Macroeconomics week 7 + 8
Module code: EC108
Lecturer: Stefania Paredes Fuentes
Topics
● Deflation trap
● 3 equation model and deflation
● 3 equation model and expectations
● Inflation bias
● Fiscal policy
● Unconventional monetary policy
● Discretionary fiscal policy and automatic stabilisers
● Debt dynamics, sovereign debt
● Ricardian equivalence
The 3 equation model and deflation
Made up of 3 equations:
1. The IS curve
2. The monetary rule
3. The Phillips curve
How the CB responds to shocks to the economy
- What is the CB trying to achieve? (preferences)
- What prevents the CB from achieving its target? (constraints)
- How does the CB translate its objectives into monetary policy? (monetary rule)
Transmission channels of monetary policy in a negative demand shock:
- Lowers the policy rate to allow for output + inflation to adjust
- Then they gradually increase the policy rate until output = eq
- Positive demand shock = deflationary pressure
,The deflation gap
Why deflation is bad:
1. Increase in real burden of debts → lenders benefit but they tend to have a greater
propensity to save than borrowers, majority of people are borrowers
2. Consumers then delay purchases → effects on real IR: zero lower bound (nominal
IR cannot be negative)
3. Increases labour rigidity → workers do not accept falling nominal wages
The ZLB:
- Short term nominal interest rate close to 0 = liquidity trap
- Persistent deflation that can spiral downward when there’s 0% interest (ZLB)
- Leads to lower production, lower wages, decreased demand, lower prices
- Monetary policy becomes ineffective
- The economy is at the zero lower bound (can’t fall anymore)
- Recall the Fisher equation → i = r + pi^E
- The ZLB implies min r ≥ - pi^E where i = 0
- Cannot achieve a real IR below the one that is set
Nominal interest rates:
- CB responds to shocks by adjusting the nominal interest rate such that the real interest
rate changes and affects AD through the IS relation
- Must take into account expected inflation
- The CB will respond to falling inflation by reducing the IR to stimulate demand
- If the real interest rate needed is 0.75% and expected inflation is -1% then a nominal
IR of -0.25% would be required
- Constraint of min r ≥ - pi^E
- The minimum real IR achievable is 1% which is not low enough to get the economy
onto the MR and to eq (rs < minimum feasible rate 1%)
- If inflation is at -1% then it will be impossible to achieve the eq level of output using
monetary policy, stuck at point A
, The deflation trap and the 3 equation model
Period 0:
- Economy starts at A (bliss point) and is hit by a large permanent negative AD shock
which shifts the IS curve to IS’ and the economy moves to B
- Reduces output (y0 < ye) and inflation is less than the target (it's now negative -
deflation)
- Point B is not on the MR curve
- CB forecasts PC in the next period: aas inflation is below eq, the PC will shift to
- CB needs to locate point C on the MR curve by setting an IR of r’0
- This is below the min real IR they can achieve by setting i = 0
- The lowest is r0 = - pi 0
- IS will stay at IS’ next period
- The IR change comes into effect one period later so at the end of period 0 inflation =
pi0, output = 0, IR = r0
Period 1:
- The new IR has had time to affect AD, it boosts investment and output and moves the
economy to C but output < eq at y1
- This is below the CB’s BR level of y’1 causing inflation to fall further to pi1
- The CB forecasts PC to move to now they need to find D
- Set an IR of r’1 but this is below the min real IR, lowest us r1 = - pi1
- Period one ends with inflation = pi1, output = y1, IR = r1
Module code: EC108
Lecturer: Stefania Paredes Fuentes
Topics
● Deflation trap
● 3 equation model and deflation
● 3 equation model and expectations
● Inflation bias
● Fiscal policy
● Unconventional monetary policy
● Discretionary fiscal policy and automatic stabilisers
● Debt dynamics, sovereign debt
● Ricardian equivalence
The 3 equation model and deflation
Made up of 3 equations:
1. The IS curve
2. The monetary rule
3. The Phillips curve
How the CB responds to shocks to the economy
- What is the CB trying to achieve? (preferences)
- What prevents the CB from achieving its target? (constraints)
- How does the CB translate its objectives into monetary policy? (monetary rule)
Transmission channels of monetary policy in a negative demand shock:
- Lowers the policy rate to allow for output + inflation to adjust
- Then they gradually increase the policy rate until output = eq
- Positive demand shock = deflationary pressure
,The deflation gap
Why deflation is bad:
1. Increase in real burden of debts → lenders benefit but they tend to have a greater
propensity to save than borrowers, majority of people are borrowers
2. Consumers then delay purchases → effects on real IR: zero lower bound (nominal
IR cannot be negative)
3. Increases labour rigidity → workers do not accept falling nominal wages
The ZLB:
- Short term nominal interest rate close to 0 = liquidity trap
- Persistent deflation that can spiral downward when there’s 0% interest (ZLB)
- Leads to lower production, lower wages, decreased demand, lower prices
- Monetary policy becomes ineffective
- The economy is at the zero lower bound (can’t fall anymore)
- Recall the Fisher equation → i = r + pi^E
- The ZLB implies min r ≥ - pi^E where i = 0
- Cannot achieve a real IR below the one that is set
Nominal interest rates:
- CB responds to shocks by adjusting the nominal interest rate such that the real interest
rate changes and affects AD through the IS relation
- Must take into account expected inflation
- The CB will respond to falling inflation by reducing the IR to stimulate demand
- If the real interest rate needed is 0.75% and expected inflation is -1% then a nominal
IR of -0.25% would be required
- Constraint of min r ≥ - pi^E
- The minimum real IR achievable is 1% which is not low enough to get the economy
onto the MR and to eq (rs < minimum feasible rate 1%)
- If inflation is at -1% then it will be impossible to achieve the eq level of output using
monetary policy, stuck at point A
, The deflation trap and the 3 equation model
Period 0:
- Economy starts at A (bliss point) and is hit by a large permanent negative AD shock
which shifts the IS curve to IS’ and the economy moves to B
- Reduces output (y0 < ye) and inflation is less than the target (it's now negative -
deflation)
- Point B is not on the MR curve
- CB forecasts PC in the next period: aas inflation is below eq, the PC will shift to
- CB needs to locate point C on the MR curve by setting an IR of r’0
- This is below the min real IR they can achieve by setting i = 0
- The lowest is r0 = - pi 0
- IS will stay at IS’ next period
- The IR change comes into effect one period later so at the end of period 0 inflation =
pi0, output = 0, IR = r0
Period 1:
- The new IR has had time to affect AD, it boosts investment and output and moves the
economy to C but output < eq at y1
- This is below the CB’s BR level of y’1 causing inflation to fall further to pi1
- The CB forecasts PC to move to now they need to find D
- Set an IR of r’1 but this is below the min real IR, lowest us r1 = - pi1
- Period one ends with inflation = pi1, output = y1, IR = r1
