Lecture notes on Financial Macroeconomics

8/7/2019 Lecture notes on Financial Macroeconomics

http://slidepdf.com/reader/full/lecture-notes-on-financial-macroeconomics 1/38

Lecture notes on

Financial Macroeconomics

Francesco Ricci1

July 2003lecture at the Silesian International Business School

preliminary and incomplete2

do not quote or copycomments welcomed

1Thema-Universite de Cergy-Pontoise. E-mail: [email protected] lecture was more complete than these notes. Here you will find references to last

year’s lecture notes. Pictures are attached in separate pdf files.



2



Contents

1 The credit market 71.1 The financial system . . . . . . . . . . . . . . . . . . . . . . . . . . . 7

1.1.1 Financial markets . . . . . . . . . . . . . . . . . . . . . . . . . 7

1.1.2 From markets to intermediaries . . . . . . . . . . . . . . . . . 71.1.3 The banking system . . . . . . . . . . . . . . . . . . . . . . . 7

1.2 Savings, investment and the interest rate . . . . . . . . . . . . . . . . 71.2.1 Savings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71.2.2 Borrowing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

Investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10Public deficit . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

1.2.3 Equilibrium on the credit market and the real interest rate . . 11Small open economy . . . . . . . . . . . . . . . . . . . . . . . 12Large open economy . . . . . . . . . . . . . . . . . . . . . . . 13

2 Money 152.1 Demand for money . . . . . . . . . . . . . . . . . . . . . . . . . . . . 162.2 Money supply . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16

2.2.1 The process of monetary creation . . . . . . . . . . . . . . . . 172.2.2 The objective of Central Banks . . . . . . . . . . . . . . . . . 172.2.3 Empirical and theoretical state of the art on monetary policy . 182.2.4 The tools of monetary policy . . . . . . . . . . . . . . . . . . . 202.2.5 Channels of transmission of monetary policy . . . . . . . . . . 212.2.6 Situations where private expenditure does not react to changes

in the rate of interest . . . . . . . . . . . . . . . . . . . . . . . 22

2.3 Money market equilibrium . . . . . . . . . . . . . . . . . . . . . . . . 23

3 Simultaneous equilibrium of the credit, money and goods market 253.1 The goods market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 253.2 General equilibrium with fixed prices . . . . . . . . . . . . . . . . . . 25

3.2.1 Policy mix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25

4 Inflation, employment and monetary policy 274.1 The Phillips curve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27

3



4 CONTENTS

4.1.1 Rational expectations and the independence of Central Banks 294.2 Aggregate demand . . . . . . . . . . . . . . . . . . . . . . . . . . . . 304.3 Simultaneous determination of inflation and production . . . . . . . . 31

4.4 Monetary policy rules . . . . . . . . . . . . . . . . . . . . . . . . . . . 324.4.1 Inflation targeting . . . . . . . . . . . . . . . . . . . . . . . . . 324.4.2 Taylor’s rule . . . . . . . . . . . . . . . . . . . . . . . . . . . . 334.4.3 Monetary base growth rule . . . . . . . . . . . . . . . . . . . . 35

4.5 Economic policy in closed economies . . . . . . . . . . . . . . . . . . 35



List of Figures

1.1 Life-cycle income, expenditure and savings . . . . . . . . . . . . . . . 81.2 Equilibrium interest rate . . . . . . . . . . . . . . . . . . . . . . . . . 121.3 The current account in a small economy . . . . . . . . . . . . . . . . 13

1.4 Savings, public deficit, investment and the current account . . . . . . 142.1 Equilibrium on credit and money market . . . . . . . . . . . . . . . . 23

4.1 Inflation and production . . . . . . . . . . . . . . . . . . . . . . . . . 314.2 Inflation targeting under demand shocks . . . . . . . . . . . . . . . . 334.3 Inflation targeting under supply shocks . . . . . . . . . . . . . . . . . 344.4 Reagan-Volker economic policy to curb inflation . . . . . . . . . . . . 374.5 Clinton-Greenspan economic policy to reduce public deficit . . . . . . 38

5



6 LIST OF FIGURES



Chapter 1

The credit market

1.1 The financial system

For this section see last year’s lecture notes

1.1.1 Financial markets

1.1.2 From markets to intermediaries

1.1.3 The banking system

1.2 Savings, investment and the interest rate

1.2.1 Savings

The main determinants of the aggregate propensity to save (aggregate savings /

aggregate income) are:

•

Life-cycle considerations

– income (labor and capital income) is unevenly distributed over the life of

an individual, reaching a maximum around her/his late 50’s;

– individuals or households prefer to have a relatively constant level of

consumption (expenditure) [see figure 1.1];

7



8 CHAPTER 1. THE CREDIT MARKET

-

6

desired expenditure

?

labor income

saving and

debt servicing

borrowing

dissaving

age

$

Figure 1.1: Life-cycle income, expenditure and savings

⇒ the financial system allows individuals and households to save when income

is relatively high (in their 40’s and 50’s) and to borrow or to use the accumu-

lated savings to finance consumption when income is relatively low (in their

20’s-30’s and after retirement in their 70’s).

Remarks:

individuals’ expenditure (and saving) decisions are based on both current

and expected future income, together with their initial wealth and the

expected return on savings: this set of current and expected elements

of personal income takes the name of permanent income. If individu-

als adapt their expenditure to their permanent income, changes in the

economic situation have a very different impact on individuals’ currentexpenditure depending on whether the changes were expected or not,

and whether the changes are permanent or temporary (the latter have a

smaller impact on permanent income than the former);

because of the uneven evolution of saving behavior, the demographic

structure of the population is crucial in determining aggregate savings;



1.2. SAVINGS, INVESTMENT AND THE INTEREST RATE 9

the introduction or the reform of a pay-as-you-go pension system to sup-

port income of retired individuals modifies the propensity to save.

• Precautionary saving. Individuals and households save to be prepared for

emergencies, if it is difficult to borrow against uncertain future personal in-

comes. Again the social security system, unemployment insurance or public

health system can modify individuals’ propensity to save with respect to this

motive.

• Altruism. Individuals usually leave bequests to the members of their family.

They may want to save to this end.

• Real interest rate. The expected real return on savings (in purchasing

power, re = i− πe) affects the propensity to save.

If the real interest rate increases:

– saving becomes more interesting, that is present expenditure becomes

more expensive relative to future expenditure (giving up the purchase of a television set today allows me to buy it next year together with a DVD

player in the real interest rate is high enough) ⇒ the propensity to save

increases;

– the value of households’ assets (houses, stocks, bonds) increases, they

feel (and are) richer ⇒ they can borrow more and spend more ⇒ the

propensity to save increases;

– because on net households are creditors, they receive a larger capital

income ⇒ their permanent income increases ⇒ they wish to spend more

tomorrow but also more today ⇒ their propensity to save tends to fall;

The first two forces dominate the third and the aggregate supply of savings

increase with the real interest rate, and vice versa. We can represent this result




with an upward sloping curve on the diagram (Funds, r). The curve shifts South-

East when the aggregate propensity to save expands, for instance when the ratio of

individuals in their 40-50’s to retired individuals increases (in US during the 1990,

with baby-boomers born in 1945-1955 entering in their 50’s), or the reduction of

social security benefits (lower unemployment insurance, pensions), or a temporary

increase in current income which would be mostly saved because it has a small

impact on permanent income.

1.2.2 Borrowing

Let us abstract from households’ borrowing and focus on firms’ and government’s

borrowing requirements.

Investment

Let us consider firms’ investment decisions, they depend on:

• expected profitability of capital (real return on investment), influenced by the

expectations concerning

– the development of new technologies;

– the opening and development of new markets (trade liberalization);

– expected growth in demand;

– expected changes in corporate taxation;

• expected real interest rate, determining:

– the present value of the stream of profits generated by the investment

project (more sensitive to r the longer the life time of the project);

– the cost of funds necessary to finance the investment project (particularly

the interest rate on long term loans)



1.2. SAVINGS, INVESTMENT AND THE INTEREST RATE 11

– the opportunity cost of using internal funds to finance investment projects

rather than holding (risk-less) bonds.

Therefore the demand for funds from firms is a decreasing function of the real

rate of interest. It can be represented graphically as a downward sloping curve in

the (Funds, r) diagram.

Public deficit

The government also borrows funds to finance public expenditure. We assume that

this demand for funds is independent of the level of the real interest rate

The sum of funds demanded by firms and by the government for each and any

level of the real interest rate is represented in the (Funds, r) diagram as a downward

sloping curve. This curve shifts North-East when the expected profitability of capital

improves or the public deficit grows, and vice versa it shifts South-West when the

expected profitability falls or the public deficit shrinks.

1.2.3 Equilibrium on the credit market and the real interestrate

Putting together demand of and supply for funds, we can determine the level of

savings and funds borrowed, as well as the equilibrium level of the real interest rate

[see figure 1.2].

The real interest rate increases and the funds borrowed increase too, when the

demand for funds shifts NE, that is in the case of an improvement of the expected

profitability of investments or of a deepening of public deficit (remark: a larger deficit

increases the interest rate and reduces indirectly firms’ investment, a phenomenon

defined as crowding out ). Opposite movements of the demand for funds curve reduce

national savings and reduce the real interest rate. The real interest rate increases

but the funds borrowed decrease when the supply of funds curve shifts NW, as the




-

6Savings

Borrowing

Funds

r

S ∗

r∗E

Figure 1.2: Equilibrium interest rate

result of a fall in the aggregate propensity to save. The latter could be due to

various factors, such as the ageing of population, the improvement of social security

benefits, or a temporary fall in current income with a small impact on permanent

income.

Small open economy

A small open economy has no influence on the foreign real rate of interest. Domes-

tic households have the opportunity to hold foreign assets paying interest rw, and

domestic firms and the government can borrow abroad at interest rate rw. Suppose

that the determinants of domestic savings and borrowing are such that the real rate

of interest, that would prevail if the economy were closed, is below the foreign real

rate (that is the intersection between domestic demand and supply of funds is at

some level of the real interest rate rc

< rw

and of funds borrowed S c

) [see figur

1.3]. Then in the small open economy, no household would accept a lower interest

rate than rw, so that borrowing will be below S c, while the households will save

more than S c. The difference between national savings and borrowing is the current

account surplus (see the national accounting definitions of the balance of payments

in the first chapter of any textbook on macroeconomics or international economics),






- 6

-

6 6S G

DG92

r rDREU DG

89 S REU

rw89

rc92rw92...............................................................................

CAG92 < 0 CAREU

92 > 0

Figure 1.4: Savings, public deficit, investment and the current account

rw89, allowing the real interest rate in Germany to settle at a level below rc92. The new

equilibrium is attained at an interest rate rw92, such that rw89 < rw92 < rc92, where the

German current account deficit coincides precisely with the current account surplus

of the rest of the EU, CAG92 = −CAREU

92 . Therefore, the reunification rises the

interest rate and savings all over the EU; it increases borrowing in Germany, but it

reduces borrowing abroad; it reduces the German current account and increases the

current account to the rest of the EU.



Chapter 2

Money

Money is defined as the set of means of payment. The roles of money are:

• unit of account

• medium of exchange

• store of value

In principle any durable asset could be used as means of payment. These possible

assets differ however in their degree of liquidity: the easiness (cost) with which the

asset can be used for payments. Money itself is defined, according to its degree of

liquidity, in three different ways:

• M1=cash+cheackable deposits (narrow money, the most liquid assets, used

directly to pay)

• M2=M1+deposits that can be used with additional effort but at no or low

cost (for instance: savings accounts, for which you need to go to the bank;

short time deposits, ≤ 2 years)

• M3=M2+monetary market bonds, long term bank certificates ...

Money is based on trust: it is accepted as means of payment only if the seller

believes that it can use the money later to purchase goods and services. Systemic

doubts can cause the monetary system to collapse (panic and bank runs).

15



16 CHAPTER 2. MONEY

2.1 Demand for money

Determinants:

• volume of transactions ∼ quantity of goods produced in the economy (GDP

gross domestic product), Y

• nominal value of the goods and services exchanged ∼ index of the general level

of prices P

• opportunity cost of money holding ∼ i, the nominal interest rate that could

be earned on the alternative placement (risk-less bonds)

M d = P L (Y, i)

the quantity of money demanded by the agents is proportional to the level

of prices (agents only care about the purchasing power of money, not about

the absolute amount of zloties they hold), it is increasing in the volume of

transactions and production (Y ), it is decreasing in the interest rate (the cost

of holding money).

We can draw the money demand curve in the (M , i) diagram as a downward-

sloping curve [see figure 2.1]. An increase in prices, P , or in production, Y , shifts

the curve North-East (NE).

2.2 Money supply

The supply of money in the economy is controlled by the Central Bank which has the

privilege of printing banknotes. The quantity of money in the economy is determined

by the banking system



2.2. MONEY SUPPLY 17

2.2.1 The process of monetary creation

The central bank creates money by changing the liabilities (or equivalently the

assets) in its balance sheet. For instance the CB injects 1 million zl in Poland by

lending it to the Treasury with a loan1 (an increase in assets), taking 1 million zloties

out of its vaults and putting them in circulation (“printing” money, that is creating

liabilities “cash in circulation”).

Banks multiply money by lending money: they sell the right to use their de-

positors money. It is a risky activity, because of the gap in liquidity between their

liabilities (very liquid) and their assets (not liquid).Example: the Treasury buys a good with the money issued by the CB, so the

Treasury’s supplier receives the sum on its banking account. Her bank will use a

part of her deposit to lend it to a customer. The bank’s customer receives the money

from the loan, uses it to purchase a good, and the supplier puts the money in his

own bank account. Now the quantity of deposits in the banks has increased by

the amount of the deposit of the Treasury’s supplier plus the amount of the latter

supplier, therefore there are more deposits (money, M1) than the quantity provided

by the CB.

Central Bank Banksassets liabilities assets liabilitiesgold cash in circulation reserves depositsforeign exchange reserves loanssecuritiesloans

2.2.2 The objective of Central Banks

According to Art. 3 of the 1997 Act on the NBP

1. the primary objective of the NBP is maintaining price stability, that is avoiding

high inflation or deflation;

1Actually this is forbidden by the 1997 Act on NBP, but it is meant to be just a simple example



18 CHAPTER 2. MONEY

2. the secondary objective, which shall not compromise price stability, is provid-

ing support to government’s economic policy.

The objective of the government is often to fight unemployment. The predomi-

nance of price stability over any other goal is stated formally because, as it will be

explained in chapter 4, there seems to be a contradiction between fighting against

inflation and fighting against unemployment.

Other possible objectives for the central bank are:

• the maintenance of a constraining exchange rate regime, such as a fixed ex-

change rate or a crawling peg. This objective can be in conflict with that of

price stability.

• ensuring the stability of the financial system, by acting as lender of last resort

to financial institutions. Also this objective can lead to a conflict with the

objective of maintaining price stability.

The exchange rate regime is chosen by the government, but its management is

the responsibility of the CB.

The ECB has the same objective as the NBP.

2.2.3 Empirical and theoretical state of the art on monetarypolicy

In the long run:

• there exists a strong and positive correlation between the rate of growth of

money supply and inflation, over a large sample of countries since World War

II (there cannot be a general increase in the level of prices without an expansion

in the quantity of sloties in the economy) [ see picture 1];

• there exists no correlation between the rate of growth of money supply and

economic growth, over a large sample of countries since World War II;



2.2. MONEY SUPPLY 19

• there exists no correlation between the rate of growth of money supply and

inflation or economic growth, for the smaller sample of low-inflation countries

(π < 5% on average).

In the short and medium term (≤2 years):

• monetary policy (changes in the supply of money or of the interest rate decided

by the CB) have real effects (on employment, production and real rate of

interest);

• this effects are very variable and uncertain;

• they depend strongly on expectations.

Two schools of thought dominated the debate over monetary policy:

• the traditional main-stream view: monetary policy is unable to influence real

economic variables (employment production and real rate of interest), and it

should therefore be targeted to maintaining prices stable.

• the keynesian view: monetary policy is efficient and can influences the level

of employment and the other real economic variables, it should be targeted to

promote economic growth and to ensure full employment.

Nowadays a new consensus has been reached: monetary policy should target

price stability, precisely because the decisions of the CB can have important conse-

quences on real economic variables, but these are uncertain in size and timing, while

the costs of inflation are sure and high, and can be avoided with and appropriate

monetary policy.



20 CHAPTER 2. MONEY

2.2.4 The tools of monetary policy

The CB controls the rate of interest on the interbank market, and banks’ creditcreation, using typically three main tools of intervention (providing credit to banks,

or absorbing liquidity from the banking system):

• Open market operations. These are mainly repurchase agreements (repos)

auctioned on the primary market for bonds, where the CB sells or buys. In the

Eurozone the auctions take place once a week, and the term of the repurchase

agreement varies from one day to a few months, but most of the operations

are done on the term of two weeks repurchasing agreement [see the example

handed out in class].

• Standing facility for overnight loans and deposits by banks. A Lombard loan

is a loan from the CB to a bank for 24 hours, at an interest rate (Lombard

rate) chosen by the CB. This interest rate establishes the maximum interest

rate on the interbank market, because no bank will borrow at a higher rate (it

would be better to borrow from the CB). Banks can deposit funds at the CB

for 24 hours on end-of-the-day deposits, receiving an interest rate chosen by

the CB. This rate establishes a floor to the rate of interest on the over-night

interbank market, because no lender would accept a lower rate. Therefore the

standing facility creates a corridor within which the overnight interests rate is

fixed on the interbank market [see picture 2].

• Required reserve ratio. This is a regulation establishing that the banks

shall hold a percentage of their liabilities (customers’ deposits) as liquid re-

serves, in the form of a deposit (reserves) of the bank at the CB. In Poland it

is 5%, in the EMU is 2%.





22 CHAPTER 2. MONEY

The mechanism works in the symmetric but opposite direction in the case of a

higher rate of interest. We conclude that the monetary policy (restrictive if it rises

the rate of interest, expansionary if it lowers it) has a direct impact on the aggregate

demand for goods and services.

2.2.6 Situations where private expenditure does not reactto changes in the rate of interest

• Over-investment and rapid technological change. The present value of

an investment project is not sensitive to changes in the interest rate, when the

project generates profits in a very short time, which is the case when there

is fast obsolescence of equipment goods. Similarly, firms do not expand their

investment, following a reduction in the interest rate, if they have too much

capital installed.

• Liquidity trap. Suppose that there are expectations of deflation: πe < 0.

Then money holding earns a positive real return, stimulating money hoarding,

and reducing incentives to spend money. When the CB injects money in

economy, households may keep it in their pockets, so that the policy is not

effective to stimulate demand. Furthermore, firms and households do not wish

to borrow because the real burden of debt increases (even with i = 0, the

purchasing power of debt service, repaying the principal, is expected to be

positive and increasing). Therefore a reduction in the nominal rate of interest

in the interbank market may not generate any expansion in the volume of

credit.

• (Hidden) banking crisis. Suppose that an important share of the banks’

assets are insolvent, but the bank decides to hide it. Then the bank is forced

to increase the share of liquid assets to avoid bankruptcy. The only way to

do this, it is to wait that the non liquid assets arrive to maturity, avoiding to



2.3. MONEY MARKET EQUILIBRIUM 23

-

6

-

6

M Y

ii M s

Dem(Y 0)

Dem(Y 1)

i∗0

i∗1 i∗1

i∗0

Y 0 Y 1

LM

Figure 2.1: Equilibrium on credit and money market

provide new loans in the meanwhile. During such an adjustment phase, the

bank does not provide any new credit, whatever the interest rate. Actually, a

lower interest rate can make the problem even worst, because it reduces the

cost of the fraudulent practice of evergreening bad loans.

2.3 Money market equilibrium

If the supply of money is controlled by the CB, we can treat it as an (exogenous)

economic policy variable. In the (M ,i) diagram the supply is represented as a vertical

line. Together with the money demand curve, they determine the equilibrium rate

of nominal interest. An expansionary monetary policy shifts the supply curve to the

East, and lowers, everything else equal, the equilibrium rate of interest (nominal).

This is why it is equivalent to speak of an expansionary monetary policy as an

increased supply of money in the economy or as a reduction of the interest rate.

It is important to understand that in the diagram we are treating the volume

of savings as given. Savings can be held in one of two forms: money (that earn no

interest) or as bonds (that pay interest). Therefore the equilibrium on the money

market must imply also the equilibrium on the credit market (the interest rate at

which demand for credit equals supply of credit).



24 CHAPTER 2. MONEY

However the volume of savings, and therefore the demand for money changes

with real income (the volume of production, GDP, Y) and with the general level

of prices. Higher income shifts NE the money demand curve and requires a higher

interest rate for a constant supply of money. Vice versa a lower income requires a

lower interest rate, for the money (and credit) market to be in equilibrium. This

positive interdependence between national income (GDP) and the interest rate that

ensures the equilibrium on the many and credit markets is defined as the upward-

sloping LM curve in the (Y ,i) diagram [see figure 2.1].



Chapter 3

Simultaneous equilibrium of thecredit, money and goods market

3.1 The goods market

For this chapter see last year’s lecture notes

3.2 General equilibrium with fixed prices

The IS-LM model determining simultaneously the level of production and of the

interest rate, under the assumptions that there is excess capacity and firms are ready

to meet any level of aggregate demand for goods and services without increasing their

prices.

3.2.1 Policy mix

This section presents various examples of combinations of fiscal and monetary policy

using the IS-LM framework.

• German reunification: expansionary fiscal policy with restrictive monetary

policy. It increases strongly the interest rate and generates a small economic

expansion.

• US adjustment in the 1990’s: expansionary monetary policy with restrictive

fiscal policy to reduce the public deficit. It reduces strongly the interest rate

25



26CHAPTER 3. SIMULTANEOUS EQUILIBRIUM OF THE CREDIT, MONEY AND

and stimulates private investment, countering the negative impact of the fiscal

policy on employment and production.

• US in the early 1980’s: expansionary fiscal policy with very restrictive mone-

tary policy.

• Brazil in the late 1990’s: restrictive fiscal policy with restrictive monetary

policy to convince foreign investors and strengthen the real.



Chapter 4

Inflation, employment andmonetary policy

4.1 The Phillips curve

An apparent empirical regularity in the 1950’s and 60’s, known as Phillips curve,

showed that lower unemployment was correlated to higher inflation, and higher

unemployment to lower inflation. This finding served as argument for economic

policy and in particular to justify expansionary monetary policies meant to stimulate

employment, albeit at the inevitable cost of higher inflation. After the experience of

the 1970’s, with high and growing inflation and unemployment, it became evident to

everyone that the relationship between the rate of unemployment and the inflation

rate is weak (if it exists at all) and unstable.

How could we explain a trade-off between inflation and unemploy-

ment?

If the nominal wages (in szloties) are fixed over some period of time (2 years or

more), they will be set, at the outcome of the bargaining process between employers

and trade unions, on the basis of their expectations concerning the evolution of the

price level over the period of time (the next two years). Expected inflation (πe) is

crucial to set the level of nominal wages today, because the workers only care about

the purchasing power of their wage, and firms only care about the real cost of labor

27



28 CHAPTER 4. INFLATION, EMPLOYMENT AND MONETARY POLICY

in their plants.

The level of employment, and therefore of production, depends on the effective

real wage and cost of labor, thus on the effective inflation rate, π. Hence we can

deduce how much firms wish to produce (and employ) as function of the effective

inflation rate:

• if π = πe, the real wage is at its ‘equilibrium’ level, set by bargaining between

firms and workers, unemployment is at the ‘natural’ level, u, and production

is at its ‘potential’ level, Y (full-employment)

• if π > πe, the real wage is below its equilibrium level ⇒ firms employ more, so

that unemployment is below the natural level, u < u, ⇒ production is above

its potential level, Y > Y ;

• if π < πe, the real wage is above its equilibrium level ⇒ firms employ less, so

that unemployment is above its natural level, u > u, ⇒ production is below

its potential level, Y < Y .

We can draw in the (Y ,π) diagram the Aggregate Supply (AS) curve describing

the level of output that firms wish to produce for any possible value of effective in-

flation. The curve passes through the point (Y ,πe): when effective inflation matches

expected inflation (perfect forecast, πe = π) firms produce potential output by defi-

nition. The AS curve is upward sloping. If expectations of inflation increase, the AS

curve shifts North-West (NW), and vice versa. The curve shift NW for any increase

in the costs of production (increased prices of primary inputs such as oil; a push

in real wages resulting from stronger trade unions), or for changes in the supply of

inputs (public health troubles such as SARS in China; the destruction of factories

during a war). All these events go under the heading of “ supply shocks”.



4.1. THE PHILLIPS CURVE 29

4.1.1 Rational expectations and the independence of Cen-tral Banks

Private agents (can) understand the functioning of the economic system as well as

the CB can do. They will not repeat mistakes in shaping their expectations. In

particular, they learn and make no systematic mistakes.

If the CB may be interested in fighting unemployment by creating surprise in-

flation (π > πe), private agents will take into account this incentive and will expect

high inflation. As a result high inflation will not represent a surprise any longer,

and it will therefore be useless, that is it will not create additional jobs.

In the game between private agents and the CB, illustrated in the table below,

whatever the expectations, the CB seeking to fight unemployment will choose an

expansionary policy. Therefore rational agents expect high inflation. The outcome

is therefore high inflation with natural unemployment (the SE corner).

private agents’ expectationslow inflation high inflation

CB restrictive natural unemployment high unemployment

policy expansionary low unemployment natural unemployment This outcome is not optimal, because society would prefer to have low inflation given

that unemployment stays at its natural level. The only way to get there consists in

convincing private agents that the CB will not conduct an expansionary monetary

policy, whatever their expectations. To do so, in the 1990’s many countries have

adopted and promoted:

• the independence of the CB from government influence, established formally

by the law and the statute of the CB, and reinforced by political behavior;

• the reputation of the CB as inflation buster, based on its forecastable and clear

decisions, consistent with their words.

CB independence is correlated with low inflation in historical records [see picture

1].




4.2 Aggregate demand

The demand for domestic goods and services is also related to the level of inflationrelative to expectations. Given that the nominal wages are fixed for some time

(sticky wages), and given that households are in aggregate net creditors to the rest

of the economy:

• if π = πe the real wage and the real interest rate are at their ‘natural’ levels,

and households and firms realize their projects and receive their expected

income, so that demand is at its potential level;

• if π > πe the real wage and real interest rate are lower than their natural

levels ⇒ households income, both from labor and from savings, is lower than

expected ⇒ demand is below its potential level, Y < Y ;

• if π < πe the real wage and real interest rate are higher than their natural

levels ⇒ households income, both from labor and from savings, is higher than

expected ⇒ demand is above its potential level, Y > Y .

We can draw in the (Y ,π) diagram the Aggregate Demand (AD) curve describing

the level of output that households, firms and the public administration wish to pur-

chase for any possible value of effective inflation. The AD curve passes through the

point (Y ,πe): when effective inflation matches expected inflation (perfect forecast)

aggregate demand is at its potential level by definition. Then the curve is downward

sloping. If expectations of inflation increase, the AD curve shifts North-East (NE),

and vice versa. The curve shift NE for any increase in the determinants of the

demand: increased public expenditure or disposable income (lower taxes); an ex-

pansionary monetary policy which, by lowering the interest rate, fosters both firms’

investment and households’ expenditure. The expansion in aggregate demand at a

given level of inflation (a shift NE of the curve) could be determined by other events,



4.3. SIMULTANEOUS DETERMINATION OF INFLATION AND PRODUCTION 31

6-

6

6 AS

AD

E π∗

Y

Figure 4.1: Inflation and production

such as a boom abroad that fuels demand for domestic products, or a change in the

saving behavior of the households, driven for instance by a reform of the pension

system. All these events go under the heading of “demand shocks”.

4.3 Simultaneous determination of inflation and

production

Using the AS and AD curve in the (Y ,π) diagram, we can determine the level

of production and of inflation [see figure 4.1]. There is an equilibrium only when

inflation matches expectations (π = πe). Otherwise Y will be equal to the smaller

of demand or of supply.

The diagram can be used to study in a simple way what the impact of changes in

policies or in fundamental variables affect the economy in the short-run (when expec-

tations are given). Positive demand shocks (AD curve shifts NE) generate economic

booms with increasing inflation. Negative demand shocks (AD curve shifts SW)

generate recessions or slowdowns with decreasing inflation. Positive supply shocks

(AS curve shifts SE) generate economic booms with decreasing inflation (more prod-

ucts at lower prices: technological progress, trade liberalization...). Negative supply




shocks (AS curve shifts NW) generate recessions or slowdown with increasing infla-

tion.

4.4 Monetary policy rules

Most CBs do not stick strictly to a rule, but rules for the conduct of monetary policy

are widely used as reference, guidance to policy design and evaluation.

4.4.1 Inflation targeting

Adopted in New Zealand 1989, Canada 1991, UK 1992, Sweden and Finland 1993,

..., Poland in 1997.

The CB announces a quantitative target for the inflation rate over one year (or

two): π∗. It should also specify the degree of tolerance for fluctuations around the

target, the timing for policy reaction, and the forecasts for inflation.

1. The target is meant to coordinate expectations: πe = π∗ if effective.

2. It provides simple and clear guidelines to monetary policy, facilitating thepublic understanding of the decisions of the CB.

3. Targeting inflation stabilizes the business cycle, when it is driven mainly by

demand shocks. In fact, during a boom generated by unusual expansion of

aggregate demand, the CB has to conduct a restrictive monetary policy in or-

der to fight inflationary pressures, and this policy will moderate the expansion

in aggregate demand. Vice versa, during a slowdown generated by unusual

shrinking of aggregate demand, the CB has to conduct an expansionary mon-

etary policy in order to keep inflation high enough close to target, and this

policy will reduce the contraction in aggregate demand [see figure 4.2].

4. However targeting inflation reinforces the business cycle, when it is driven

mainly by supply shocks. In fact, during a recession generated by a contrac-



4.4. MONETARY POLICY RULES 33

6-

6

6 AS 0

AD0

AD1

.....................................................AD2

.........................................................

.........................................................E 0

E 2

π∗

πLF

πIT

Y Y LF Y IT

Figure 4.2: Inflation targeting under demand shocks

tion in aggregate supply, the CB has to conduct a restrictive monetary policy

in order to fight inflationary pressures, and this policy will exacerbate the

recession by adding a negative demand shock to the supply shock [see figure

4.3]. Therefore the CB should let inflation go out of target when there is a

supply shock. This kind of policy takes the name of flexible inflation targeting .

The problem of such a policy is its credibility: how can the CB convince the

public that deviations from the strict rule are indeed due only to this kind of

considerations and not justified by other policy goals? It is important to avoid

a loss of credibility, which could imply πe > π∗. The communication strategy

becomes very important (some CBs publish all the debate that takes place

during the meetings of the monetary policy committee).

4.4.2 Taylor’s rule

This rule is used by market operators to obtain a sketchy forecast of the decisions

of the CB, because of its simplicity and relative accuracy in describing the Federal

Reserve policy during last 15 years [see picture 4]. It states that the CB shall increase

slowly the interest rate if the forecast of:





4.5. ECONOMIC POLICY IN CLOSED ECONOMIES 35

growth0.5% 2.5% 4.5%

0% 1%

inflation 2% 3% 4%5% 8%

Exercise: complete the table and try other cases.

4.4.3 Monetary base growth rule

Used by CB during the 1980’s (US, Germany, NSB, Canada, ...) but then abandoned

by most (NSB in 1999). Still a reference for the ECB.

From the quantitative theory of money, the demand for money is described by:

vM = P Y

where v is the velocity of circulation, a character of the demand function. Expressed

in growth rates:

∆M

M

= π +∆Y

Y

−∆v

vwith π = ∆P

P . If the CB wants to ensure that π = π∗, it should control the rate

of growth of money, ∆M

M , because it cannot influence economic growth, ∆Y

Y , nor the

evolution of velocity, ∆vv

. The latter should be estimated by the CB. Unfortunately

∆vv

can be forecasted on the long term, but it is very unstable in the medium run.

Therefore the CB cannot rely on this rule to control inflation in the medium run.

Forecasts of the CB decisions are much less accurate than using the Taylor rule [see

picture 4].

4.5 Economic policy in closed economies

In the short and medium run fiscal and monetary policies affect:

• the level of production and employment;




• the interest rate;

• and inflation.

Therefore there is interdependence of objectives. Furthermore the actions of each

policymaker constrain the possible actions of other policymakers:

• the CB sets the interest rate, and this influences the burden of public debt

service, with a direct impact on the government’s budget;

• the Treasury issues public bonds, which constitute the main market where

the CB intervenes to influence the level of the rate of interest, through open

market operations.

A coordination between the actions of the CB and of the Treasury is desirable. A

given target for economic policy can be attained by different combinations of fiscal

and monetary policies (policy mix ).

Example: during an economic slowdown, economic policy may stimulate produc-tion and employment without fostering inflation in any of the three following policy

mix:

fiscal policy monetary policyrestrictive (∆B/Y = 0%) expansionary (i = 1%)

expansionary (∆B/Y = −2%) conservative (i = 3%)aggressive (∆B/Y = −3.5%) restrictive (i = 4%)

Even though these three policy mix can generate the same pattern of growth and

inflation in the short and medium term, they differ substantially in terms of their

long term impact and distributional effects. For instance, comparing the first and

third policy mix, private investment is much lower while public employees’ income

is higher in the latter case than in the former.

Examples of policy mix :



4.5. ECONOMIC POLICY IN CLOSED ECONOMIES 37

-

6 6

-

6

..........

........

........

...............

.........................................................

r

r0

r1

r2

Y

Y Y 1

Y 1

πe0

πe2

π1

IS 0

IS 1

LM 0

LM 1 LM 2

AD0AD1

AS 0

AS 2

E 0

E 1

E 2

E 0

E 1

E 2

Figure 4.4: Reagan-Volker economic policy to curb inflation

• Reagan-Volker, US 1980-86: very restrictive monetary policy to fight inflation

and change expectations, with a very expansionary fiscal policy, based on a

large tax cuts and a public expenditure boom (defense budget). Analysis using

the IS-LM and the AS-AD frameworks in figure 4.4.

• Clinton-Greenspan, US 1992-2000: expansionary monetary policy first con-

ducive to growth, then restrictive fiscal policy thanks to (1) higher tax rev-

enues generated by growth in income, and (2) the low burden of public debt

service. The public budget is in surplus by 2000. Analysis using the IS-LM

and the AS-AD frameworks in figure 4.5.




-

6 6

-

6

π

..

r

r0

Y

Y

..........

..........

..........

..........

..............

.

πe

0

........

........

..............

........

........

........

........

IS 0

..................................................

LM 0

LM 1

IS 1

AD0

E 1

AS 0

E 2

E 0

E 1

E 2E 0 AD1

AD2

AS 2

r1r2

Figure 4.5: Clinton-Greenspan economic policy to reduce public deficit

Documents

Lecture notes on Financial Macroeconomics