rec13.pdf - Recitation 13 Topics Stabilization Policy...

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Recitation 13 Topics: Stabilization Policy, Fiscal Nature of Hyperinflation, Zero Lower Bound (ZLB) 1 Stabilization Policy 1.1 Monetary Policy Monetary policy can set real interest rate MP curve is horizontal. The full modern business cycle model includes: Monetary policy: set R t IS curve: e Y t = a - b ( R t - r ) Phillips curve: π t = π t - 1 + v e Y t + o Okun’s law: e Y t = - 2 ( u t - u ) 1
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Let’s see how this works: Assume we get an outward-shift of the IS curve (due to more government spending, for example). This increases the output gap This new output gap leads to a higher inflation as can be seen in its intersection with the Philips Curve Inflation expectations adapt, leading to an upward shift in the Philips Curve as people expect higher inflation for any level of output in the future Okun’s law lets us go back and forth between Output gap and Unemployment: 2
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Suppose we have an IS curve shock: stabilization policy works as followed to stabilize both inflation and output gap. If the central bank acts immediately and with the appropriate magnitude, neither inflation nor output deviate from their initial values In response to price shocks, there is a trade-off between creating a recession (point B) and accept higher inflation (point A) 3
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How did it work during Volker disinflation: In response to the very high inflation when he took office, Volcker raised interest rates drastically and thereby orchestrated a reces- sion. This led to lower inflation and hence lower inflation expectations which continues
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