,How do central banks use monetary policy to respond to shocks in the economy?
coreecon
Inflation: Key Concepts
Inflation = an increase in the general price level
Zero inflation = A constant price level from year to year
Deflation = A decrease in the general price level
Disinflation = A decrease in the rate of inflation
coreecon
What's wrong with inflation?
For people on fixed nominal income, higher inflation means lower real value of income.
Inflation reduces the real value of debt - good for borrowers, bad for lenders.
Real interest rate = Nominal interest rate - Inflation rate [The Fisher equation]
High rate of inflation makes the economy work less well:
•
High inflation is often volatile -> uncertainty

 This is similar to a negative shock to
aggregate demand.
Deflation increases the real debt burden, which may lead households to cut consumption to
return to their target wealth.
coreecon
Causes of inflation
Recall: Wages and prices are determined
by interactions between firms,
consumers, and workers.
Inflation may be due to:
· Increases in bargaining power of firms
over their consumers
(e.g reduction in competition)
· Increases in the bargaining power of
workers over firms
Wage-setting curve
Real wage
Price-setting curve
shifts down
Price-setting curve
1 Owners' power rises relative to
consumers' (e.g lower competition) -
medium to long run
Wage-setting curve
Real wage
Wage-setting curve
shifts up
Price-setting curve
2 Employees' power rises relative to
owners' (e.g stronger unions) -
medium to long run
Wage-setting curve
Unemployment falls
Real wage
Price-setting curve
1
Employment, N
3

(MRS)
coreecon
The role of expectations
Real wage
Wage-setting curve
2% = Bargaining gap
Price-setting curve
Trade-off between inflation and unemployment
is not stable: Phillips Curve shifts over time
Expectations of future prices can cause the
Phillips curve to shift.
Inflation = expected inflation + bargaining gap
The inflation-stabilizing rate is the
unemployment rate which keeps inflation
constant.
Inflation rate

 countries of the eurozone
coreecon
quantitative easing (QE) Central bank purchases of financial
assets aimed at reducing interest rates on those assets when
conventional monetary policy is ineffective because the policy
interest rate is at the zero lower bound See also: zero lower bound.
Bank of England
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Q
Home / Monetary policy / Quantitative easing
Quantitative easing
Quantitative easing (QE) is one of the tools we use to meet our 2% inflation
target

,Calculate the nominal policy rate that will produce the appropriate market interest rate.
coreecon
Asset prices
A change in the policy rate has a ripple effect through all the interest rates in the economy.
When the interest rate goes down, the price of assets goes up.
Households who own assets will be wealthier, which will increase their consumption.
coreecon
Profit expectations
Consistent policymaking and good communication with the public builds confidence in the
central bank.
If the central bank lowers the policy rate and explains its reasoning, this can lead firms to
expect higher demand, who will therefore increase investment.
Similarly, if it increases the confidence of households that they will not lose their jobs, then
they may also increase their spending.
coreecon
Monetary policy in the multiplier model
Aggregate demand, AD
Y = AD on 45-degree line
AD
A
AD (lower consumption, co',
and higher investment due
to lower interest rate, r)
7
AD (lower level of
consumption, co')
Co + I(r) + G + X
Co' + I(r') + G + X
B
45°
To stabilize the economy, the central bank
stimulates investment by lowering the real
interest rate

QE lowers long-term borrowing costs to support spending in the
economy and hit the inflation target.
Related links
>
Inflation and the 2% target
>
Interest rates and Bank Rate
coreecon
Demand shocks
Demand shock = An unexpected change in aggregate demand
Governments can use both fiscal and monetary policy to
stabilize the economy:
•
Monetary policy - decreasing the nominal interest rate
· Fiscal policy - tax cuts and increased government spending
Labour supply
Phillips curve
Inflation

N
AD (before the downturn)
AD (monetary and fiscal stimulus)
C
Aggregate demand
7
AD (investment slump)
D
45°
€
Output (income)
coreecon
Inflation targeting
Inflation targeting = monetary policy regime where the central bank uses policy instruments to keep
the economy close to an inflation target
Making the central bank independent
from the government gives inflation
targets credibility and prevents an
inflation spiral by setting expectations.
Labour supply
Inflation

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