Monetary Policy Notes

Week 1 – Monetary Policy

• IS-PC-MR model

• Extending IS-PC-MR to include inter-temporal loss and rational expectations

• Inflation bias

• Basic model:

  • Output is a function of technology, capital and labour.

  • 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:

  • 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:

  • 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:

  • Where WS = PS in nominal labour supply space

• Involuntary/Voluntary Unemployment:

  • Involuntary is unemployment that happens from excess supply (horizontal distance between Es and WS), voluntary from decision to choose labour.

  • 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:

  • 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:

  • When output rises, less than fully employed workers can be fully utilised, resulting in higher output without a change in unemployment.

  • 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:

  • 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.

  • 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_ty_e=a(r_t1r_s)+b, where r_s 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.

  • 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):

  • Relates changes in the labour market to inflation.

  • 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.

  • 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 level P, which is price level last period adjusted for expected inflation from t-1 to t (denoted π_t^e

    • Adaptive expectations assumes: π_t^e=π_t1

  • 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...

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