Chapter 21 Output, Inflation and Monetary Policy Conceptual and Analytical Problems Explain the determinants of potential growth. Answer: Growth of potential output depends on the growth rate of the capital stock, the growth rate of the labor force, and the rate of technological improvement. Explain how a recessionary output gap would emerge in an economy where the long-run aggregate supply curve is persistently shifting to the right. Answer: Shifts to the right in the long-run aggregate supply curve reflects growth in the potential output of the economy. A recessionary gap would arise if actual output grew more slowly than potential output. Describe the determinants of the long-run real interest rate and speculate on the sort of events that would make it fluctuate. Answer: The long-run real interest rate equates aggregate expenditure with potential output. If a component of aggregate expenditure that it not sensitive to changes in the interest rate such as government spending rises, aggregate expenditure rises above potential output at the original real interest rate. If potential output remains unchanged, the long-run real interest rate must rise to reduce interest-sensitive expenditures such as investment to offset the increase in interest-insensitive spending. Potential output can rise because of improvements in technology. In order for aggregate expenditure to rise with potential output when there is no change in an interest-insensitive component of spending, the long-run real interest rate will fall so that interest-sensitive components rise. Explain how and why the components of aggregate expenditure depend on the real interest rate. Be sure to distinguish between the real and nominal interest rates, and explain why the distinction matters. Answer: The real interest rate equals the nominal rate minus expected inflation; when firms and households make economic decisions their decisions are based on the real interest rate. Aggregate expenditure equals consumption plus investment plus government spending plus net exports. Higher real interest rates increase the cost of borrowing and increase the rewards to saving, reducing consumption. A higher real cost of borrowing lowers the profitability of potential investments, reducing the investment component of aggregate demand. Higher real interest rates make U.S. financial assets more attractive to foreigners, increasing demand for the dollar and raising its value. A rise in the inflation-adjusted value of the dollar makes U.S. exports more expensive to foreigners and makes foreign imports cheaper to U.S. consumers, lowering net exports. Changes in the real interest rate have little effect on government spending and so can be ignored. Suppose that the aggregate expenditure curve for an economy can be expressed algebraically as AE = 3,000 – 2,000r, where AE is aggregate expenditures and r is the real interest rate expressed as a decimal. If the level of potential output in this economy is 2,900, what is the long-run real interest rate? Answer: The aggregate expenditure curve shows the real interest rate at each level of desired spending, including the interest rate associated with potential output. The long-run real interest rate is the interest rate where aggregate expenditure equals potential output. To find that rate, set AE equal to 2,900 and solve for r: 2,900 =3,000 – 2,000r or 2,000r = 100. Solving for r gives r* = 0.05, or 5%. Suppose the U.S. economy is in equilibrium at the long-run real interest rate that prevails when aggregate expenditure equals potential output. Draw a diagram of aggregate expenditure showing this initial equilibrium. Then suppose that foreign demand for U.S. exports falls due to a recession abroad. Show how the long-run real interest rate will change and explain your results. Answer: The reduction in U.S. exports diminishes U.S. aggregate expenditures at each level of the real interest rate. Thus, the AE curve shifts to the left to AE' and the long-run real interest rate declines from r* to r*'. The European Central Bank’s primary objective is price stability. Policymakers interpret this objective to mean keeping inflation below, but close to, 2 percent, as measured by a euro-area consumer price index. In contrast, the FOMC has a dual objective of price stability and high economic growth. How would you expect the monetary policy reaction curves of the two central banks to differ? Why? Answer: The ECB is more aggressive in targeting inflation than the FOMC. For equal deviations in current inflation from target inflation, the ECB will change interest rates by a greater amount than the FOMC. Therefore, the monetary policy reaction curve of the ECB is steeper than the monetary policy reaction curve of the FOMC. Explain why the short-run aggregate supply curve is upward sloping. Under what circumstances might it be vertical? Answer: The short-run aggregate supply curve is upward sloping due to stickiness in the prices of inputs into production, such as wages. As output prices rise, firms can earn higher profits by increasing their production. If all input prices were perfectly flexible and adjusted instantly whenever demand shifted, there would be no profit opportunity from increasing output. As a result, the short-run aggregate supply curve would be vertical, like the long-run aggregate supply curve. Assume the short-run aggregate supply curve can be expressed algebraically as Ys= 4,800 + 3,000π where YS is aggregate supply, and the dynamic aggregate demand curve can be written as Yd = 5,000 – 1,000π. where Yd is aggregate demand. Find the numerical value for equilibrium output, Y, in the short run. Find the numerical value for the short-run inflation rate, π. Answer: The answer requires that you solve these two simultaneous equations. To start, rearrange the second equation, solving for π in terms of Yd:
1,000π = 5,000 – Yd
π = 5 – 0.001Yd
Substituting this expression for the inflation rate into the first equation gives
Ys = 4,800 + 3,000(5 – 0.001 Ys)
Ys = 4,800 + 15,000 – 3 Ys
4Ys = 19,800
Ys = 4,950
Then, using this in the second equation, we obtain
4,950 = 5,000 – 1,000π
1,000π = 50
π = 0.05
Consider Panel B of Figure 21.16 where, at the initial short-run equilibrium point 0, current inflation is below expected inflation and output is below potential output. Suppose that the initial inflation target was at the level corresponding to point 1, but the central bank chooses to stimulate demand to speed the adjustment to long-run equilibrium. What action must the central bank take and what are the costs and benefits of such a policy? Answer: The central bank must raise its inflation target, shifting both the monetary policy reaction curve and the aggregate demand curve to the right. The cost is higher inflation and the benefit is that the output loss may be eliminated more quickly if the policy returns output to Yp faster than if the central bank waited for production costs to fall. Suppose the real interest rate unexpectedly falls in the absence of other economic changes. What would you expect to happen to (a) consumption, (b) investment, and (c) net exports in the economy? Answer: Consumption will rise as borrowing to purchase consumer durables becomes less costly. In addition, the reward to saving falls, reducing saving and increasing consumption. Investment will rise as more projects will be profitable at the lower real interest rate. Net exports will rise as the dollar will depreciate in the face of a fall in foreign investor demand for U.S. assets given the lower return. This makes U.S. exports less expensive to foreigners and imports more expensive for American consumers, increasing net exports. Economy A and Economy B are similar in every way except that in Economy A, 70 percent of aggregate expenditure is sensitive to changes in the real interest rate and in economy B, only 50 percent of aggregate expenditure is sensitive to changes in the real interest rate. Which economy will have a steeper aggregate expenditure curve? How would the dynamic aggregate demand curves differ given that the monetary policy reaction curve is the same in both countries? Explain your answers. Answer: Economy B will have a steeper aggregate expenditure curve. For a given fall in the real interest rate, aggregate expenditure will increase more in Economy A and so the curve is flatter than in Economy B. Economy B will also have a steeper dynamic aggregate demand curve. As the two countries have the same monetary policy reaction curves, an increase in inflation will result in the same increase in the real interest rate in both countries. This change in the real interest rate will result in a bigger change in aggregate output in Economy A, resulting in a flatter dynamic aggregate demand curve. Given the expected relationship between the real interest rate and investment, how would you explain a scenario where investment continued to fall despite low or even negative real interest rates? Answer: Changes in the level of investment depend on both the level of real interest rates and changes in expectations about future business conditions. If firms are pessimistic about the economic outlook, investment may remain weak despite low or negative real interest rates. We can see that during the recession that started in December 2007, investment continued to fall as a percentage of GDP (reflecting falling investment in absolute terms) while real interest rates were negative. State whether each of the following will result in a movement along or a shift in the monetary policy reaction curve and in which direction the effect will be. Policymakers increase the real interest rate in response to a rise in current inflation. Policymakers increase their inflation target. The long-run real interest rate falls. Answer: This would result in a movement up along the monetary policy reaction curve. This would result in a shift in the monetary policy reaction curve to the right as real interest rate equals the long-run real interest rate at a higher level of inflation. This would result in a shift in the monetary policy reaction curve to the right. There is a lower real interest rate at every level of inflation. Suppose a natural disaster wipes out a significant portion of the economy’s capital stock, reducing the potential level of output. What would you expect to happen to the long-run real interest rate? What impact would this have on the monetary policy reaction curve and the dynamic aggregate demand curve? Answer: The reduction in the potential level of output in the economy would lead to an increase in the long-run real interest rate in the economy. The higher real interest rate would drive down the interest-sensitive components of aggregate expenditure to equate aggregate expenditure with the new lower level of potential output. The monetary policy reaction curve would shift to the left, as a higher real interest rate would now be associated with each level of inflation. As the real interest rate is now higher at each level of inflation, the level of output is lower and so the dynamic aggregate demand curve shifts to the left. Suppose there were a wave of investor pessimism in the economy. What would the impact be on the dynamic aggregate demand curve? Answer: A wave of investor pessimism would reduce investment and therefore aggregate expenditure at each real interest rate. This would be reflected in a shift to the left of the dynamic aggregate demand curve. Explain how each of the following affects the short-run aggregate supply curve. Firms and workers reduce their expectations of future inflation. There is a rise in current inflation. There is a fall in oil prices. Answer A reduction in inflationary expectations means that nominal wages will rise by less, lowering costs and thus increasing production at each level of current inflation. The short-run aggregate supply curve will shift to the right. There will be a movement up along the short-run aggregate supply curve. With lower costs, production will increase at each level of inflation and so the short-run aggregate supply curve will shift to the right. Suppose the economy is in short-run equilibrium at a level of output that exceeds potential output. How would the economy self-adjust to return to long-run equilibrium? Answer: The expansionary gap exerts upward pressure on costs, shifting the short-run aggregate supply curve to the left until the economy reaches the long-run equilibrium point where aggregate demand, short-run aggregate supply and long-run aggregate supply all intersect. At this point, the economy has returned to the potential level of output. Why do you think the surge in oil prices in 2007–2008 had a much smaller impact on inflation expectations compared with the oil price shocks of the 1970s? Answer: The response of inflation expectations to changes in economic conditions depends to a large extent on the credibility of the monetary policymaker. If the central bank is credible due, for example, to a long record of matching its actions with its words, then long-term inflation expectations are well-anchored and transitory changes in input costs do not undermine expectations that inflation will remain under control. The smaller impact of the 2007-2008 surge in oil prices compared with those in the 1970s reflects the greater credibility of the central bank. You read a news story blaming the central bank for pushing the economy into recession. The article goes on to mention that not only has output fallen below its potential level but that inflation had also risen. If you were to respond defending the central bank, what argument would you make? Answer: You should state that monetary policy actions by the central bank affect the dynamic aggregate demand curve and that shifts in the aggregate demand curve move output and inflation in the same direction. The situation described in the news story is one where inflation rises when output falls. This is most likely the result of a shock that shifted the short-run aggregate supply curve to the left. For each of the following economies, select the term—inflation, deflation, or disinflation—that best describes what the economy is experiencing.
March April May
Annual percent change in the consumer price index
Economy A -1.5% -1.5% -1.5%
Economy B 3.2% 2.3% 0.8%
Economy C 1.5% 1.5% 1.5%
Answer: Economy A is experiencing deflation, as the price level is falling each period. Economy B can be best described as experiencing disinflation, as there is a slowdown in the pace of inflation. Economy C is experiencing inflation, as the price level is rising each period. As a monetary policymaker, would you be more concerned if the aggregate price level were persistently rising by 2 percent or persistently falling by 1 percent? Explain your answer. Answer: The deflation scenario, where the price level is falling, should be of more concern, as conventional monetary policy tools are less effective in the face of deflation. For example, assuming the effective lower bound on nominal interest rates is around zero, the real interest rate could fall to -2 percent in the scenario where inflation is 2 percent but would be bounded at +1 percent in the face of deflation. Moreover, due to downward rigidity of nominal wages, deflation pushes up real labor costs, making it more difficult for monetary policymakers to achieve their objectives when output is below the long-run equilibrium. Data Exploration Are long-term inflation expectations “well anchored?” Using monthly data since 2003, plot a measure of long-term inflation expectations based on the difference between the yields on a five-year Treasury bond (FRED code: GS5) and a five-year Treasury Inflation Protected Securities (TIPS) bond (FRED code: FII5). What do you conclude? How did the financial crisis of 2007-2009 affect the measure? Answer: Based on this measure, long-term inflation expectations were reasonably consistent with the Fed’s 2-percent inflation target for the decade though mid-2013, and have drifted down a bit since that time. The key exception was during the financial crisis, when a flight by investors to the most liquid Treasury instruments (the nominal bonds, not the TIPS) combined with temporary fears of deflation resulted in a temporary downward spike of the measure. When aggressive Fed supply of liquidity normalized financial market conditions, the spike ended. Is investment sensitive to the real interest rate? Plot since 1990 a measure of the real interest rate – based on the difference between Moody’s Baa corporate rate (FRED code: BAA) and a survey of expected inflation (FRED code: MICH) – and (on the right scale) the share of investment (FRED code: GPDIC1) in real GDP (FRED code: GDPC1). Explain the cyclical pattern. Answer: The data are plotted below, where falling real interest rates through the 1990s were associated with rising capital investment. Note that during the recession of 2001, investment fell as the real interest rate rose. Falling rates again saw rising investment until the financial crisis of 2007-2009. During the crisis, real rates rose sharply and investment fell sharply. Since the end of the recession, low or declining real rates are again generally associated with rising capital investment. Moody's Seasoned Baa Corporate Bond Yield© [BAA], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/BAA. University of Michigan, University of Michigan: Inflation Expectation© [MICH], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/MICH. How sensitive is private investment to risk? Plot since 2004 the share of real gross private domestic investment (FRED code: GPDIC1) in real GDP (FRED code: GDPC1) and (on the right scale) a measure of anticipated stock market volatility (FRED code: VIXCLS). Explain the pattern. Answer: The data plot below is for a short horizon, but suggests that expectations of rising stock market volatility (measured on the basis of stock options prices) are associated with falling capital investment. Firms become cautious about investment if they anticipate greater variability in economic activity that will make their return on investment more unpredictable and riskier. Similarly, low or falling stock market volatility has generally been associated with improved or rising capital investment since the financial crisis of 2007-2009. Chicago Board Options Exchange, CBOE Volatility Index: VIX© [VIXCLS], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/VIXCLS. A recession may reflect declines in aggregate demand, aggregate supply, or both. Are swings in consumer sentiment characteristic of recessions? Plot a measure of sentiment (FRED code: UMCSENT) and discuss its evolution during the recessions since 1980? Explain why consumer sentiment is an important example of an aggregate demand shock. Answer: Consumption is about 70 percent of U.S. GDP, so swings in household sentiment about the economy can have a major impact on the timing, depth, and duration of economic recessions. On the plot below, large declines in sentiment tend to precede (or occur simultaneously with) the onset of recessions. The same timing characterizes upturns in sentiment and economic recoveries. University of Michigan, University of Michigan: Consumer Sentiment© [UMCSENT], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/UMCSENT. How often are negative supply shocks associated with recessions? Plot on a quarterly basis since 1971 the real price of oil – measured as the ratio of the nominal spot price of West Texas intermediate oil (FRED code: OILPRICE) to the U.S. consumer price index (CPIAUCSL). To extend this measure, add a second line showing the ratio of West Texas intermediate oil prices (FRED code: MCOILWTICO) to the consumer price index (CPIAUCSL). (These series will overlap for their common period, so use the Format option in FRED to plot then with the same color.) Identify recessions that may have been triggered in part by an oil price shock. Answer: Sharp increases in the real price of oil preceded several U.S. recent recessions. The most obvious instances are the recessions that began in 1973, 1979, and 2007. However, the evidence of falling inflation during the recessions shown in Table 21.5 suggests that the demand shocks usually were larger than the supply shocks in past U.S. downturns. Dow Jones & Company, Spot Oil Price: West Texas Intermediate (DISCONTINUED)© [OILPRICE], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/OILPRICE indicates more difficult problems. Solution Manual for Money, Banking and Financial Markets Stephen G. Cecchetti, Kermit L. Schoenholtz 9781259746741, 9780078021749, 9780077473075
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