Lecture notes, lectures 1-10 PDF

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Summary

Econ 2004 RevisionClose Economyv The Demand Side v The Supply Side v Expectation v Monetary Policy v Fiscal Policy v Financial Crisis v Balance Sheet and Debt Crisis Open Economyv Assumptions in the open economy v Three Equation Model (compare the differences, assumptions) v Demand Side &amp...

Description

Econ%2004%Revision% !

Close!Economy!! v v v v v v v

The!Demand!Side!! The!Supply!Side!! Expectation!! Monetary!Policy!! Fiscal!Policy!! Financial!Crisis! Balance!Sheet!and!Debt!Crisis!!!

!

Open!Economy!! v v v v v v v v !

Assumptions!in!the!open!economy!! Three!Equation!Model!(compare!the!differences,!assumptions)! Demand!Side!&!Trade!Balances!! Supply!Side!and!AD-BT-ERU!Model!! Oil!Shocks!! External!Imbalances!! Eurozone!! Crisis!! ! !

The%Demand%and%Supply%Side%% Demand%Side%% At!market!clearing!(𝑦 " = 𝑦)!(Keynesian!Consumption!Functions)! 𝐴𝐷 = 𝐶 + 𝐼 + 𝐺!

Determinants!! ! • • •

Expectation!of!future!post-tax!income!and!assets!value!! Degree!of!credit!constraint!! Interest!Rate!!

!

Consumptions! Permanent!Income!Hypothesis!(PIH)! ! PIH:)Households)choose)a)consistent)consumption)level)via)allocating)their)expected)lifetime)wealth) (present)value))due)to)diminishing)marginal)utility.)) ! • Present!Value!(PV)! ! 3 , 𝜓+

= 1 + 𝑟 𝐴+/0 + 145

1 1+𝑟

1

𝑦,+21!

𝑤ℎ 𝑒𝑟𝑒9𝑟9𝑖𝑠 9𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 9𝑟𝑎𝑡𝑒, 𝐴9𝑖𝑠9𝑎𝑠𝑠𝑒𝑡, 𝑦9𝑖𝑠 9𝑖𝑛𝑐𝑜𝑚𝑒 ! •

! Euler!Equation!!

! 𝐶+ =

1+𝜌 𝐶 9𝑤ℎ𝑒𝑟𝑒9𝜌9𝑖𝑠9𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 9𝑟𝑎𝑡𝑒! 1 + 𝑟 +20

! •

By!PV!and!Euler!Equation! 𝐶+ = o

𝑟 𝜓, ! 1+𝑟 +

Assumptions!!

! Ø Ø Ø Ø Ø

Forward!looking!behavior! Infinite!life!time! Consumption!smoothing!! Discount!rate=interest!rate!(𝜌 = 𝑟)! Constant!interest!rate!

! • •

Foreseen'change'has!no!effect!when!it!occurs!! Only!News'and'Unexpected'changes!have!effects!when!they!occur!

! PIH!Violated!! ! • Uncertainty!of!future!income:!higher!saving! • Impatience!𝜌 ≠ 𝑟! o E.g.!WW2!windfall:!high!spending!shows!high!discount!rate!(violate!𝜌 = 𝑟)!

• Non-constant!interest!rate!! • Presence!of!credit!constraint! Temporary!change!! ! • If!income!increases!by!1!unit!for!one!period,!𝜓+, !increases!by!1!unit!and!𝐶+ !increases!by!

G

02G

!

• ∆𝐶+ < 1!! ! Permanent!change!! ! 02G , • If!income!increases!by!1!unit!for!permanently,!𝜓+ !increases!by! G !unit,!and!𝐶+ !increases!by! 1!unit!! • ∆𝐶+ = 1!!! ! Marginal+Propensity+to+Consume+(MPC):)Level)of)change)in)consumption)corresponding)to)the) increase)in)the)(post-tax))disposable)income)) ) Consumption+Smoothing:)Households)adjust)their)consumption)based)on)their)expected)future) wealth)and)resources,)including)assets)value)and)income.))) ) Hand-to-mouth!behaviour!(HTM)! ! • Simply!consume!current!income,!so!high!discount!rate!! • E.g.!! o Impatience!! o Insecurity:!unable!to!save!money!! o No!access!to!the!financial!market!(unlikely!to!happen!in!current!economy)! • Take!into!account!of!HTM!and!PIH! ! MOP 𝐶+ = 𝛼𝐶KLM 9𝑤ℎ𝑒𝑟𝑒 9𝛼9𝑖𝑠 9%9𝑜𝑓9𝑃𝐼𝐻! + + 1 − 𝛼 𝐶+ ! Multiplier!and!aggregate!demand!! ! 𝑦=

0 0/UV 0/+

(𝑐5 + 𝐼 𝑟 + 𝐺)!!where!

0

0/UV 0/+

!is!the!multiplier!

! Paradox!of!Thrift!! ! • When!all!people!try!to!save!money,!the!overall!consumption!is!reduced!and!the!AD!is! reduced.!This!does!not!help!to!escape!from!recession!! !

! Investment! ( IS!curve 9𝑦 = 𝐴 − 𝑎𝑟)!! Fisher!Equation!! ! 𝑟 = 𝑖 − 𝜋, ! ! •

Zero!lower!bound!(ZLB)!is!imposed!on!nominal!interest!rate!(i)!

Assumption! ! • Firm!is!not!credit!constraint:!Investment!depends!on!interest!rate!(r)!but!independent!on! cash!flow! IS!curve!! ! • Assume!investment!depends!on!real!interest!rate!! ! 𝐼 𝑟 = 𝑎 5 − 𝑎0 𝑟! ! 0 • Subtract!it!back!to!equation!𝑦 = (𝑐5 + 𝐼 𝑟 + 𝐺)!,!we!will!get!the!IS!equation!! 0/UV 0/+

! 𝑦 = 𝐴 − 𝑎𝑟,! ! where!𝐴 = 0/U

0 0/+

V

×(𝑐5 + 𝑎5 + 𝐺)!and!𝑎 =

0

0/UV 0/+

×𝑎0 !

! •

Larger!multiplier!or/and!higher!interest!sensitivity!of!investment!(𝑎0 )!increase!the!effect!of!a! change!in!the!interest!rate!on!output!(i.e.!IS!is!flatter)! Violation:!Firm!is!credit!constraint!and!dependent!on!cash!flow!

• ! Q!theory!!

𝑞= • • • • •

𝑝𝑓_ 𝑀𝐵 = ! 𝑀𝐶 𝑟 + 𝛿

) Assimption:!Firm!is!not!credit!constraint:!Investment!depends!on!interest!rate!(r)!but! independent!on!cash!flow! MB=MC,!𝑞 = 1,!investment!=cost!) MB 1,!investment!>costà!invest) Determinant!) o 𝑟9 ↑, 𝑞 ↓) o 𝛿 ↑, 𝑞 ↓) o 𝑓𝑘 ↑, 𝑞 ↑)

!

Supply%Side%% !

Comparison-!perfect!competitive!market!and!Imperfect!labour!market! ! Assumptions!

Price!flexibility! (sticky!wage)!

Perfect!competitive!market!! • No!market!power! •

Compete!contract!!

•

Complete!information!

• •

Optimal!output! Price!and!wage!adjustment! are!perfectly!flexible!

Imperfect!competitive!market! • Market!power!(union! bargaining!power)! • Incomplete!contract:!cannot! observe!effort! • Incomplete!information! (strategy)! • Not!optimal!! • Wage!is!set!periodically!

Price!adjust!according!to! wage! Labour!supply!curve!! Wage!setting!curve! Wage!setting!curve!>!Labour!supply!curve! • The!extent!of!imperfect!competition!! • Efficiency!wage!! P=MC! P>MC;!!P=(1 + 𝜇)MC! Voluntary!unemployment!! Both!voluntary!and!involuntary! unemployment!(as!WS>LS)! •

Supply!curve!

Price! Unemployment!

! Labour!supply!curve!! ! • In!perfect!competitive!market;!full!employment!and!voluntary!unemployment! • Backward-bending:!income!effect!>!substitution!effect!! • Income!effect:!wage!↑,!work!↓! • Substitution!effect:!wage!↑,!work!↑! !

Imperfect!Competitive!Market!! Assumptions!! • Incomplete!contract!! • Efficiency'wage'' • Price'Stickiness'' • Marginal!Product!of!Labour!is!constant!(productivity):!𝜆! h

•

𝑃 = 1 + 𝜇 𝑀𝐶; 99𝑀𝐶 = (1 + 𝑡) i :!firm!sets!mark-up!

• •

Firm!requires!a!Fixed)profit!margin!! h Consumer!cares!about!real!wage:! ! K

! Price!Setting!Curve!and!Wage!Setting!Curve!! ! ! w/p! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! ! Price!Setting!Curve!! Determinants!! • Productivity! • Taxes!! • Mark-up! Equation!! ! 𝑊 𝜆 ! 𝑊 Kk = = 1+𝑡 1+𝜇 𝑃 ! 999999999999999999999≈ (1 − 𝜇)𝜆! !

! ! !

!!!!!!!WS! LS! ! PS!

!

!

N! Wage!Setting!curve!! • Employment!! • Other!wage!push!factors!! ! 𝑊 hk = !

𝑊 𝑃

= 𝐵(𝑁, 𝑍 h )!

Push-Factors! (up)!

• • •

Competition!↑!(affect!𝜇9 ↓)! Taxes!↓! Productivity!𝜆!↑!

• •

Union!bargaining!power!↑! Unemployment!rate!↓:!affect! bargaining!power! Unemployment!benefit!↑!

• ! ! Equilibrium!! • WS=PS! • At!equilibrium,!the!level!of!real!wages!secures!sufficient!supply!of!labour!to!ensure!sufficient! production!for!achieving!the!profit!margin!! • Constant!inflation!rate:!price!increase!as!the!wage!increase!! ! Nominal!Rigidities!! ! Nominal+Rigidities:)Nominal)wages)and)prices)do)not)adjust)immediately)in)response)to)the) fluctuation)of)aggregate)demand)to)keep)the)economy)at)the)equilibrium)output.)) ! • Include!price!stickiness!and!wage!stickiness! • Described!by!Keynes!in!The)General)Theory)! ! Price!Stickiness!(Ref.!Alan!Blinder)! ! Price+Stickiness:+resistance)for)firm)to)change)price)in)response)to)the)change)in)aggregate)demand) ) • Price!setting!is!independent)from)AD)and)dependent)on)wage)(flexible!response!to!wage)! • Price!change!less!than!annually!! • Maintain!effort:!firm!prefer!to!fire!workers!instead!of!cutting!wage!and!setting!a!higher!price! • Application:! o Economy!recover!slowly!from!the!recession! o Internet!might!improve!the!flexibility!of!pricing!for!some!good!such!as!CD!(Ref.!The! Economist)! • Reasons!! o Menu!Cost:!e.g.!losing!customers!! o Time!lag:!AD!↑!à!Wage!↑!à!Price!↑:!depends!on!wage!period!! o As!P>MC,!firms!can!afford!of!not!changing!price!when!the!AD!change!! o Price)is)one)of)the)elements!that!affect!demand:!firm!change!the!quality!(enhance!or! reduce)!to!respond!to!demand!change!(rather!than!changing!price)! o Coordination)failure:!firms!do!not!change!their!price!unless!their!competitor!move! first!! o Implicit!contact:!firms!have!low!understanding!on!consumer!demand!! o Explicit!nominal!contract:!firm!has!a!limit!to!set!price! o Cost-based!pricing :!price!is!not!changed!unless!the!cost!change!! o Inventory:!firms!alter!inventory!in!response!to!demand!change!rather!than!changing! prices!! Wage!Stickiness! ! Wage+Stickiness:+wage)paid)to)the)workers)have)slow)response)to)the)change)in)performance)of)the) company)and/)or)the)demand)change)in)the)macro)economy.)) !

•

Reasons:! o Wage!is!set!periodically!! o Maintain!effort:!firm!prefer!to!fire!workers!instead!of!cutting!wage!and!setting!a! higher!price! o Adjust!wage!once!a!year:!stickier!than!price!! o Resistance!from!Union:!resistance!to!cut!the!wage!!

! Efficiency!Wages!! ! Efficiency+Wages:+firms)set)wage)higher)than)then)market-clearing)price)to)maintain)workers’)effort.) ! • Effectiveness:! o Increase!workers’!effort!(not!observed)! o Avoid!shrinking!! o Reduce!worker’s!retention!cost!(e.g.!training)! o Attract!workers!! • Set!the!price!higher!than!the!market-clearing!price! o Market!failure!(monopoly!model)! o Involuntary!unemployment!!

! Phillips!Curve!(PC)! 𝜋 = 𝜋 , + 𝛼(𝑦 − 𝑦o )! ! • •

Parallel!to!wage!setting!curve!(π!and!wage!are!set!at!the!same!time!after!the!period!end)! Sticky!wage:!PC!is!flatter!!

! !

%

w/p! ! ! ! ! ! !

! ! !

! ! ! ! ! ! Constant!π!

!!!!!!!WS! Upward!π! PS! !

!

!

!

!

N!

The%Three%Equation%Model%% ! ! IS!

Equation!! = 𝐴 − 𝑎𝑟+/0 !

PC!

𝜋 = 𝜋 , + 𝛼(𝑦 − 𝑦o )!

MR!

𝑦 − 𝑦o = −𝛼𝛽(𝜋+ − 𝜋 O )! ! 𝑦 − 𝑦o

Loss! WS!

q

+ 𝛽 𝜋+ − 𝜋 O q !

! ! 𝑊 hk

Assumption! Time!Lag! Taylor!Principle!! Adoptive!expectation! ! Apply!IS/!PC! assumptions! N/A!

Slope!! 𝑎!(multiplier)! 𝛼!slope!of!PC! Slope!of!WS! 𝛼, 𝛽! Flatter!if!𝛽!↑,!𝛼!↑! ! Circle,!𝛽!

𝑊 = 𝐵(𝑁, 𝑍 h )! = 𝑃

Imperfect!competitive! Same!as!PC! market!! curve! !

𝑊 ≈ (1 − 𝜇)𝜆! 𝑃

Imperfect!competitive! horizontal! market!!

! PS!

𝑊 Kk =

Factor!of!Shift! 𝑟+ ,!𝑦+ ! (Demand!Shock)! 𝜋, ! 𝑦o ! (Supply!shock)! CB!preference! Bargaining!power! Unemployment! UN!benefit! ! 𝜆!(productivity)! 𝜇!(mark-up)! competition! t!(tax)!

! Key!Issues! ! • Temporary,!Permanent!Demand!(Supply)!Shock!! • Deflation!Trap!!! • Central!Bank!inflation!adverse!! ! Taylor+Principle:)Central)Bank)should)raise)the)nominal)interest)rate)and)higher)than)the)inflation) rate)to)achieve)a)real)interest)to)stablise)the)economy)(on)IS))

! Phillips!Curve!(PC)! •

CB!prefers!Monetary!Policy!over!Fiscal!Policy!! o Limitation!of!fiscal!policy!! § Lengthy!parliament!process!! § Taxation:!high!resistance! o Limitation!of!monetary!policy!! § Zero!Lower!Bound!(ZLB)!! § Fixed!exchange!rate:!Eurozone;!cannot!stablise!one!shock!in!single!country! Assume!adoptive!expectation!!

• ! Cause!of!Inflation!! ! • Distributional)conflict:!wage!increase!but!price!increase!! • Efficiency)wage) • Union!bargaining!power!! • Demand)grow)faster)than)productivity!e.g.!increase!supply!for!money!(more!money!but!not! enough!goods)!

• • •

Government)subsidies)and)regulation:!less!subsidies!on!productionà!less!supplyà!positive! output!gap!! Government)debt)and)taxation:!Debt!↑!à!Taxation!↑!à!Price!↑! Consumer)confidence:!stable!economyà!Consumption!↑!à!inflation!!

! Effect!of!Inflation!! ! • Need!for!deflation!if!the!inflation!goes!too!high!à!costly!(high!unemployment)! • Volatile!inflation! o Uneven!technical!progress!à!change!the!supply!à!high!productivity!sector!price! falls!faster!à!change!the!relative!price! o Shoe-Leather!cost:!high!inflationà!less!willing!to!hold!cash!! ! Shoe-Leather+Cost:+cost)of)holding)less)money)and)invest)more)time)on)managing)financial)assets.) ) o Menu!cost:!cost!of!frequently!changing!price!! • Reduce!debt!burden!! ! Danger!of!deflation!! ! • Low!AD:!try!to!use!low!𝑖!(ZLB!limits!the!ability!and!continue!the!low!AD)! • Increase!read!debt!burden!! • Difficult!to!cut!nominal!wage!! o Low!demand!sector!need!change!relative!price!through!inflation!! o Deflation!limit!the!ability!to!change!the!relative!wage!! o Price!stickiness!! !

The!Three!Equation!Model!! Monetary+Rule+(MR):)path)along)which)the)central)bank)tries)to)guide)the)economy)back)to)the) preferred)output)and)inflation)combination.)) ! • MR!curve!derived!from!the!Loss!function!! • ! 𝐿 = 𝑦 − 𝑦o q + 𝛽 𝜋+ − 𝜋 O q ! ! ! • • •

𝛼 !is!the!slope!of!PC,!the!higher!𝛼 ,!the!steeper!PC! 𝛽!is!the!level!of!inflation!adverse,!higher!𝛽,!more!inflation!adverse! Slope!of!MP! o Flatter!if!𝛽!↑!,!𝛼 !↓!

! Using!the!Three!Equation!Model!! 1. Define!the!current!state!(y,!π,!r)!of!the!economy;!Any!interest!rate!effect!from!the!previous! period!! 2. Shock!! 3. Expectation!of!inflation!and!the!Phillips!Curve!shift!(assume!adoptive!expectation)! 4. Wage!is!set!in!nominal!term!based!on!expected!inflation!and!employment.!This!put!pressure! onto!WS!curve.!!!

5. Firm!set!price!as!mark-up!corresponding!to!the!increase!in!expected!nominal!wage.!The! price!change!is!the!rate!of!inflation.!! 6. Identify!temporary!or!permanent!shock! 7. CB!set!Interest!rate!based!on!the!expected!inflation!in!the!next!period!to!move!the!economy! back!to!MR!curve!with!one!period!time!lag!as!it!is!not!the!equilibrium!point!! 8. Period!end:!define!the!y,!π!and!r!by!the!end!of!period!0! 9. Draw!a!Time!Path!! !

!

!

!

!

!

! ! !

!

Expectation%% ! Types!of!Expectations!! • Static:!inflation!do!not!change!! • Adoptive:!Backward!looking,!systematic!error!! • Rational:!no!systematic!error,!lower!cost!! ! 𝜋 = 𝜋 , + 𝛼(𝑦+ − 𝑦o )! ! ! Static! Adoptive! , Equation! 𝜋 = 𝜋! 𝜋 = 𝜋+/0 + 𝛼(𝑦+ − 𝑦o )! ! Feature! No!MR!curve! Backward-Looking! Simply!reflect!CB!preference! Error! Systematic!error! Systematic!error! Cost! Costly! Costly!

Output!

N/A!

Time!

N/A!

Move!away!from! equilibrium! Time!lag!

Rational! 𝜋 = 𝜋 + 𝛼(𝑦+ − 𝑦o )! ! Forward-looking! O

No!systematic!error! Less!costly! Only!one!period!shock! Interest!rate!do!not!raise! Always!at!equilibrium! No!Time!lag!

! ! Risk:)individual)makes)decision)about)the)future)based)on)known)probability.)) ) Uncertainty:+it)is)impossible)to)assign)the)probability)about)the)future)outcome)and)some)outcome) might)be)unknown.)) ) Rational+Expectation:+Use)all)the)information)available)to)make)a)reasoned)decision)and)do)not) make)systematic)errors.) !

Rational!Expectation!! Assumption! ! • Wage!setters!and!price!setter!understand!the!model!! ! !

Creditability!! How!

1) Independence!of!central!bank!! o Move!away!from!political!pressure! 2) Information!transparency! o Clear!measure!of!the!effectiveness!of!monetary!policy!! o Allow!public!to!participate!in!the!decision!making!! o Communication:!monetary!report!detailed!the!reasons!and! minutes!! 3) Credible!and!sustainable!!!

Outcome!of!the!policy!in!the!previous!period!will!also!shape! consumers!expectation!in!the!current!period!! 𝜋 = 𝜒𝜋 O + 1 − 𝜒 𝜋+/0 + 𝛼(𝑦+ − 𝑦o ),!where!𝜒!is!the!degree!of!creditability!! ! 𝜋 , = 𝜒𝜋 O + 1 − 𝜒 𝜋+/0 ! ! • Fully!credible!𝜒 = 1:!only!one!period!inflation!shock;!CB!does!not!have!to! change!the!interest!rate!! • Partial!credible!0 < 𝜒 < 1! • Non!credible!𝜒 = 0!interest!rate!adjustment;!move!away!from!equilibrium;! number!of!period!to!move!back!to!target!! •

Model!!

! !

Lucas!Critique!! Argument!! ! There!is!a!danger!of!using!the!historical!data!to!model!and!forecast!the!future!as!consumer!behavior! change!in!response!to!the!different!policy.!The!correlation!between!the!policy!and!consumer! behavior!is!not!taken!into!account!when!modeling!using!the!historical!data.! ! • Consumer!behavior!did!not!response!to!what!is!expected!in!the!model!as!the!policy!change! ! Example!! 1. Government!use!expansionary!fiscal!policy!(expect!low!unemployment!and!rise!in!inflation)! à!rational!expectation!from!previous!period:!𝜋 O (did!not!response!to!the!change)! à!one!period!increase!in!output!without!raising!inflation!! à!follow!by!a!decrease!in!output!in!the!following!period!! 2. 1970!Stagflation:!attempt!lower!unemployment!but!result!in!both!high!inflation!and!high! unemployment!! !

Inflation!Bias!! Assumption:!government!controls!the!monetary!policy!! Procedure:!! o Attempt!to!shift!the!output!without!shifting!the!inflation!target!(i.e.!MR!shift!and! aims!at!higher!equilibrium!output)! o As!the!output!does!not!actually!shift:!there!is!a!raise!in!inflation!without!increasing! output!! o The!shift!in!inflation!is!the!inflation!bias! ! Inflation+Bias:+The)difference)between)the)initial)inflation)(target))and)the)new)inflation) ) • Inflation!bias!raises!regardless!to!adoptive!or!rational!expectation!! • Model!! o Adoptive! 𝑦M − 𝑦o 𝜋+ = 𝜋+/0 = 𝜋 O + ! 𝛼𝛽 o Rational!! 𝑦M − 𝑦o ! 𝜋+ = 𝜋+ = 𝜋 O + 𝛼𝛽

• •

! •

Solution! o Independent!central!bank!! o Inflation!targeting!regime!(higher!value!of!𝛽,!inflation!adverse)! o No!extend!output!target!! o Building!creditability!!

! Ineffective!Policy!! Classical!Economics!! ! • Free!market!is!self-stablising;!the!policy!will!make!things!worse!! ! Neo!classical!Economics!! ! • Rational!expectation!implies!that!consumer!behave!in!the!optimal!way!in!response!to!the! shock.!The!policy!will!not!have!effect!on!it!or!it!will!destabilise!the!economy.!! ! ! !

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Monetary%Policy% ! Cost!of!inflation! • Uncertainty!about!future:!hard!to!forecast! • Menu!cost!! • Less!saving:!shoe-leather!cost;!Paradox!of!Thrift!!! • Hard!to!change!relative!price!! ! Taylors!principle!! • Central!bank!should!raise!the!nominal!interest!rate!by!enough!the!set!the!real!interest!rate! to!affect!the!economy!! 𝑖+ = 𝑖 ∗ 9 + 𝛾0 𝜋+/0 − 𝜋 O + 𝛾q (𝑦+ − 𝑦o )! ! • 𝑖 ∗ !is!the!nominal!interest!rate!at!inflation-target!! • Taylors!principle:!𝛾0 > 1!where!the!increase!in!inflation!leads!to!an!increase!in!real!interest! rate! • If!!𝛾0 < 1,!monetary!policy!is!said!to!be!destablising!! ! ! 1 (𝜋+/0 − 𝜋 O )! 𝑟5 − 𝑟w = 1 𝑎 𝛼+ 𝛼𝛽 • a!↑!(multiplier),!!𝑟5 − 𝑟w !↓!:!greater!interest!sensitivity:!so!a!small!reduce!in!interest!can!have! enough!effect!on!inflation! • 𝛼!↑,!𝑟5 − 𝑟w9 ↓:!PC!steeper;!MR!flatter,!more!sensitive!to!output!loss!so!small!increase!in! interest!rate!(small!increase!in!output)!needed!to!achieve!the!same!effect!! • 𝛽!↑,!𝑟5 − 𝑟w !↑:!more!inflation!adverse,!attempt!to!scarify!more!output!loss!to!bring!back!the! inflation! ! Modern!MP!framework!! ! • Official!interest!rate!affects!inflation!through!directly!affecting!the!following:!! o Market!interest!rate! o Asset!price!! o Expectation!! o Exchange!market!! ! • Dual!Mandate:!Financial!Reserve’s!goal!of!achieving!stable!price!and!maximum!employment!! • Modern!central!banks!are!inflation-targeting!! o E.g.!Bank!of!Japan!Acts!states!achieving!a!price!stability!is!beneficial!to!economic! growth!! • Modern!CB!assume!one!equilibrium!!

! Deflation!! Cost!of!deflation!! ! • Zero!lower!bound!! • Deflation!trap!!

• •

Higher!debt!burden!! Price!↓!!-----!debt!↑!-----!C,!I!↓!(to!pay!the!debt)----!π!↓!------!Price!↓!

! Cold!Turkey!approach!! ! • Allowing!large!reduction!in!output!(welfare)!to!achieve!the!inflation!target!in!a!short!period! • MR!curve!is!flatter!! • More!inflation!adverse:!𝛽 > 1! • Higher!interest!rate!! ! Gradualist!approach!! ! • Prefer!smaller!reduce!in!output!to!move!the!inflation!back!to!target!eventually!! • Requires!...