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Monetary Policy Notes

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This is an extract of our Monetary Policy document, which we sell as part of our Macroeconomics Notes collection written by the top tier of University Of Oxford, Balliol College students.

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Week 1 - Monetary Policy
- IS-PC-MR model
- Extending IS-PC-MR to include inter-temporal loss and rational expectations
- Inflation bias--

Basic model:
o Output is a function of technology, capital and labour.
o Perfect competition, so labour demand defined by marginal product of labour

Real wage is nominal wage relative to prices, adjusts to clear the market

Employment then determined by and used in output function to set output

Equilibrium output is unique, so invariant to price level: this assumes a vertical aggregate supply, meaning nominal prices have no real effect, because it is only the real wage that consumers base their decision on (this makes sense if consumers can observe the price level)
Labour supply:
o Wage strictly above the schedule - gap is called the real wage premium - which is motivated by union power and government regulation eg. Minimum wages, which artificially increase the wage

Shifts in labour supply need not actually shift the wage schedule (WS). The wage schedule and the real wage premium only shift proportionally if new workers are non-union labour and precise substitutes for union labour
Labour demand:
o There is a price setting curve for monopolistic firms, PS, which is strictly below the competitive one, as they always offer lower wages because there is imperfect competition

Special case where profit share falls with employment to offset the declining MPL,
meaning the PS is horizontal

Curve is shifted by degree of monopoly power

Increase in the productivity of labour makes using labour more cost efficient than using capital equipment , so demand curve shifts out

Equilibrium:
o Where WS = PS in nominal labour supply space
Involuntary/Voluntary Unemployment:
o Involuntary is unemployment that happens from excess supply (horizontal distance between Es and WS), voluntary from decision to choose labour.
o Argument for positive unemployment even with perfect information: if there is high unemployment there will be some involuntary employment, so positive output gaps are bad. You don't want unemployment = 0, because there are people whose output is less valuable than leisure to themselves, also people who want to stay --unemployed to keep looking for a job, might be most efficient to wait for people to have a good job available for them (this is about the frictionally unemployed)
Labour Market and the PC:
o Only equilibrium implies NAIRU (non-accelerating inflation rate of unemployment=
level of unemployment below which inflation rises, also called long-run PC).
Everything else, due to an expectations augmented PC, implies a change in output which implies a change in inflation
Okun's law:
o When output rises, less than fully employed workers can be fully utilised, resulting in higher output without a change in unemployment.
o The newly employed after period of output expansion could come from somewhere other than the pool of unemployed - people previously not looking for work but wage increase meant they now are. thus, output increases are associated with a less than proportional increase in demand for labour 3 equations: Correlation between output and inflation denoted by the Phillips Curve, a vertical PC showing the steady state in equilibrium; whereas, relationship between interest rates and output are constituted by the IS curve. The monetary rule, showing the set of the best responses, is defined by the MR curve.
IS curve:
o Describes the relationship between real interest rate and output - output is negatively proportional to interest rate. Low interest rate means there are more investment opportunities that are better uses of money than putting it in banks or low risk bonds, so investment increases when interest is low, meaning that national income increases.
o In a closed economy, output depends on expenditure (C+I+G) which depends on the real interest rate

The CB sets r in (t-1) to influence output via the IS curve and inflation via the PC in t

Assume 1 period lag between the change in the real interest rate and the effect this has on the change in output

y t − y e =−a ( r t−1−r s ) +b , where rs is the stabilizing interest rate at which y=y e and

π ❑=π T , a is the slope of the IS curve, describing sensitivity of investment to the interest rate, and b describes an aggregate demand shock
Downward sloping because as the monetary authority reduces the nominal, and therefore the real interest rae, this causes an increase in investment so output will increase.
o Slop of IS curve determined by a (the interest sensitivity of expenditure). If a is larger, steeper slope of the IS curve, so change in real interest rate has a smaller effect on output
PC curve (Phillips curve):
o Relates changes in the labour market to inflation.
o Process: demand shock causes a change in output, so employment demand changes,
meaning nominal wages change as labour demand has changed and therefore prices change.
o Assumptions:
 Unions set W (nominal wage) to achieve target real wage on WS curve
 To achieve this target real wage, unions must formulate expectations over price olevel P, which is price level last period adjusted for expected inflation from t1 to t (denoted π et e

o o

o

o

o o

o

 Adaptive expectations assumes: π t =π t−1
Derived from the WS-PS labour market framework
In perfect competition, equilibrium employment rate found at the point where the
Es and Ed curves intersect. Es curve is employment supply (slopes upwards, as wages increase agents switch from leisure to labour. The Ed curve is employment demand,
which is equal to marginal product of labour because firms in perfect competition earn zero profit so pay workers marginal product of what they are producing
However, with imperfect competition, there are trade unions on the supply side
(hold monopoly power) so they can target real wages above the Es curve which gives the wage setting curve. WS curve more steeply sloped than the Es curve because as employment increases, unions have more power because there are fewer unemployed who might accept a lower wage, so they can therefore demand a higher wage.
On the demand side, firms also have some monopoly power, such as if there is a monopsony over the labour market, so they will set their price higher than marginal cost, so firms will therefore set real wage as lower than marginal product of labour.
Thus, PS curve lies below the Ed curve.
There is both voluntary and involuntary unemployment in this model
The intersection of the WS and the PS curves gives the vertical Phillips curve:
 WS curve pushed upwards by a positive output shock, leading to higher nominal wages eg. Unions demanding higher wages, so upward sloping PC
with respect to output
 If WS curve shifted down due to a decrease in union power from legislation change. This then means vertical PC has shifted to the right. A shift in the
VPC also shifts the PC down, as it now must go through point Z'. This new PC
is the new constraint, so inflation would then fall to 2% and the economy moves to point B.

PC equation given by: π t =π t−1 +a ( y t − y e ) +ut , where ut represents shocks to
❑inflation that can shift the curve up or down. π t−1 = π et when we assume adaptive expectations.
o If WS is stepper and PS also steeper, then PC is stepper (when wages and prices are flexible and so can be consistent with union/firm objectives).
If there is stickiness of wages and prices, then PC is flatter. The steeper the PC the more easily inflation is controlled by monetary policy

A permanent gap will lead to permanently rising inflation - wage setting is suggested to be done as 'wages make up for inflation, and we also want extra because economy is doing well'. Wage setters tend to set adaptively = make up for the previous period's inflation
Monetary Rule:
o CB objectives: inflation targeting by finding optimal inflation on the PC as a function of output and interest rates etc. They minimise deviation from the norm, or loss function. Most MR curves are positive in output, meaning they prefer not to depress output to achieve inflation

MR gives range of output/inflation possibilities defined by PC at prevailing expected inflation rates. The highest indifference curve that the PC is tangential to (on the loss function) in output and inflation space is the best.
o Loss function: represents how much the CB relatively cares about inflation. It is a circle in the output/inflation space. PC tangents to loss function are ideal points.

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