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• The short-run model summary:

– Through the MP curve
Chapter 12 • the nominal interest rate determines the
Monetary Policy real interest rate
and the – Through the IS curve
Phillips Curve • the real interest rate influences GDP in the
short run
By Charles I. Jones – The Phillips curve
Media Slides Created By
• describes how booms and recessions
Dave Brown affect the evolution of inflation
Penn State University

12.1 Introduction
• In this chapter, we learn:
– How the central bank effectively sets the real interest
rate in the short run, and how this rate shows up as the
MP curve in our short-run model.
– That the Phillips curve describes how firms set their
prices over time, pinning down the inflation rate.
– How the IS curve, the MP curve, and the Phillips curve
make up our short-run model.
– How to analyze the evolution of the macroeconomy in
response to changes in policy or economic shocks.

12.2 The MP Curve: Monetary

• The federal funds rate Policy and the Interest Rates
– The interest rate paid from one bank to • Large banks and financial institutions
another for overnight loans borrow from each other.
• The monetary policy (MP) curve • Central banks set the nominal interest
– Describes how the central bank sets the rate by stating what they are willing to
nominal interest rate lend or borrow at the specified rate.

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• Banks cannot charge a higher rate.
– everyone would use the central bank.
• Banks cannot charge a lower rate.
– They would borrow at the lower rate and lend
it back to the central bank at a higher rate.
– This is called the arbitrage opportunity.
• Thus, banks must exactly match the rate
the central bank is willing to lend at.
From Nominal to Real Interest Rates
• The relationship between the interest
rates is given by the Fisher equation.
Nominal Real Rate of
interest interest inflation
rate rate
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• The sticky inflation assumption
– The rate of inflation displays inertia, or
stickiness, so that it adjusts slowly over time.
– In the very short run the rate of inflation does
not respond directly to monetary policy.
– Central banks have the ability to set the real
interest rate in the short run.
Case Study: Ex Ante and Ex Post
Real Interest Rates
• A sophisticated version of the Fisher
equation replaces the inflation rate with
the expected rate of inflation.
Expected
rate of
inflation
• Using the expected rate of inflation gives
an ex ante real interest rate:
• The ex ante real interest rate is relevant
for investment decisions.
• Once inflation is known, we can calculate
the ex post interest rate:
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The IS-MP Diagram

• The MP curve
– Illustrates the central bank’s ability to set
the real interest rate
• Central banks set the real interest rate
at a particular value.
– The MP curve is a horizontal line.

Example: The End of a Housing

Bubble
• Suppose housing prices had been rising,
but then they fall sharply.
– The aggregate demand parameter declines.
– The IS curve shifts left.
• If the central bank lowers the nominal
interest rate in response:
– The real interest rate falls as well because
inflation is sticky.
– If judged correctly and without lag, the
economy would not have a decline in output.

• The economy is at potential when

– The real interest rate equals the MPK.
– There are no aggregate demand shocks.
– Short-run output = 0.
• If the central bank raises the interest rate
above the MPK
– Inflation is slow to adjust.
– The real interest rate rises.
– Investment falls.

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Case Study: The Term Structure of

Interest Rates

• The term structure of interest rates

– The different period lengths for interest
rates • Expected inflation
• It should be the case that interest rates – The inflation rate firms think will prevail in
on investments of different lengths of the economy over the coming year.
times will yield the same return.
– If not, everyone would switch investment to
the one with a higher return.

• Interest rates at long maturities are equal to an • Firms expect next year’s inflation rate to
average of the short-term rate investors expect be the same as this year’s inflation rate.
in the future

• When the Fed changes the overnight rate,

interest rates at longer magnitudes change.
– Financial markets expect the change will persist for • Under adaptive expectations firms adjust
some time.
– A change in rates today often signals information
their forecasts of inflation slowly.
about likely changes in the future. • Expected inflation embodies the sticky
inflation assumption.

• The Phillips curve

– Describes how inflation evolves over time as
12.3 The Phillips Curve a function of short-run output

• Recall the inflation rate is the percent

change in the overall price level.
This Last Short run
year’s year’s output
inflation inflation
• Firms set their prices on the basis of • If output is below potential
– Their expectations of the economy-wide – Prices rise more slowly than usual
inflation rate
• If output is above potential
– The state of demand for their product.
– Prices rise more rapidly than usual

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• Later critiques
– Stimulating the economy would raise output
temporarily
– Firms will build high inflation into their price
changes
– Output will return to potential.

• Using the equations:

Price Shocks and the Phillips Curve

Change in
inflation • We can add shocks to the Phillips curve
to account for temporary increases in
• Therefore, the Phillips curve can be expressed as: the price of inflation:

The parameter measures

how sensitive inflation is
to demand conditions.

Case Study: A Brief History of the • The actual rate of inflation now depends
Phillips Curve on three things:

• Originally
– The Phillips curve showed a relationship
between the level of inflation and economic Expected rate Adjustment Shock to
activity. of inflation factor for state inflation
of economy
– Low inflation implied low output.
• Rewrite again:

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• Oil price shock
– The price of oil rises
– Results in a temporary upward shift in the
Phillips curve
Cost-Push and Demand-Pull
Inflation
• Price shocks to an input in production
– Cost-push inflation
– Tends to push the inflation rate up
• The effect of short-run output on
inflation in the Phillips curve
– Demand-pull inflation
– Increases in aggregate demand pull up the
inflation rate.
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Case Study: The Phillips Curve and
the Quantity Theory
• An increase in the growth rate of real
GDP would reduce inflation.
• The Phillips curve, however, seems to
say a booming economy causes the
rate of inflation to increase.
• Which one is correct?
• The quantity theory
– Long-run model
– An increase in real GDP reflects an
increase in the supply of goods, which
lowers prices.
• The Phillips curve
– Part of our short-run model
– An increase in short-run output reflects an
increase in the demand for goods.
12.4 Using the Short-Run
Model
• Disinflation
– Sustained reduction of inflation to a stable
lower rate
• The Great Inflation of the 1970s
– Misinterpreting the productivity slowdown
contributed to rising inflation.
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The Volcker Disinflation

• Reducing the level of inflation requires a

sharp reduction in the rate of money
growth–a tight monetary policy.

• Because of the stickiness of inflation

• Lowering the inflation rate
– The classical dichotomy is unlikely to hold
– Can create the cost of a slumping economy
exactly in the short run.
– High unemployment and lost output
– Just a reduction in the rate of money growth
may not slow inflation immediately. • Once inflation has declined sufficiently
• Thus, the real interest rate must increase – Real interest rate can be raised back to MPK
to induce a recession. – Allowing output to rise back to potential
– The recession causes inflation to become
negative.
– As demand falls firms raise their prices less
aggressively to sell more.

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3. The Federal Reserve did not have

perfect information.
– Thought the productivity slowdown was a
recession
• it was actually a change in potential
output.
– The Fed lowered interest rates in response
to what they perceived was a demand
shock.
• which increased output above potential
• generated more inflation

The Great Inflation of the 1970s

• Inflation rose in the 1970s for three

reasons:
1. OPEC coordinated oil price increases.
• Oil shock as shown in the model

2. The U.S. monetary policy was too loose.

The Short-Run Model in a Nutshell
– The conventional wisdom was that reducing
inflation required permanent increases in
employment.
– In reality, disinflation requires only a
temporary recession.

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Case Study: The 2001 Recession
• The recession of 2001 had a “jobless
recovery.”
– Even after the return of strong GDP,
employment continued to fall.
– This is an exception to Okun’s law.
• Reasons that the classical dichotomy fails
12.5 Microfoundations:
Understanding Sticky Inflation
• The short run model
– Changes in the nominal interest rate affect
the real interest rate.
• The classical dichotomy
– Changes in nominal variables have only
nominal effects on the economy.
– If monetary policy affects real variables, the
classical dichotomy fails in the short run.
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The Classical Dichotomy
in the Short Run
• How to make the classical dichotomy
hold at all points in time?
– All prices, including wages and rental
prices, must adjust in the same proportion
immediately.
in the short run:
– Imperfect information
– Costs of setting prices
– Contracts also set prices and wages in
nominal rather than real terms.
• There are bargaining costs to
negotiating prices and wages.
• Social norms and money illusions
– Cause concerns about whether the
nominal wage should decline as a matter
of fairness
• Money illusion
– The idea that people sometimes focus on
nominal rather than real magnitudes
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Case Study: The Lender • The nominal interest rate

of Last Resort
• Central banks ensure a sound, stable
financial system by:
– Making sure banks abide by certain rules
– Including the maintenance of a certain
• If the nominal interest rate is higher than
amount of reserves to be held on hand
– Is the opportunity cost of holding money
– Is the amount you give up by holding money
instead of keeping it in a savings account
– Is pinned down by equilibrium in the money
market
its equilibrium level
– Households hold their wealth in savings rather
than currency.
– The nominal interest rate falls.

• Central banks ensure a sound, stable

financial system by:
– Acting as the lender of last resort
• lending money when banks experience
financial distress
– Having deposit insurance on small- and
medium-sized deposits
• can increase risky behavior

12.6 Microfoundations: How • The demand for money

Central Banks Control – Is a decreasing function of the nominal
interest rate
Nominal Interest Rates – Is downward sloping
– Higher interest rates reduce the demand for
• The central bank controls the level of the money.
nominal interest rate by supplying the
money that is demanded at that rate.
• The supply of money
• The money market clears through
– Is a vertical line for the level of money the
changes in velocity. central bank provides
– Which is driven by changes in the nominal
interest rate

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Changing the Interest Rate
• To raise the interest rate
– The central bank reduces the money
supply
– Creates an excess of demand over supply
– A higher interest rate on savings accounts
reduces excess demand.
– The markets adjust to a new equilibrium.
Why it instead of Mt?
• The interest rate is crucial even when
central banks focus on the money supply.
• The money demand curve is subject to
many shocks, which shift the curve.
– Changes in price level
– Changes in output
• If the money supply is constant
– The nominal interest rate fluctuates
– Resulting in changes in output
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• The money supply schedule is effectively
horizontal at a targeted interest rate.
• An expansionary (loosening) monetary policy
– Increases the money supply
– Lowers the nominal interest rate
• A contractionary (tightening) monetary policy
– Reduces the money supply
– Increases the nominal interest rate
12.7 Inside the Federal Reserve
Conventional Monetary Policy
• Reserves
– Deposits held in accounts with the central
bank
– Pay no interest
• Reserve requirements
– Banks required to hold a certain fraction of
their deposits
• Discount rate
– Interest rate charged by the Federal Reserve
on loans made to commercial banks
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Open-Market Operations: How the Fed

Controls the Money Supply

• Open-market operations
– The central bank trades interest-bearing
government bonds in exchange for currency or
non-interest bearing reserves.
• To increase the money supply, the Fed sells
government bonds in exchange for currency
or reserves.
– The price at which the bond sells determines the
nominal interest rate.

• The Phillips curve

12.8 Conclusion – Reflects the price-setting behavior of
individual firms
• Policymakers exploit the stickiness of
inflation.
– Changes in the nominal interest rate change
the real interest rate.
• Through the Phillips curve booms and Current Shocks to
Expected rate
recessions alter the evolution of inflation. of inflation demand inflation
conditions
• Because inflation evolves gradually, the
only way to reduce it is to slow the
economy.

Summary • The Phillips curve can also be written as:

• The short-run model

– IS curve
– MP curve
– Phillips curve
• Central banks set the nominal interest • This equation shows that in order to
rate. reduce inflation, actual output must be
reduced below potential temporarily.
• The IS-MP diagram allows us to study the
consequences of monetary policy and • The Volcker disinflation of the 1980s is the
shocks to the economy for short-run classic example illustrating this
output. mechanism.

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• Three important causes contributed to the

Great Inflation of the 1970s:
– The oil shocks of 1974 and 1979
– The mistaken view that reducing inflation
required a permanent reduction in output
– The fact that the productivity slowdown was
initially interpreted as a recession

• Central banks control short-term interest

rates by their willingness to supply
whatever money is demanded at a
particular rate.
• Long-term rates are an average of current
and expected future short-term rates.
– This structure allows changes in short-term
rates to affect long-term rates.

This concludes the Lecture

Slide Set for Chapter 12

Additional Figures for Worked Macroeconomics

Second Edition
Exercises
by
Charles I. Jones

W. W. Norton & Company

Independent Publishers Since 1923

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