Lecture 6

• in an inflation shock, the shock parameter changes for only 1 period, but the price level rises permanently
• in an inflation shock, the AS curve shifts up
• an inflation shock causes stagflation, where inflation increases and there is a negative output gap
• the increase in price during an inflation shock is not as big as the shock, as the central bank responds by increasing interest rates to manage inflation, which opens the output gap
• in an inflation shock, the expected inflation increases, and so the AS curve very slowly adjusts back to initial position
• in an inflation shock, the slow movement of the AS curve to the initial position means inflation falls only slowly
• in an inflation shock, inflation falls because firms lower their prices slowly in response to falling demand
• sticky prices slows the return of the AS curve to its initial level after an inflation shock
• the output gap causes the return to the steady state after an inflation shock
• in the long-term of an inflation shock, the economy will return to its initial steady state
• transition dynamics after an inflation shock means that movement back to the steady state is fastest the further away the economy is from its steady state
• a price (inflation) shock causes a prolonged slump and causes stagflation
• a price shock will cause inflation that only reduces slowly, even with central bank intervention
• disinflation occurs when policymakers lower the inflation target; causing the AD curve to shift down, to a lower inflation level (but not to the new target) and a negative output gap
• in disinflaiton, after the initial AD shift down, the expected inflation reduces, and causes a slow shift of the AS curve right, to the new steady state at a 0 output gap and lower inflation
• if the Classical Dichotomy holds, the AD and AS curves both immediately shift during disinflation, and the new steady state is reached with no recession (negative output gap)
• if there is sticky inflation, a recession is needed to adjust expectation down during disinflation
• if rational expectations are used instead of adaptive expectations, the AS curve becomes reliant on expected inflation, not past inflation
• when rational expectations are used, firms must expect a recession in order to prevent a recession being necessary
• when expected inflation is close to the inflation target, expectations are well anchored
• when expected inflation is far from the inflation target, expectations are deanchoring
• when the Fed lowers its inflation target, rational expectations will cause the AS curve to shift immediately down, meaning there is no change in output gap, and only inflation will reduce
• if the central bank can control expectations of inflation, it can be kept low without recessions
• inflation targeting involves committing to a long-run inflation rate / target
• inflation targeting maintains flexibility to respond to shocks (such as covid-19) as discretionary policy
• inflation targeting will anchor inflation expectations close to the inflation target, while temporary deviations can stabilise output
• modern monetary policy is rigid, with rules that are simple to be understood, and with little flexibility
• the short-term monetary policy model involves the IS curve, the MP curve and the Philips curve, which create an approximate representation of the economy
• the output gap is the difference between the actual output and the long term potential output (taken as given)
• the simple monetary policy rule is the taylor rule
• the simple monetary policy rule is that Rt - r = m (current - target inflation)
• in the taylor rule, m is how aggressively the central bank responds to inflation
• a policymaker willing to generate a large recession to counter inflation will make the use of this policy less likely
• delegating recessionary policymaking to someone not reliant on re-election is needed, in order for them to make decisions that benefit the economy, not their popularity
• a politician cannot commit to a recession, so inflation expectations will take this into account, causing a higher and more unstable inflation rate
• someone reliant on being elected will not cause a recession, and result in ineffective monetary policy
• a central banks willingness to fight inflation is a key factor in expected inflation
• a central banks willingness to fight inflation is a key factor in expected inflation
• if firms know the central bank will be aggressive in keeping inflation low, they are less likely to raise their prices
• the AD curve shifts out when there is an increase in the aggregate demand parameter