Lecture 18 -- Monetary Policy

Lecture 18 -- Monetary Policy - ECO 320L Fall 2010...

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ECO 320L, Fall 2010, Professor Beatrix Paal updated 10/4/2010 10:36 AM Lecture 17: Inflation expectations, Money market equilibrium 1 Lecture 18 Asset Market equilibrium and the LM curve Last time the quantity theory of money inflation expectations Today (review rational expectations) aggregation in the asset market ( Chapter 7.4 ) LM curve ( Chapter 9.3 ) Next time business cycle measurement and facts ( Chapter 8.1, 8.2, and 8.3 ) more on the LM curve ( Chapter 9.3 ) Rational Expectations definition when agents in the model form expectations rationally, they expect the inflation rate that the model (which itself incorporates the rational expectations hypothesis) actually implies This is a circular, but not incorrect logic. We look for expectations such that the implied behavior by agents results in an equilibrium where these expectations are justified by the actual outcome. It is technically usually hard to work with rational expectations models, because it is hard to find solutions to this fixed-point problem. We will explore some of these issues here. What is the model’s prediction for inflation? the money market is in equilibrium in every period, so combining these two conditions we get the exact or the approximate relationships: 2 1 1 1 and t t t t t t M M P P L L + = = verticalbraceright verticalbraceright 1 1 1 , or t t t t t t M P M P M L L P P M L L + + + π σ = = - PDF Created with deskPDF PDF Writer - Trial :: http://www.docudesk.com
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ECO 320L, Fall 2010, Professor Beatrix Paal updated 10/4/2010 10:36 AM Lecture 17: Inflation expectations, Money market equilibrium 2 Rational Expectations cont’d How to predict the growth rate of money demand? using the elasticities of money demand w.r.t. income and the nominal interest rate, we already saw that the future growth rate of real income, in the classical model, is determined by the real side again. We will discuss this later, when we look at economic growth. For now the important point is that the unknown monetary variables do not affect future real growth, so we can treat that as exogenous. the future rate of change in the nominal interest rate is a more difficult. in a fully dynamic model, people resort to simulations to solve for the rational expectations equilibrium we will use the simplification g2212g2191 g2191 uni2044 =g2777 Justification: This is a similar simplification to the two-period model we used for the goods market. We imagine that there are two parts of time: current period, and an infinite future path. We simplify this future path to be a balanced growth path.
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