Chapter 12 - 6/23/2011 12.1 Introduction In this chapter,...

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6/23/2011 1 Chapter 12 Monetary Policy and the Charles I. Jones Phillips Curve 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. – the Phillips curve describes how firms set their – 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. • The federal funds rate – 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 • The short-run model summary: – Through the MP curve • the nominal interest rate determines the real interest rate – Through the IS curve • the real interest rate influences GDP in the the real interest rate influences GDP in the short-run – The Phillips curve • describes how booms and recessions affect the evolution of inflation 12.2 The MP Curve: Monetary Policy and the Interest Rates • Large banks and financial institutions borrow from each other • Central banks set the nominal interest Central banks set the nominal interest rate by stating that is willing to lend or borrow at the specified rate.
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6/23/2011 2 • 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 Interest Rate Real Interest Rate Rate of inflation • 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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6/23/2011 3 The IS-MP Diagram • The MP curve – illustrates the central bank’s ability to set the real interest rate.
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This note was uploaded on 08/23/2011 for the course ECON 3203 taught by Professor Robertpennington during the Summer '11 term at University of Central Florida.

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Chapter 12 - 6/23/2011 12.1 Introduction In this chapter,...

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