Lecture 5 - Monetary Policy and the Phillips Curve Flashcards
(20 cards)
What is the MP curve?
Shows how central banks set the real interest rate (R) in the short run. Derived from: R = i - π (Fisher equation), where i = policy rate and π = sticky inflation.
What is the Phillips Curve?
Short-run relationship: Δπ = vŶ + δ. Inflation change depends on output gap (Ŷ) and shocks (δ). Adaptive expectations: π_t = π_t-1 + vŶ + δ.
How does the central bank influence the real interest rate?
By setting nominal rates (i) while inflation (π) is sticky. R = i - π. Higher i → higher R → lower investment/output (via IS curve).
What are adaptive vs. rational expectations in the Phillips Curve?
Adaptive: π_t^e = π_t-1 (backward-looking). Rational: π_t^e incorporates all available info (forward-looking). Affects inflation persistence.
What causes cost-push vs. demand-pull inflation?
Cost-push: Supply shocks (δ > 0, e.g., oil prices). Demand-pull: Output gaps (Ŷ > 0 from C, I, G, or NX shocks).
What is the short-run model’s three-equation framework?
- IS curve: Ŷ = ā - b(R - r̄). 2. MP curve: R = i - π. 3. Phillips Curve: Δπ = vŶ + δ. Links output, rates, and inflation.
How does the Volcker disinflation illustrate the Phillips Curve?
Fed raised rates (↑R) to reduce π, causing recession (Ŷ < 0). Δπ turned negative as firms slowed price hikes due to weak demand.
What is the term structure of interest rates?
Relationship between bond yields and maturities. Expectations hypothesis: Long rates = avg. expected future short rates.
Why target interest rates (i) instead of money supply (M)?
Money demand is unstable (shifts with output/tech). Targeting i avoids volatility in R and output. Implemented via open-market operations.
What is a ‘soft landing’ in monetary policy?
Lowering inflation without recession. Requires credible policy (rational expectations) so firms adjust π_t^e without large Ŷ changes.
How do oil shocks affect the Phillips Curve?
Positive price shock (δ > 0) shifts Phillips Curve up → higher π. Central bank may raise R to anchor expectations, risking recession.
What is the neutrality of money in the long run?
In long run, ΔM only affects π (not Ŷ or R). Quantity theory: π = g_M - g_Y. Contrasts with short-run sticky inflation.
What determines money demand?
M^d decreases with i (opportunity cost of holding cash). Shifts with output (↑Y → ↑M^d) and payment tech (e.g., digital cash).
How do open-market operations work?
Central bank buys bonds (↑M_s, ↓i) or sells bonds (↓M_s, ↑i) to hit target rates. Primary tool for monetary policy implementation.
What happens if inflation expectations become unanchored?
Self-fulfilling spiral: High π_t^e → firms raise prices → actual π rises. Requires credible policy to re-anchor (e.g., Volcker’s actions).
Why was the 1970s Great Inflation hard to control?
- Oil shocks (δ > 0). 2. Loose policy (low R). 3. Fed misjudged potential output, overstimulating demand (Ŷ > 0).
How does the IS-MP diagram analyze shocks?
MP curve (horizontal at R) intersects IS curve (downward-sloping). Shocks: AD shocks shift IS; policy changes move MP.
What is the ex ante vs. ex post real interest rate?
Ex ante: R = i - π^e (expected π). Ex post: R = i - π_actual. Matters for investment decisions under uncertainty.
How do rational expectations change policy effectiveness?
Firms anticipate policy → adjust prices faster. Reduces output costs of disinflation but requires central bank credibility.
What is the role of sticky inflation in the MP curve?
Allows central banks to control R via i (since π adjusts slowly). Without stickiness, Δi would immediately affect π, leaving R unchanged.
