Lecture 5

• in the 1970s, inflation rose due to the oil price shock, loose monetary policy, and imperfect information at the Fed
• in the 1970s, US monetary policy was too loose, as policymakers thought reducing inflation needed permanent unemployment increases, but it actually only needs a temporary recession
• in the 1970s, the Fed didnt have perfect information, and thought the productivity slowdown was a recession, so they lowered interest rates, which overheated the economy
• mistaking a productivity slowdown for a recession caused excess inflation because the Fed tried to increase output instead of decreasing it to reduce the output gap
• adaptive expectations mean that firms expect next years inflation rate to be the same as this years rate
• adaptive expectations means firms adjust their forecasts of inflation slowly, and embodies sticky prices assumption
• adaptive expectations involves firms changing their prices now for expected future inflation
• cost-push inflation is a price shock due to input in production
• cost push inflation tends to shift the Philipps curve to push the inflation rate up
• demand-pull inflation is due to changes in short-run output
• demand pull inflation increases AD, and causes a movement along the phillips curve
• the housing bubble burst when house prices decreased unexpectedly, which decreased AD and shifted the IS curve left, causing a negative output gap, so the Central Bank responded by lowering interest rates
• in the housing bubble, the IS curve shifted so far that for output to be at potential, real interest rates would have had to be negative
• the central bank controls the nominal interest rate by supplying the money that is demanded at that rate
• money supply changes as a consequence of changes in demand
• the Central bank targets interest rate instead of money demand, because money demand is subject to many shocks which would result in a very varied interest rate
• responding to changes to money demand would cause changes in interest rates, inflation and output, so it is not done, and interest rate is controlled instead
• 'tracker' mortgages have reduced in popularity over time, which has slowed the transition of monetary policy through the economy
• a higher length of time that a mortgage is fixed at means more of the interest rate risk is shifted from the client to the bank
• rational expectations can be used to influence inflation expectations without changing interest rates as much
• with rational expectations, the central bank can 'promise' to slow down the economy, and reduce inflation, which means companies expect prices to fall so they lower their prices today
• using rational expectations to control the expectations causes a 'soft landing', and was done by the USA recently
• sticky inflation is necessary for the MP curve
• the sticky inflation assumption is that price adjusts slowly over time, and that prices dont change every day
• interest rates of investments of different lengths of time should yield the same return
• when the Central Bank changes the overnight rate, financial markets expect the change to persist
• the central bank changing the overnight rate signals information about likely changes to the future for financial markets
• An increase in years until maturity will increase yield, as there is less certainty about the future, and you dont have the cash for longer
• the yield curve in march 2019 was much flatter than for 2016
• the Yield curve shows the different yeilds for different lengths of time until maturity of an investment
• the Central bank controls the overnight interest rate
• the overnight interest rate is the rate that banks use to borrow and lend funds from eachother overnight
• changes to the overnight rate can immediately affect household demand due to tracker mortgages, whose interest rates are directly linked to the overnight rate
• the overnight rate is a yearly rate, so the actual overnight rate that the banks pay is the overnight rate /365
• the central bank can target interest rates through reserves, loans, and open market operations
• reserves are the deposits held in accounts with the central bank, have interest pain on them, and are split into required and voluntary
• required and voluntary reserves pay different interest rates
• levels of voluntary reserves held in the central bank have increased over time, and the interest rate paid on these resevrves are now the Central Banks most important tool
• the most important tool for controlling interest rates is interest paid on reserves
• using loans as a way of managing interest rates is linked to when central banks act as a lender of last resort, and involves changing the interest charged on these loans