《货币银行学》课程授课教案（英文讲义）Chapter 12 Modern Monetary Policy

Chapter 12Modern Monetary PolicyChapterOverviewEveryone is preoccupied with monetary policy,from traders to consumers topoliticians.In this and the next chapter we construct a framework that will showhow interest rates, inflation,and real growth are linked.This chapter describes theaggregate demand curve, which shows the quantity of real output demanded at eachlevel of inflation.The next chapter will introduce aggregate supply:As we movethrough the discussion of long-run equilibrium and aggregate demand, keep in mindthatour ultimate objective is to understand how modern central bankers set interestrates, and what they are reacting to when they change the target.ImportantPointsoftheChapterTo understand monetary policy we need to develop a macroeconomic model offluctuations in the business cycle in which monetary policy plays a central roleShort-run movements in inflation and output can arise from changes in aggregatedemand and changes in aggregate supply.Modern monetary policymakers work toeliminate the volatility that such changes cause by adjusting the target interest rate,which influences the components ofaggregatedemand.Application of Core PrinciplesPrinciple#5:Stability (page 551)In the short run, output can be above orbelow itspotential.Principle#4:Time (page 557)An investment can be profitable only if its internalrate of return exceeds the cost of borrowing, so the higher the real interest rate, thelowerthelevel ofinvestment.Principle #5: Stability (page 560)The relationship between the real interest rate andaggregate demand helps central bankers stabilize current output at a level close topotential output; they adjust the rate to close any output gap.Principle #5: Stability (page 563)Central bankers envision themselves as reacting tochanges in the economic environment.They change nominal interest rates in order

Chapter 12 Modern Monetary Policy Chapter Overview Everyone is preoccupied with monetary policy, from traders to consumers to politicians. In this and the next chapter we construct a framework that will show how interest rates, inflation, and real growth are linked. This chapter describes the aggregate demand curve, which shows the quantity of real output demanded at each level of inflation. The next chapter will introduce aggregate supply. As we move through the discussion of long-run equilibrium and aggregate demand, keep in mind that our ultimate objective is to understand how modern central bankers set interest rates, and what they are reacting to when they change the target. Important Points of the Chapter To understand monetary policy we need to develop a macroeconomic model of fluctuations in the business cycle in which monetary policy plays a central role. Short-run movements in inflation and output can arise from changes in aggregate demand and changes in aggregate supply. Modern monetary policymakers work to eliminate the volatility that such changes cause by adjusting the target interest rate, which influences the components of aggregate demand. Application of Core Principles Principle #5: Stability (page 551) In the short run, output can be above or below its potential. Principle #4: Time (page 557) An investment can be profitable only if its internal rate of return exceeds the cost of borrowing, so the higher the real interest rate, the lower the level of investment. Principle #5: Stability (page 560) The relationship between the real interest rate and aggregate demand helps central bankers stabilize current output at a level close to potential output; they adjust the rate to close any output gap. Principle #5: Stability (page 563) Central bankers envision themselves as reacting to changes in the economic environment. They change nominal interest rates in order

to bring about changes in real interest rates that will affect the economic decisions offirms andhouseholds and so return theeconomytothedesired level.Principle #2: Risk (page 573) Rising inflation drives aggregate demand downbecause it increases the uncertainty associated with inflation, making stocks a morerisky investment and reducing wealth.Principle #5: Stability (page 577)Policymakers can avoid them recessions byneutralizing shifts in aggregate demand that arise from other sources.TeachingTips/Student Stumbling BlocksThischapterand the next arethe heart of the newapproach tomacroeconomics,anapproachthatcentersonwhatcentral bankers reallydoIt culminates in a simpler and more realistic macroeconomic model to explainbusinesscyclefluctuationsA section is included below (following the end-of-chapter problems andsolutions) called “The Algebra of Dynamic Aggregate Demand and AggregateSupply"written by Stephen G.Cecchetti, which details theformulation of themodel.Chapter 21 (as well as Chapter 22) are about stability, emphasizing CorePrinciple5.Focus your studentsattention on themonetary policy reactioncurve, including the factors that determine its position, slope, and why it shiftsThey will then be well prepared for the full analysis of economic fluctuationspresented inChapter22,wherethe ability(and limitations)ofmonetarypolicyto control inflation and output fluctuations is discussedApointtostress:Theimportanceofthepropertiesofthemonetarypolicyreaction curve is that the central bank can use these properties to exert controlover the slope and position of the economy's aggregate demand curve.This chapter will lay a foundation for the concept of aggregate demand andhow monetary policy can affect it. Then, in Chapter 22, the concept ofaggregate supply is introduced. With aggregate demand and supply together,you will then be able to explain how to analyze economy-wide equilibrium. Inparticular, you can explicitly point out how the central bank, through itscontrol of the position and slope of the aggregate demand curve, can influenceequilibrium in the economyAlso included in Chapter 21 is a presentation of the idea of the long-run realinterest rate, a key concept in determining the long-run equilibrium of theeconomy. As interest rates show the time value of money, the discussion andanalysis of the long-run real rate is another application of Core Principle 1.Features in this Chapter

to bring about changes in real interest rates that will affect the economic decisions of firms and households and so return the economy to the desired level. Principle #2: Risk (page 573) Rising inflation drives aggregate demand down because it increases the uncertainty associated with inflation, making stocks a more risky investment and reducing wealth. Principle #5: Stability (page 577) Policymakers can avoid them recessions by neutralizing shifts in aggregate demand that arise from other sources. Teaching Tips/Student Stumbling Blocks  This chapter and the next are the heart of the new approach to macroeconomics, an approach that centers on what central bankers really do. It culminates in a simpler and more realistic macroeconomic model to explain business cycle fluctuations.  A section is included below (following the end-of-chapter problems and solutions) called “The Algebra of Dynamic Aggregate Demand and Aggregate Supply” written by Stephen G. Cecchetti, which details the formulation of the model.  Chapter 21 (as well as Chapter 22) are about stability, emphasizing Core Principle 5. Focus your students’ attention on the monetary policy reaction curve, including the factors that determine its position, slope, and why it shifts. They will then be well prepared for the full analysis of economic fluctuations presented in Chapter 22, where the ability (and limitations) of monetary policy to control inflation and output fluctuations is discussed.  A point to stress: The importance of the properties of the monetary policy reaction curve is that the central bank can use these properties to exert control over the slope and position of the economy’s aggregate demand curve.  This chapter will lay a foundation for the concept of aggregate demand and how monetary policy can affect it. Then, in Chapter 22, the concept of aggregate supply is introduced. With aggregate demand and supply together, you will then be able to explain how to analyze economy-wide equilibrium. In particular, you can explicitly point out how the central bank, through its control of the position and slope of the aggregate demand curve, can influence equilibrium in the economy.  Also included in Chapter 21 is a presentation of the idea of the long-run real interest rate, a key concept in determining the long-run equilibrium of the economy. As interest rates show the time value of money, the discussion and analysis of the long-run real rate is another application of Core Principle 1. Features in this Chapter

Your Financial World:Using the Word Inflation (page 554)In normal conversation, when people use the word “inflation"they are talking aboutprice increases.As it is commonly used, the term does not distinguish a one-timechange in the price level from a situation in which prices are rising continuously.Toeconomists, inflation means a continually rising price level, a sustained rise thatcontinuesfor days, months, even years.Tools of the Trade:Measuring Inflation Expectations (page 558)Inflation expectations are central to many economicdecisions.Expected inflationcan be measured by surveying people on their expectations or by looking at the pricesof certain bonds in the financial markets.We can get an estimate of expectedinflation by subtracting the real interest rate on Treasury Inflation ProtectionSecurities from the nominal interest rate on traditional Treasury bonds.Your Financial World: It's the Real Interest Rate that Matters (page 559)High nominal interest rates can be misleading, they fool people into thinking that theirincomes are high.But since high nominal rates almost always result from highinflation, spending all the interest income causes a gradual decline in the purchasingpower of one's savings.To maintain the real purchasing power of their interestincome, retirees can spend only the real return.Applying the Concept:The Remarkable 1990s (pages 577-579)The 1990s were a remarkable decade of unprecedented economic stability.Therearethreepossibleexplanationsfor this phenomenal worldwideeconomic performanceone is just luck, the second is that economies have become more flexible inresponding to external economic shocks, and the third is that maybe monetarypolicymakers have finally figured out how to do their jobs more effectively.Thethird is probably the most likely explanation.In the News:On Presidential Politics, the Fed Walks a Tight Rope (pages 579-580)Most economists dismiss the complaints of both Republicans and Democrats that theFed engages in political favoritism.However, the Fed does try not to start raisinginterest rates in the months before a presidential election, in part to keep frombecoming a political issue.Lessons of the Article: Central bank independence is supposed to freemonetary policymakers from political pressure.Yet it offers only partial

Your Financial World: Using the Word Inflation (page 554) In normal conversation, when people use the word “inflation” they are talking about price increases. As it is commonly used, the term does not distinguish a one-time change in the price level from a situation in which prices are rising continuously. To economists, inflation means a continually rising price level, a sustained rise that continues for days, months, even years. Tools of the Trade: Measuring Inflation Expectations (page 558) Inflation expectations are central to many economic decisions. Expected inflation can be measured by surveying people on their expectations or by looking at the prices of certain bonds in the financial markets. We can get an estimate of expected inflation by subtracting the real interest rate on Treasury Inflation Protection Securities from the nominal interest rate on traditional Treasury bonds. Your Financial World: It's the Real Interest Rate that Matters (page 559) High nominal interest rates can be misleading; they fool people into thinking that their incomes are high. But since high nominal rates almost always result from high inflation, spending all the interest income causes a gradual decline in the purchasing power of one’s savings. To maintain the real purchasing power of their interest income, retirees can spend only the real return. Applying the Concept: The Remarkable 1990s (pages 577-579) The 1990s were a remarkable decade of unprecedented economic stability. There are three possible explanations for this phenomenal worldwide economic performance: one is just luck, the second is that economies have become more flexible in responding to external economic shocks, and the third is that maybe monetary policymakers have finally figured out how to do their jobs more effectively. The third is probably the most likely explanation. In the News: On Presidential Politics, the Fed Walks a Tight Rope (pages 579-580) Most economists dismiss the complaints of both Republicans and Democrats that the Fed engages in political favoritism. However, the Fed does try not to start raising interest rates in the months before a presidential election, in part to keep from becoming a political issue. Lessons of the Article: Central bank independence is supposed to free monetary policymakers from political pressure. Yet it offers only partial

protection,especiallybeforeapresidential election.Thehigherthelevel ofoutputand employment, the more likely an incumbent president is towinreelection.But increases in interest rates slow the economy, reducingaggregate demand.Thus, raising interest rates just before an election—even ifdoing so is justified by economic conditionsputs the central bank on acollision coursewith politicians.Additional Teaching ToolsWho is the moneyman everyoneloves?According to this article from The WallStreet Journal ("Alan Greenspan: The Money Man Everyone Loves," by GeorgeMellon, May 25, 2004) it's the Chairman of the U.S.Federal Reserve.The articlerelates how Mr.Greenspan has been appointed by both Republican and Democraticpresidents and details some of the crises that he has faced in his tenure.Mellonwrites,“ClearlyMr.Greenspan has been as skillful at playingthe hugeFederalReserve pipe organ as he once was playing the sax, keeping the economy liquid andboth interest rates and inflation at remarkably low levels."In the July 1,2004 issue of The Wall Street Journal, G. Thomas Sims writes about theECBreaction totheFed'smove(“ECB Isn't LikelytoFollowFed MoveAnd RaiseRates"),explaining that theECB would“like to raise ratesto stem inflation, but doingso could spell a quick end to the euro zone's sluggish growth."The article makesclear the ECB's dilemma, pointing out that the ECB has missed its inflation target infour of the past five years" but that an increase in rates to stamp out inflation couldcrush an incipient recovery that's so slow in coming."VirtualToolsHere's a site with good links for information on inflation rates and purchasing power:http://eh.net/hmit/Learn more about the effects of inflation on this page, How much is that?" whichallowsyou to entermoneyvalues from thepast and find out howmuch they areworthtoday and vice versa:http:/www.eh.net/ehresources/howmuch/dollarq.phpFor More DiscussionHow important is consumer confidence?Do consumers really change their spendingpatterns based on their expectations about the economy?

protection, especially before a presidential election. The higher the level of output and employment, the more likely an incumbent president is to win reelection. But increases in interest rates slow the economy, reducing aggregate demand. Thus, raising interest rates just before an election—even if doing so is justified by economic conditions—puts the central bank on a collision course with politicians. Additional Teaching Tools Who is the money man everyone loves? According to this article from The Wall Street Journal (“Alan Greenspan: The Money Man Everyone Loves,” by George Mellon, May 25, 2004) it’s the Chairman of the U.S. Federal Reserve. The article relates how Mr. Greenspan has been appointed by both Republican and Democratic presidents and details some of the crises that he has faced in his tenure. Mellon writes, “Clearly Mr. Greenspan has been as skillful at playing the huge Federal Reserve pipe organ as he once was playing the sax, keeping the economy liquid and both interest rates and inflation at remarkably low levels.” In the July 1, 2004 issue of The Wall Street Journal, G. Thomas Sims writes about the ECB reaction to the Fed’s move (“ECB Isn’t Likely to Follow Fed Move And Raise Rates”), explaining that the ECB would “like to raise rates to stem inflation, but doing so could spell a quick end to the euro zone’s sluggish growth.” The article makes clear the ECB’s dilemma, pointing out that the ECB has missed its inflation target “in four of the past five years” but that “an increase in rates to stamp out inflation could crush an incipient recovery that’s so slow in coming.” Virtual Tools Here’s a site with good links for information on inflation rates and purchasing power: http://eh.net/hmit/ Learn more about the effects of inflation on this page, “How much is that?” which allows you to enter money values from the past and find out how much they are worth today and vice versa: http://www.eh.net/ehresources/howmuch/dollarq.php For More Discussion How important is consumer confidence? Do consumers really change their spending patterns based on their expectations about the economy?

ChapterOutlineI.Output and Inflation in the Long Runa.Potential Output1. Potential output is what the economy is capable of producing when itsresources are used at normal rates.2.Potential output is not a fixed level, because the amount of labor andcapital in an economy can grow, and improved technology can increase theefficiency of the production process.3.Unexpected events can push current output away from potential output,creating an output gap; if current output is greater than potential output, itis an expansionary gap and if it is less then there is a recessionary gap.4.In thelong run, current output equals potential output.b. Long-Run Inflationi.In the long run, since current output equals potential output, real growthmust equal growth in potential output.ii.Ignoring changes in velocity, in the long run, inflation equals moneygrowth minus growth in potential output.II.Money Growth, Inflation, and Aggregate DemandAggregate demand tells us how spending by households, firms, thegovernment, and foreigners changes as inflation goes up and downThelevel of aggregatedemand is tied to monetary policythrough the2equation of exchange (MV=PY) because the amount of money in theeconomy limits the ability to make payments.3. Rearranging the equation of exchange results in an expression that tells usthat aggregate demand (Y) equals the quantity of money times velocitydivided by the price level.4.From this expression it is clear that an increase in the price level reducesthe purchasing power of money,which means less purchases are made,pushing down aggregate demand.To shift thefocus to inflation, we need tolook at changes in theprice5.level.Suppose that inflation exceeds money growth (with velocity held constant).6.Real money balances will fall and so will aggregate demand.7. 0Because real money balances fall at higher levels of inflation, resulting ina lower level of aggregate demand, the aggregate demand curve isdownward sloping.8.Changes in the interest rate also provideamechanismforaggregatedemand to slope down

Chapter Outline I. Output and Inflation in the Long Run a. Potential Output 1. Potential output is what the economy is capable of producing when its resources are used at normal rates. 2. Potential output is not a fixed level, because the amount of labor and capital in an economy can grow, and improved technology can increase the efficiency of the production process. 3. Unexpected events can push current output away from potential output, creating an output gap; if current output is greater than potential output, it is an expansionary gap and if it is less then there is a recessionary gap. 4. In the long run, current output equals potential output. b. Long-Run Inflation i. In the long run, since current output equals potential output, real growth must equal growth in potential output. ii. Ignoring changes in velocity, in the long run, inflation equals money growth minus growth in potential output. II. Money Growth, Inflation, and Aggregate Demand 1. Aggregate demand tells us how spending by households, firms, the government, and foreigners changes as inflation goes up and down. 2. The level of aggregate demand is tied to monetary policy through the equation of exchange (MV=PY) because the amount of money in the economy limits the ability to make payments. 3. Rearranging the equation of exchange results in an expression that tells us that aggregate demand (Y) equals the quantity of money times velocity divided by the price level. 4. From this expression it is clear that an increase in the price level reduces the purchasing power of money, which means less purchases are made, pushing down aggregate demand. 5. To shift the focus to inflation, we need to look at changes in the price level. 6. Suppose that inflation exceeds money growth (with velocity held constant). Real money balances will fall and so will aggregate demand. 7. Because real money balances fall at higher levels of inflation, resulting in a lower level of aggregate demand, the aggregate demand curve is downward sloping. 8. Changes in the interest rate also provide a mechanism for aggregate demand to slope down

IIIThe MonetaryPolicyReaction CurveMonetaryPolicyand theReal Interest RateCentral bankers control short-term nominal interest rates by controlling themarketfor reserves.But the economic decisions of households and firms depend on the realinterest rate; so to alter the course of the economy, central banks mustinfluence the real interest rate as well.In the short run, because inflation is slow to respond, when monetarypolicymakerschangethenominal interestratetheychangethereal interestrate.The real interest rate, then, is the lever through which monetary policymakersinfluence the real economy. In changing real interest rates, they influenceaggregatedemand.Aggregate Demand and the Real Interest RateAggregatedemand is divided intofour components:consumptioninvestment, government purchases, and net exports.It is helpful to think of aggregate demand as having two parts, one that issensitive to real interest rate changes and one that is not.Investment is the most important of the components of aggregate demand thatare sensitive to changes in the real interest rateConsumption and net exports also respond to the real interest rate,consumption decisions often rely on borrowing, and the alternative toconsumption is saving (higher rates mean more saving)Asfornet exports,whenthereal interestrate intheUnited Statesrises,U.sfinancial assets become attractive to foreigners,causing thedollar toappreciate,which inturn means more imports andfewer exports (lower netexports).Thus, considering consumption, investment, and net exports, an increase in thereal interest rate reduces aggregate demand (the effect on the 4thcomponent, government spending, is small enough to be ignored)The relationship between the real interest rate and aggregate demand can beused by central bankers to stabilize current output at a level close topotential output; they can adjust the rate to close any output gapThe Long-Run Real Interest RateThere must be some level of the real interest rate at which aggregate demandequals potential output, this is the long-run real interest rate.The rate will change if a component of aggregate demand that is not sensitiveto the real interest rate goes up (or down) or if potential output changes.For example, an increase in government purchases (all else held constant) willraiseaggregatedemand ateverylevel ofthereal interestrate.Toremainin equilibrium, one of the interest-sensitive components of aggregate

III. The Monetary Policy Reaction Curve Monetary Policy and the Real Interest Rate Central bankers control short-term nominal interest rates by controlling the market for reserves. But the economic decisions of households and firms depend on the real interest rate; so to alter the course of the economy, central banks must influence the real interest rate as well. In the short run, because inflation is slow to respond, when monetary policymakers change the nominal interest rate they change the real interest rate. The real interest rate, then, is the lever through which monetary policymakers influence the real economy. In changing real interest rates, they influence aggregate demand. Aggregate Demand and the Real Interest Rate Aggregate demand is divided into four components: consumption, investment, government purchases, and net exports. It is helpful to think of aggregate demand as having two parts, one that is sensitive to real interest rate changes and one that is not. Investment is the most important of the components of aggregate demand that are sensitive to changes in the real interest rate. Consumption and net exports also respond to the real interest rate; consumption decisions often rely on borrowing, and the alternative to consumption is saving (higher rates mean more saving). As for net exports, when the real interest rate in the United States rises, U.S. financial assets become attractive to foreigners, causing the dollar to appreciate, which in turn means more imports and fewer exports (lower net exports). Thus, considering consumption, investment, and net exports, an increase in the real interest rate reduces aggregate demand (the effect on the 4th component, government spending, is small enough to be ignored). The relationship between the real interest rate and aggregate demand can be used by central bankers to stabilize current output at a level close to potential output; they can adjust the rate to close any output gap. The Long-Run Real Interest Rate There must be some level of the real interest rate at which aggregate demand equals potential output; this is the long-run real interest rate. The rate will change if a component of aggregate demand that is not sensitive to the real interest rate goes up (or down) or if potential output changes. For example, an increase in government purchases (all else held constant) will raise aggregate demand at every level of the real interest rate. To remain in equilibrium, one of the interest-sensitive components of aggregate

demand must fall, and for that to happen, thelong-run real interest ratemustriseThe same would be true for increases in other components of aggregatedemand that are not interest sensitiveA change in potential output has an inverse effect on the long-run real interestrate; when potential output rises, aggregate demand must rise with it,which requires a decrease in the real interest rate.Inflation,theReal InterestRate,andtheMonetaryPolicyReactionCurvePolicymakers set their short-run nominal interest rate targets in response to1.economic conditions in general and inflation in particular.2.While they state their policies in terms of nominal rates they do soknowingthatchanges inthenominal interest ratewilleventuallytranslateinto changes in the real interest rate, and it is those changes that influencethe economic decisions of firms and households.3.Deriving the Monetary Policy Reaction CurveToensurethat deviations of inflation from thetarget are onlya.temporary,monetarypolicymakersrespondto changein inflationbychanging the real interest rate in the same directionb.Themonetarypolicyreactioncurveis setsothatwhencurrent inflationequalstarget inflation,thereal interestrateequalsthelong-runrealinterestrate.The slope of the curvedepends on policymakers'objectives; whenc..central bankers decide how aggressively to pursue their inflation target,and how willing they are to tolerate temporary changes in inflation,theydeterminetheslopeofthecurved. Policymakers who are aggressive in keeping current inflation neartarget will havea steep curve,meaningthat a small changeininflationwill be met with a large change in the real interest rate.A relatively flat curve means that central bankers are less concernede.thantheymightbewithkeepingcurrent inflationneartargetovertheshortterm.4.Shifting the Monetary Policy Reaction Curvea.When policymakers adjust the real interest rate they are either movingalong a fixed monetary policy reaction curve or shifting the curve.b.Amovementalongthe curveisa reaction toa change incurrentinflation, a shift in the curve represents a change in the level of the realinterestrateateverylevel of inflation.If either target inflation or the long-run real interest rate change, thenc.theentire curvewill shiftd.With a higher inflation target, the central bank will set a lower currentreal interest rateateverylevel ofcurrent inflation,shifting themonetary policy reaction curve to the right (a reduction would have theoppositeeffect)

demand must fall, and for that to happen, the long-run real interest rate must rise. The same would be true for increases in other components of aggregate demand that are not interest sensitive. A change in potential output has an inverse effect on the long-run real interest rate; when potential output rises, aggregate demand must rise with it, which requires a decrease in the real interest rate. Inflation, the Real Interest Rate, and the Monetary Policy Reaction Curve 1. Policymakers set their short-run nominal interest rate targets in response to economic conditions in general and inflation in particular. 2. While they state their policies in terms of nominal rates they do so knowing that changes in the nominal interest rate will eventually translate into changes in the real interest rate, and it is those changes that influence the economic decisions of firms and households. 3. Deriving the Monetary Policy Reaction Curve a. To ensure that deviations of inflation from the target are only temporary, monetary policymakers respond to change in inflation by changing the real interest rate in the same direction. b. The monetary policy reaction curve is set so that when current inflation equals target inflation, the real interest rate equals the long-run real interest rate. c. The slope of the curve depends on policymakers’ objectives; when central bankers decide how aggressively to pursue their inflation target, and how willing they are to tolerate temporary changes in inflation, they determine the slope of the curve. d. Policymakers who are aggressive in keeping current inflation near target will have a steep curve, meaning that a small change in inflation will be met with a large change in the real interest rate. e. A relatively flat curve means that central bankers are less concerned than they might be with keeping current inflation near target over the short term. 4. Shifting the Monetary Policy Reaction Curve a. When policymakers adjust the real interest rate they are either moving along a fixed monetary policy reaction curve or shifting the curve. b. A movement along the curve is a reaction to a change in current inflation; a shift in the curve represents a change in the level of the real interest rate at every level of inflation. c. If either target inflation or the long-run real interest rate change, then the entire curve will shift. d. With a higher inflation target, the central bank will set a lower current real interest rate at every level of current inflation, shifting the monetary policy reaction curve to the right (a reduction would have the opposite effect)

Thelong-runreal interestrateisdetermined bythestructureofthee.economy,if itweretoriseasaresultofan increaseingovernmentpurchases (or some other component of aggregate demand that is notsensitive to the real interest rate) then the monetary policy reactioncurvewouldshiftleftf.Any shift in the monetary policy reaction curve can be characterized aseither a change in target inflation or a shift in the long-run real interestrate.5.ExchangeRateTargetingAdecisiontofixtheexchangeratemeansadoptingthemonetarya.policy reaction curve of the country to whose currency the exchangerate has been peggedIV.The Aggregate Demand CurveA. Output, Inflation, and the Aggregate Demand Curve1.When current inflation rises, aggregate demand falls, and vice versa.2.This is because monetary policymakers raise the real interest rate inresponse to higher inflation, moving upward along the monetary policyreaction curve.Thehigher real interest ratereduces the interest-sensitivecomponents ofaggregatedemand, causing it tofall.3.Changes in current inflation move the economy along a downward-slopingaggregate demand curve.4.This is in addition to the effect of higher inflation on real money balancesnoted earlier.B. The Slope of the Aggregate Demand Curve1.The slope of the aggregate demand curve tells us how sensitive currentoutput is to a given change in current inflation.2.The aggregate demand curve will be relatively flat if current output is verysensitive to inflation (a change in current inflation causes a largemovement in current output)and steep if current output is not verysensitiveto inflation3.Three factors influence the sensitivity of current output to inflation: thestrength of the effect of inflation on real money balances, the extent towhich monetary policymakers react to a change in current inflation, andthe size of the response of aggregate demand to changes in the interestrate.4.The second factor relates to the slope of the monetary policy reactioncurve.5.If policymakers react aggressively to a movement of current inflation awayfrom its target level with a large change in the real interest rate, themonetary policy reaction curve will be steep and the aggregate demandcurve is flat

e. The long-run real interest rate is determined by the structure of the economy; if it were to rise as a result of an increase in government purchases (or some other component of aggregate demand that is not sensitive to the real interest rate) then the monetary policy reaction curve would shift left. f. Any shift in the monetary policy reaction curve can be characterized as either a change in target inflation or a shift in the long-run real interest rate. 5. Exchange Rate Targeting a. A decision to fix the exchange rate means adopting the monetary policy reaction curve of the country to whose currency the exchange rate has been pegged. IV. The Aggregate Demand Curve A. Output, Inflation, and the Aggregate Demand Curve 1. When current inflation rises, aggregate demand falls, and vice versa. 2. This is because monetary policymakers raise the real interest rate in response to higher inflation, moving upward along the monetary policy reaction curve. The higher real interest rate reduces the interest-sensitive components of aggregate demand, causing it to fall. 3. Changes in current inflation move the economy along a downward-sloping aggregate demand curve. 4. This is in addition to the effect of higher inflation on real money balances noted earlier. B. The Slope of the Aggregate Demand Curve 1. The slope of the aggregate demand curve tells us how sensitive current output is to a given change in current inflation. 2. The aggregate demand curve will be relatively flat if current output is very sensitive to inflation (a change in current inflation causes a large movement in current output) and steep if current output is not very sensitive to inflation. 3. Three factors influence the sensitivity of current output to inflation: the strength of the effect of inflation on real money balances, the extent to which monetary policymakers react to a change in current inflation, and the size of the response of aggregate demand to changes in the interest rate. 4. The second factor relates to the slope of the monetary policy reaction curve. 5. If policymakers react aggressively to a movement of current inflation away from its target level with a large change in the real interest rate, the monetary policy reaction curve will be steep and the aggregate demand curve is flat

6.If policymakers respondmorecautiously,themonetarypolicyreactioncurve is flat and the aggregate demand curve is steepThe slope of the aggregate demand curve depends in part on the7preferences of the central bank; on how aggressive policymakers are inresponding to deviations of inflation from the target level.C. Why the Aggregate Demand Curve Slopes Down1.There are two reasons why the aggregate demand curve slopes down:first,because higher inflation reduces real money balances (thus reducingpurchases), and second, because higher inflation induces policymakers toraise the real interest rate, depressing various components of aggregatedemand.2.Rising inflation also reduces wealth, which lowers consumption and drivesdown aggregate demand.3. In addition, as inflation rises the uncertainty about inflation rises, whichmakes equities a more risky investment and drops their value, alsoreducing wealth4.Another reason for the downward slope of the aggregate demand curve isthat inflation can haveagreaterimpact onthe poorthan it does on thewealthy, redistributing income to those who are better off.5.0People may also save more as a result of the increased risk associated withinflation.6.Also, rising inflation makes foreign goods cheaper in relation to domesticgoods, driving imports up and net exports down.D. Shifting the Aggregate Demand Curve1.Shifts in the MonetaryPolicy Reaction CurveWhenever the monetary policy reaction curve shifts, the aggregatea.demand curve will shift as wellChanges in the long-run real interest rate, which is a consequence ofb..the structure of the economy,will also shift aggregate demandc.Either a fall in target inflation or a rise in the long-run real interest ratewill shift the monetary policy reaction curve to the left and theaggregate demand curve to the left.2. Changes in the Components of Aggregate DemandAny change in a component of aggregate demand that is caused by aa.factor other than a change in the real interest rate will shift theaggregatedemand curve.b..When firms become more optimistic about thefuture, or consumerconfidenceincreases, investmentorconsumptionwill increaseandaggregate demand will shift to the right.Increases in government purchases will increase aggregate demand, asC.will decreases intaxes

6. If policymakers respond more cautiously, the monetary policy reaction curve is flat and the aggregate demand curve is steep. 7. The slope of the aggregate demand curve depends in part on the preferences of the central bank; on how aggressive policymakers are in responding to deviations of inflation from the target level. C. Why the Aggregate Demand Curve Slopes Down 1. There are two reasons why the aggregate demand curve slopes down: first, because higher inflation reduces real money balances (thus reducing purchases), and second, because higher inflation induces policymakers to raise the real interest rate, depressing various components of aggregate demand. 2. Rising inflation also reduces wealth, which lowers consumption and drives down aggregate demand. 3. In addition, as inflation rises the uncertainty about inflation rises, which makes equities a more risky investment and drops their value, also reducing wealth. 4. Another reason for the downward slope of the aggregate demand curve is that inflation can have a greater impact on the poor than it does on the wealthy, redistributing income to those who are better off. 5. People may also save more as a result of the increased risk associated with inflation. 6. Also, rising inflation makes foreign goods cheaper in relation to domestic goods, driving imports up and net exports down. D. Shifting the Aggregate Demand Curve 1. Shifts in the Monetary Policy Reaction Curve a. Whenever the monetary policy reaction curve shifts, the aggregate demand curve will shift as well. b. Changes in the long-run real interest rate, which is a consequence of the structure of the economy, will also shift aggregate demand. c. Either a fall in target inflation or a rise in the long-run real interest rate will shift the monetary policy reaction curve to the left and the aggregate demand curve to the left. 2. Changes in the Components of Aggregate Demand a. Any change in a component of aggregate demand that is caused by a factor other than a change in the real interest rate will shift the aggregate demand curve. b. When firms become more optimistic about the future, or consumer confidence increases, investment or consumption will increase and aggregate demand will shift to the right. c. Increases in government purchases will increase aggregate demand, as will decreases in taxes

d.Increases in netexports that areunrelated tochanges in real interestrates will shift the aggregate demand curve to the right.3.Monetary Policy and Aggregate Demanda.Because shifts in the monetary policy reaction curve can shift theaggregate demand curve, it is possible that monetary policy can causerecessionsb.Ifpolicymakerscancauserecessions,theycanprobablyavoidthemaswell by neutralizing shifts in aggregate demand that arise from othersources.The analysis up to this point has assumed that inflation does not change over time; butin reality inflation and output are jointly determined, and monetary policy plays a roleintheshort-runmovementsofbothV.The Monetary Policy Transmission MechanismThe Traditional Channels:Interest Rates and ExchangeRatesCentral banks target a very short-term interest rate,and changes in that ratehaveadirecteffectontotal spending.As the interest rate falls, financing becomes less expensive, so investment andconsumption increase.The exchange rate is also affected; as investors demand less ofU.S. assets thevalue of the dollar drops, which in turn means higher net exports.The interest-rate channel appears to be a weak one; information problemsmake external financing too difficult and costly for firms to undertake, sothe vastmajority of investments arefinanced byfirmsthrough theirownfunds.While a change in the interest rate does change the cost of external financing,it doesn't have much of an effect on investment decisions because notmany companies obtain their funds that way.The impact on households is also rather modest because people's decisions topurchase cars or houses depend on longer-term interest rates; soconsumption will change only to the extent that changing the target rateaffects long-term interest rates, and the overall effect is not that large.As for the effect on the exchange rate, in the real world the interest ratecontrolledbypolicymakersisjustoneofmanyfactorsthatshiftthedemand and supply for the dollar, the influence of these other factorsrenders the impact of monetary policy on the exchange rate (and netexports) unpredictable.Thus, after careful analysis, we can conclude that the traditional channels ofmonetary policy transmission aren't very powerful.Yet evidence shows that monetary policy is effective; something else must beamplifying the impact of monetary policy changes on real economicactivity

d. Increases in net exports that are unrelated to changes in real interest rates will shift the aggregate demand curve to the right. 3. Monetary Policy and Aggregate Demand a. Because shifts in the monetary policy reaction curve can shift the aggregate demand curve, it is possible that monetary policy can cause recessions. b. If policymakers can cause recessions, they can probably avoid them as well by neutralizing shifts in aggregate demand that arise from other sources. The analysis up to this point has assumed that inflation does not change over time; but in reality inflation and output are jointly determined, and monetary policy plays a role in the short-run movements of both Ⅴ.The Monetary Policy Transmission Mechanism The Traditional Channels: Interest Rates and Exchange Rates Central banks target a very short-term interest rate, and changes in that rate have a direct effect on total spending. As the interest rate falls, financing becomes less expensive, so investment and consumption increase. The exchange rate is also affected; as investors demand less of U.S. assets the value of the dollar drops, which in turn means higher net exports. The interest-rate channel appears to be a weak one; information problems make external financing too difficult and costly for firms to undertake, so the vast majority of investments are financed by firms through their own funds. While a change in the interest rate does change the cost of external financing, it doesn’t have much of an effect on investment decisions because not many companies obtain their funds that way. The impact on households is also rather modest because people’s decisions to purchase cars or houses depend on longer-term interest rates; so consumption will change only to the extent that changing the target rate affects long-term interest rates, and the overall effect is not that large. As for the effect on the exchange rate, in the real world the interest rate controlled by policymakers is just one of many factors that shift the demand and supply for the dollar; the influence of these other factors renders the impact of monetary policy on the exchange rate (and net exports) unpredictable. Thus, after careful analysis, we can conclude that the traditional channels of monetary policy transmission aren’t very powerful. Yet evidence shows that monetary policy is effective; something else must be amplifying the impact of monetary policy changes on real economic activity