MP Curve & Phillips Curve

Question 1

What is the channel system?

Answer 1

Central bank does not definitely determine overnight rate. It keeps it near target by specifying lending and deposit rate. Central bank posts lending rate and deposit rate (standing facilities) with gap between two, so banks are better off if they can negotiate between themselves. The mid point between lending rate and deposit rate is the cash rate target.

Question 2

Why do banks match the cash rate target?

Answer 2

Arbitrage

Question 3

How can the central bank affect the real interest rate?

Answer 3

If central bank changes nominal (cash rate), then the real cash rate follows similar pattern because of the fisher equation and the sticky inflation assumption

Question 4

What is the term structure of interest rates?

Answer 4

The different period lengths for interest rates

Question 5

How are short and long interest rates related?

Answer 5

Interest rates at long maturities are equal to an average of the short term rates that investors expect to see in the future, i.e. arbitrage ensures no one term length is more profitable than another - with the exception of liquidity premiums

Question 6

Why do short term and long term rates move together?

Answer 6

1. Financial markets generally expect that the overnight rate change will persist for some time
2. Changes in rates today often signal information about likely changes in rates in the future

Question 7

What is the consequence of the single rate assumption?

Answer 7

Means there is no real role for financial markets in the model as they make their profit on the spread between the deposit rates and lending rates i.e. they make 0 profits in this model

Question 8

How long does it take for interest rate changes to have effects?

Answer 8

6-18 months

Question 9

Phillips Curve:

Answer 9

πt = πte + v̅Ỹt + o̅, Δπt = v̅Ỹt + o̅

Question 10

What does the Phillips Curve plot?

Answer 10

The baseline PC curve, with ∆ π on the y-axis, applies only to adaptive expectations

Question 11

What does v̅ measure in the Phillips Curve?

Answer 11

How sensitive inflation is to demand conditions, determines slope. - If v̅ is high, then price-setting behaviour is very sensitive to the state of the economy (steeper), if low then it takes a large recession to reduce the rate of inflation (flatter)

Question 12

Adaptive Expectations:

Answer 12

Assumes Sticky Inflation, Adjustment is made every year

Question 13

What kind of shock is o̅?

Answer 13

Y axis shock, can reflect changes in the price of any input to production

Question 14

How can the labour market be reflected in the Phillips Curve?

Answer 14

Union contract leading to large wage/cost increase can lead to + o̅, Immigrant flood leads to decrease in bargaining power/smaller than expected increase in wage can lead to - o̅

Question 15

What happens to the Phillips Curve in the Long run and why?

Answer 15

πt = π̅ = πt-1 + v̅Ỹt, 0 = v̅Ỹt, Ỹ = 0

Question 16

Cost Push:

Answer 16

Changes in o̅

Question 17

Demand Pull:

Answer 17

Changes in v̅Ỹt

Question 18

What is the Divine Coincidence?

Answer 18

For the central bank, demand pull is easier to handle - reducing/raising inflation only means moving economy back to potential

Question 19

How do the Phillips Curve and Quantity Theory differ?

Answer 19

Quantity theory - increase in growth rate of RGDP leads to inflation falling. Q.T is a long run model, where an increase in RGDP indicates an increase in the supply of goods. In long run growth models, markets always clear so supply equals demand.
Phillips curve - increase in short run output leads to inflation rising. P.C is a short run model, where an increase in short-run output indicates an increase in the demand of goods. In short run models, unless economy is at potential, there is normally a gap between supply and demand

Question 20

What does Monetary Policy imply about the Classical Dichotomy in the Short Run?

Answer 20

If monetary policy is to affect real variable, it must be that the dichotomy fails to hold in the short run

Question 21

Causes of the Classical Dichotomy’s short run failure:

Answer 21

Imperfect information,
Costly consumption to ensure constant relative prices,
Nominal contracts means not all wages can increase proportionally
Bargaining costs associated with negotiating over prices and wages owing to inflationary changes
Social norms prevent wages/prices lowering
Money illusion

Question 22

What is expansionary policy?

Answer 22

Printing more money - keeping a low interest rate

Question 23

What is tight policy?

Answer 23

Contracting the money supply - keeping a higher interest rate

Question 24

Why do central banks now prefer direct I/R manipulation?

Answer 24

Using the money supply results in volatile interest rates as the demand for money is constantly changing

Question 25

What can affect v̅?

Answer 25

Price rigidity, government rules, monopoly power, people’s inflationary expectations (long term), weaker unions, anything that makes it easier for firms to change P when faced with shocks

Question 26

If the Classical Dichotomy holds in the short run, what happens to MP?

Answer 26

Changes in MP can only have nominal effects, the MP curve is stuck at MPK (b/c no more stickiness)

Question 27

If the Classical Dichotomy holds in the short run, what happens with an aggregate demand shock?

Answer 27

IS is completely real so +a still increases output

Question 28

If the Classical Dichotomy holds in the short run, what happens with an oil price shock?

Answer 28

+o shocks will still increase the rate of inflation, though it will move around more due to the lack of stickiness

Question 29

If the Classical Dichotomy holds in the short run, can the central bank adjust the rate of inflation?

Answer 29

Yes, without affecting output - increasing the interest rate (decreasing the money supply) will lower the rate of inflation

Question 30

Why is Ỹ = 0 optimal?

Answer 30

• Ỹ = unused resources, U

+ Ỹ = π which can only be remedied by -Ỹ

Question 31

If inflation were to increase for whatever reason and the CB were to hold the nominal rate constant, what would occur?

Answer 31

Increase in inflation → decrease in R (fisher) → decrease in MP → further boom (continuous cycle)

Question 32

How can inflation be decrease without affecting short run output and when is this useful?

Answer 32

Increase Y̅ through K stock, L or ideas (useful if Class Dichot holds)

Question 33

Does a high or low v̅ make killing inflation easier (smaller recession)?

Answer 33

Higher

Question 34

What effect does e-commerce have on the demand for currency?

Answer 34

Downward pressure

Question 35

Concerning the short run, Neoclassicals believe…

Answer 35

That the classical dichotomy holds so the Phillips curve is vertical (rational expectations). They also disagree with the paradox of thrift and multipliers