Money and Banking - Section 5

[1]. Consider the 3-equation policymaking framework being developed in class. The 3 equations are the IS
curve, the Phillips curve and the Monetary Policy (MP) line, the first two taking the form:

Yt − Ye = −b (rt − r∗ ) (IS)
πt = πtE + α (Yt − Ye ) + ǫt (PC)

Timing within any period t is as in class. First, private agents form expectations of inflation π E t , then the
inflation shock ǫt is realised; these two events determine the position of the Phillips curve that serves as the
central bank’s constraint/choice set. The central bank then sets interest rates and thereby determines
inflation and output (πt , Yt ).

The central bank has the familiar one-period loss function:

2 2
L = (Yt − YT ) + β (πt − πT )

where YT and πT are the bank’s target levels of output and inflation. Assume YT is greater than Ye , the
natural rate of output.

(i) If we assume the central bank minimises the one-period loss function above, what is the equation that
defines the resulting MP line? [Just practise deriving it yourself.]

(Yt − YT ) = −αβ (πt − πT ) (MP)

(ii) Assume that agents (perhaps irrationally. . . ) expect inflation equal to πT . Suppose that there is a positive
inflation shock ǫt > 0. Assuming the bank follows the MP equation you just derived, what real interest rate rt
will it end up choosing? What will be the resulting levels of output and inflation? Show your answers on a
diagram and give explicit algebraic solutions in terms of parameters and ǫt .

1
With πtE = πT , and using the MP equation and the Phillips curve:
1
πt − πT = (α (YT − Ye ) + ǫt )
1 + α2 β
1
Yt − Ye = ((YT − Ye ) − αβǫt )
1 + α2 β
1 1
rt − r∗ = − ((YT − Ye ) − αβǫt )
b 1 + α2 β

[2] “A central bank characterised by inflation bias, with YT > Ye , will tend to choose a real interest rate r that
is below the natural rate r∗ .” Evaluate this statement. [This was a short question on a previous final].

Not true. In a rational expectations equilibrium with no shocks, for example, such a central
bank will indeed choose r = r∗ .