Learning Goal: In this chapter, what we ask is how this knowledge is applied in practice. Specifically, we take a broad brush look at how central bank sets interest rate in order to control aggregate demand.
The fundamental elements of policy making. Who, what, why, when, how.
Who: Both monetary and fiscal can be used to tune the economy. Most short-term tuning is done with monetary policy. So The Who of stabilization policy mostly means the central bank.
What: What central bank dose is set a key interest rate in the economy, raise tend to cool off and lowering rates warms it up. All monetary policies works through moving AD, with little or no influence on AS. Two goals chosen with in short-run policy: keep activity high and inflation low. In the short run, as the supply curve is relatively flat. Except at very high inflation takes, boosting economic activity does much more to enhance economic welfare than does controlling inflation. On the other hand, as the long-run supply curve is vertical, so central bank policies slide the AD curve up and down along the AS(change only prices but not output) which means it can be effectively controlling the inflation but can do relatively little to increase GDP. Central bank now has recognized this tensions and has modified their policy objectives in two ways. 1st, it focus on stabilizing economic activity around a sustainable goal, rather than increasing economic activity(Essentially, the goal on the output side is to stay close to potential GDP or natural rate of unemployment). 2nd, many centrals have moved toward inflation targeting, in which all the weight is put on hitting a low and consistent inflation target and very little weight is placed on output.
When: Fed meets and sets the federal funds rate, it tries very hard not to surprise the market, so it sends advance signals of the likely future.
How: buying or selling treasury bill with money it prints, lowering rates means increasing money supply.
POLICY AS A RULE
Taylor rule : Target Rate=natural rate+inflation rate+alpha*(target inflation—natural inflation)+beta*(100%*target yield—natural yield/natural yield). Mention it is target rate respond to the change of inflation or yield. If alpha is relatively large than beta, then it will respond more aggressively to inflation in excess, and vice versa. The case of beta=0 correspond to pure inflation targeting.
INTEREST RATES AND AGGREGATE DEMAND
Y=C+I+G+NX=AD(i) Central banks focus on rate not money supply, but it is critical to link the supply to demand for two reason:
1st, Increases in the money supply are part of the link to higher prices. 2nd, the link through money supply is used to derive the AD demand curve.
HOW TO HIT THE TARGET:
1st, ask what P and Y should be. 2nd, ask how much need to shift AD or AS. 3rd, how large the policy change required to move AD or AS.
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