Macroeconomics, IES FSS (Summer 2014/2015)
ES 3: Intro to economic fluctuations
Tom´aˇs Lichard
Tom´
aˇs Lichard
Macroeconomics, IES FSS (Summer 2014/2015)
Problem 1
An economy begins in long-run equilibrium, and then a change in
government regulations allows banks to start paying interest on
checking accounts. Recall that the money stock is the sum of
currency and demand deposits, including checking accounts, so this
regulatory change makes holding money more attractive.
a) How does this change affect the demand for money?
b) What happens to the velocity of money?
c) If the CB keeps the money supply constant, what will happen
to output and prices in the short run and in the long run?
d) If the goal of the Fed is to stabilize the output, should the Fed
keep the money supply constant in response to this regulatory
change? If not, what should it do? Why?
e) If the goal of the Fed is to stabilize output, how would your
answer to part (d) change?
Tom´
aˇs Lichard
Macroeconomics, IES FSS (Summer 2014/2015)
Problem 2
Suppose the Fed reduces the money supply by 5%.
a) What happens to the aggregate demand curve?
b) What happens to the level of output and the price level in the
short run and in the long run?
c) According to Okun’s law, what happens to unemployment in
the short run and in the long run?
d) What happens to the real interest rate in the short run and in
the long run?
Tom´
aˇs Lichard
Macroeconomics, IES FSS (Summer 2014/2015)
Problem 3
Let’s examine how the goals of the central banks influence their
response to shocks. Suppose Central bank A cares only about
keeping the price level stable and Central bank B cares only about
keeping output and employment at their natural levels (in reality,
ECB is type A cares mainly about the price level and US Fed
nowadays has a dual mandate, but sometimes cares more about
output). Explain how each CB would respond to the following.
a) An exogenous decrease in the velocity of money.
b) An exogenous increase in the price of oil.
Tom´
aˇs Lichard
Macroeconomics, IES FSS (Summer 2014/2015)
Reality
PersonalConsumptionExpenditures:Chain-typePriceIndex
PersonalConsumptionExpendituresExcludingFoodandEnergy
(Chain-TypePriceIndex)
(PercentChangefromYearAgo)
5
4
3
2
1
0
-1
1996
1998
2000
2002
2004
2006
2008
2010
2012
2014
2015research.stlouisfed.org
HarmonizedIndexofConsumerPrices:AllItemsforEuroarea(17
countries)©
HarmonizedIndexofConsumerPrices:OverallIndexExcluding
Energy,Food,Alcohol,andTobaccoforEuroarea(17countries)©
(PercentChangefromYearAgo)
5
4
3
2
1
0
-1
1996
1998
2000
2002
2004
2006
2008
2010
2012
2014
2015research.stlouisfed.org
Tom´
aˇs Lichard
Macroeconomics, IES FSS (Summer 2014/2015)
Supply shocks and inflation
Why do supply shocks have effect on the price level? Why are
relative price changes inflationary?
in the long run, the inflation is determined by the amount of
money in the economy, which is set by the central bank
so if there is a shock to some prices, consumers have less
money to spend on other goods, so they should become
cheaper as the demand goes down and aggregate price level
should be unchanged
Problem – the distribution of the price changes isn’t symmetric
Tom´
aˇs Lichard
Macroeconomics, IES FSS (Summer 2014/2015)
Supply shocks and inflation (Based on Ball&Mankiw, 1995)
Tom´
aˇs Lichard
Macroeconomics, IES FSS (Summer 2014/2015)
Supply shocks and inflation (Based on Ball&Mankiw, 1995)
Model setup:
continuum of industries with continuum of imperfectly
competitive firms
nominal prices are normalized to zero in logs
C are menu costs, Θ is the shock to price (with mean is zero);
this shock affects different industries differently (distribution of
shock across industries is f )
If current price and optimal price differ, firms lose Θ2 of profit
√
The firm will thus
√ update its price only if |Θ| > C ; G is the
distribution of C across firms
The inflation is then expressed as:
Z ∞
Z ∞
π=
ΘG (|Θ|) f (Θ) dΘ =
ΘG (Θ) [f (Θ) − f (−Θ)] dΘ
−∞
0
When is the inflation positive?
Tom´
aˇs Lichard
Macroeconomics, IES FSS (Summer 2014/2015)
Supply shocks and inflation – empirical evidence
Tom´
aˇs Lichard
Macroeconomics, IES FSS (Summer 2014/2015)