Phillips Curve and Monetary Policy

Question 1

What are the different effects that MP, IS and PC have?

Answer 1

• MP: Can affect the nominal rate and real IR
• IS: Can affect the real IR and SR output
• PC: Can affect the SR Output and inflation

Question 2

What is Interest-Rate Setting for the Bank of England?

Answer 2

• BoE sets the Bank Rate
• This is a nominal rate that BoEngland charges banks to borrow, which is then passed onto consumers
• Commercial Banks borrow from eachother in LIBOR, which must match the BoEngland’s base rate

Question 3

What is the Fisher Equation? How does this link to Ex-Ante and Ex-Post interest rates?

Answer 3

• it = Rt + πt
• Sticky inflation assumption assumes that the interest rates do not adjust directly to MP- rather responds over time
• Ex-Ante takes into account inflationary expectations

Question 4

What happens when the IS and MP Curve meet?

Answer 4

• IS: Illustrates negatove relationship between Rt and SR Output
• MP: Illustrates the C.B. ability to set real IR
• LR, this is a horizontal line ar r = Rt
• Economy is at potential at this level
• If the C.B. raises i, inflation is sticky, Rt increases and I falls. This means that the MP curve (a horizontal line) shifts upwards

Question 5

Why is the Market rate different from the Bank Rate?

Answer 5

• Costs that the Commercial Bank incur
• Default Risks
• Duration of Loans Varies (need for adjustment)

Question 6

Analyse the need for the same return on annualised interest rates using an example

Answer 6

• The key example analysessaving $1000 for 5 years. The two options are buying a 5 year bond or buying 5, one year bonds
• If i(t+5) < E[it +…. + i(t+5)], you would choose option 2
• If i(t+5) > E[it +…. + i(t+5)], you would choose option 1
• The BoE interest rate signals information about likely changes in the future
• Term Structue illustrates the relationship between IR and time to maturity. It is exacyly inverted since April 2023

Question 7

What is the Phillips curve? Why is it used?

Answer 7

• Firms set prices according to expectated inflation and demand for products
• C.B. must evaluate the tradeoff between inflation and SR output- illustrated by the PC
• πt = Eπt + demand conditions

Question 8

What are some assumptions about the Phillips Curve

Answer 8

• Assume adaptive expectations {Eπt = πt-1}
• Firms embody the sticky inflation assumptions
• If we know that δπ = πt - πt-1, then we can say that:
  δπ = demand conditions + shocks

Question 9

What are the effects that shocks have on the Phillips Curve?

Answer 9

• The inclusion of shocks mean that expected inflation, demand conditions and shocks to inflation are the determinants of inflation
• CP + DP: If shocks increase, then PC shifts up
• CP = Oil prices, DP = AD shocks

Question 10

How does the Phillips Curve link to QToM?

Answer 10

• QToM: Increase in Y will reduce inflation
• This differs from the opinion of the PC
• This is because the PC analyses this through the demand side, whilst QTOM examines the supply side

Question 11

What is Volcker Disinflation?

Answer 11

• In the LR, lower inflation requires tighter monetary policy
• As inflation is sticky, reducing M will not reduce inflation immediately
• Decreasing M increases Rt- including a recession; therefore inflation falls
• As MP moves up/down, movement along PC contracts/expands
• Cost of reducing inflation, creates more unemployment and a slumping economy
• Once inflation reduces enough, Rt = r

Question 12

What was causes of the Great Inflation of 1970?

Answer 12

• REASONS: OPEC co-ordinated Oil Price increases
• US MP was too loose
• Misjudgement of Federal Reserve
• Mistook permenant productivity for temporary recession (Reduction in potential, not increased in actual output)
• Lowered i, increasing Y>Ybar, generating more π

Question 13

How is Money Demand or Money Supply determined?

Answer 13

• Households can either hold cash or buy bonds by paying a rate
• Money demand increasing will reduce i
• i is the opportunity cost of holding cash
• Supply of money is controlled by C.B.

Question 14

How can the C.B. control nominal interest rates? Why do they do this?

Answer 14

• Using OMOs, C.B. can manipulate MS, increasing or decreasing r
• Increasing/Decreasing MS will result in Buying/Selling bonds, Increasing/Decreasing price and Increasing/Decreasing i.
• C.B. uses interest rate to manipulate MD instead of Mt as Mt is normally fixed and leads to economic fluctuations
• This means that MS is horizontal

Question 15

What are Rational Expectations? How can the Central Bank use this?

Answer 15

• If C.B. can influence expectated inflation, it can reduce inflation
• The soft-landing of reduced inflation involves promising to reduce inflation by raising IR, firms trust this and reduce their prices
• This allows for the C.B. to reduce inflation without getting involved directly