]any of the hawks [people who think the Fed should do more to fight inflation] do not just differ in their outlooks [their perceptions of future inflation], but in how monetary policy works. The conventional view, shared by Mr. Bernanke, Donald Kohn, his influential vice-chairman, and their professional staff, is that monetary policy affects inflation via its impact on the real economy. Higher interest rates reduce demand relative to the economy’s potential to supply goods and services. Reduce it enough, and unused slack will accumulate, forcing firms and workers to compete for scarce customers and jobs by lowering prices and wages. The opposite happens when demand rises relative to supply. This relationship is captured in the Phillips curve, which shows inflation falling when unemployment is above its natural rate. In this view, it does not matter whether it is monetary policy or a credit crunch that raises unemployment: both put downward pressure on inflation. What is more, Mr Bernanke and his colleagues reckon today’s low fed funds rate is merely offsetting tighter financial conditions from the credit crunch. The hawks, by contrast, think that unemployment and other measures of “economic slack” have limited bearing on the transmission of monetary policy. Fed actions affect inflation primarily by altering inflation expectations. They worry that a low funds rate in itself threatens to lift inflation, and rising unemployment and the credit crunch will do little to contain it. The Economist, When hawks cry, Sep 11th 2008, http://www.economist.com/finance/displaystory.cfm?story_id=12209639 Model Building Building Blocks The medium run is defined as the period of time when inflation expectations and actual inflation are equal. The Phillips Curve is 󰇛󰇜 Okun’s Law is 󰇡󰇢 or  Aggregate Demand‐Inflation curve is  1 So, for any given period, the level of output is determined by the amount of spending by households, firms, government, etc.; by the size of the money supply, and by the inflation rate. So the change in output  from year to year (in the short run and in the medium run) should be determined • by the change in the amount of spendi ng (which we’ll ignore from now on); • by the change in the size of the money supply ∆, and • by the inflation rate .   Putting the Building Blocks Together Medium Run 1. In the medium run, expectations of inflation are met, . By the Phillips Curve 󰇛󰇜, this means that, unemployment equals the natural rate of unemployment, 2. In the medium run, output is at the natural level of output, . What determines the rate of growth of the natural level of output? The Solow Model (chapter 11) says that long‐run output growth depends on • productivity growth  u Medium‐run Phillips Curve ∆ ∆  󰇛󰇜 This combines the Phillips Curve with the definition of the medium run, . Inflation Nominal Money Growth Output Growth Phillips Curve Okun’s Law Aggregate Demand Unemployment• greater availability of resources, particularly labor and capital Neither the rate of growth of money supply nor inflation play any role in medium‐run output growth. And if  is growing, then  has to be growing at the same pace. If the natural level of output is growing at ∆, then that has to be the growth rate of actual output. ∆∆  The Aggregate Demand‐Inflation curve implies that at any point in time, output, money, and inflation are related:  However, in the medium run, the growth rate of (the natural level of) output does not depend on money growth or inflation. And money growth is exogenous. Then it must be the case that inflation is fully determined by  and by . So at any point in time, the level of inflation is  And in the medium run   Medium‐run inflation is determined by the rate of growth of the money supply and the growth rate of the natural level of output. Medium‐run inflation will be higher if money supply is This combines the AD‐π curve with medium‐run economic growth, . 89101112199519971999200120032005Trillions of $Real GDP Potential GDP012345199519971999200120032005growth rate, %Real GDP Potential GDPgrowing faster; and it will be smaller if the natural level of output is growing more quickly. In other words medium‐run inflation will be o higher if the money supply grows more quickly 󰇛󰇜.  In the medium run, the level of inflation is closely connected to the rate of growth of money supply. “Inflation is always and everywhere a monetary phenomenon” applies in the medium run. o higher if the medium‐run supply of goods (the natural level of output) grows more slowly . Medium run equilibrium is determined by the intersection of these two curves. Suppose that the growth rate of the natural level of output rises . Then, in the medium run, inflation should fall.  uMedium‐run Phillips Curve Aggregate Demand at  BA   u Aggregate Demand at  Examining the Result and Using the Model Short Run in ADAS The above implies that the monetary authority can pretty much pick its preferred level of