6-MP curve - ECO3311 Ch11:MonetaryPolicy Introduction In...

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ECO 3311 Ch 11: Monetary Policy  
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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 Frms 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—output, inflation, and interest rates—in response to changes in policy or economic shocks.
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The federal funds rate is the interest rate paid from one bank to another for overnight loans. The monetary policy (MP) curve describes how the central bank sets the nominal interest rate and exploits the fact that the real and the nominal interest rates move closely together in the short run.
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The short-run model is summarized as follows: Through the MP curve, the nominal interest rate set by the central bank determines the real interest rate in the economy. Through the IS curve, the real interest rate influences GDP in the short-run. The Phillips curve describes how booms and recessions affect the evolution of inflation.
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The MP Curve: Monetary Policy and  the Interest Rates Large banks and financial institutions borrow from each other from one business day to the next. To set the nominal interest rate on overnight loans, the central bank states that it is willing to borrow or lend any amount at the specified rate.
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Banks cannot charge a higher rate because everyone would use the central bank. Banks cannot charge a lower rate because banks would borrow at the lower rate and lend it back to the central bank at a higher rate. This opportunity for pure profit is called the arbitrage opportunity. Thus, banks must exactly match the rate the central bank is willing to lend at.
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From Nominal to Real Interest Rates The relationship between the nominal interest rate and the real interest rate is given by the Fisher equation. Changes in the nominal interest rate lead to changes in the real interest rate so long as they are not offset by corresponding changes to inflation.
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The sticky inflation assumption implies that the rate of inflation displays inertia, or stickiness, so that it adjusts slowly over time. In the very short run (6 months or so), we assume the rate of inflation does not respond directly to monetary policy. It implies central banks have the ability to set the real interest rate in the short run.
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The MP curve illustrates the central bank’s ability to set the real interest rate. Central banks set the real interest rate at a
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6-MP curve - ECO3311 Ch11:MonetaryPolicy Introduction In...

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