Wykłady Monetary All

Overview Course structure Reading materials Grading Questions
Monetary economics
Introduction
Jakub Janus
Krakow University of Economics

Department of Macroeconomics
jakub.janus@uek.krakow.pl
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Outline
1 Overview
2 Course structure
3 Reading materials
4 Grading
5 Questions
2 / 13
Outline
1 Overview
2 Course structure
3 Reading materials
4 Grading
5 Questions
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On-line materials
On-line materials and organization

E-platform course: Monetary economics (link)
Password: MonEcon2024!
All beamers and additional materials are available on the e-platform
Contact details: E-Card; e-mail: jakub.janus@uek.krakow.pl; MS Teams
Organization of the course

Lectures (15h) – Jakub Janus
Class (15h) – Krystian Mucha
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Course objectives and effects
Basic objectives
1 To introduce the modern monetary models, employed in today’s macroeconomics and
open-economy macroeconomics, in particular the canonical model and its building blocks – in
analytical and graphical representations.
2 To gain knowledge on how to use monetary economics tools do describe and analyse current
monetary phenomena and process, including their consequences for economic activity.
3 To learn how to use modern monetary economic toolbox to discuss current economic issues in the
international (open macro) environment.
4 To work out various examples: standard and unconventional monetary policies (e.g., quantitative
easing), small open economy policy issues, inflationary processes, monetary policy strategy.
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Outline
1 Overview
2 Course structure
3 Reading materials
4 Grading
5 Questions
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Course structure
Lecture Material
#1 & #2 The evolution of modern theoretical monetary models. Competing theoretical approaches
to money and money demand. Modelling traditions from real business cycle to New
Keynesian economics and DSGE modelling.
#3 The evolution of modern empirical monetary models: from Friedman and Schwartz to VARs
and high-frequency identification of monetary shocks.
#4 The 3-equation model (IS-PC-MR). The demand side: the IS curve. The supply side:
rigidities and the Phillips curve. Central bank loss function and monetary policy reaction
function. Supply and demand shocks.
#5 Applications of the closed-economy monetary model. Inflation, temporary and permanent
demand shocks. Deflation trap and the zero lower bound. Supply shocks.
#6 Open economy monetary model. Uncovered interest rate parity in a flexible exchange rate
small open economy. Building blocks of an open-economy analysis.
#7 Applications of the open economy monetary model. Interest rate vs. exchange rate and
stabilization of macroeconomic shocks. The overshooting phenomenon and exchange rate
volatility.
#8 Final test – the ”zero” term.
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Outline
1 Overview
2 Course structure
3 Reading materials
4 Grading
5 Questions
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Reading materials
Basic
1 Carlin, W., & Soskice, D. W. (2015). Macroeconomics: Institutions, Instability, and the Financial
System. Oxford University Press, USA.
Supplementary
1 Papers indicated during lectures.
2 Bain K., & Howells P. (2009), Monetary Economics: Policy and its Theoretical Basis, Palgrave
Macmillan, New York.

3 Walsh, C. E. (2017). Monetary theory and policy. MIT press.
4 Galı́, J. (2015). Monetary policy, inflation, and the business cycle: an introduction to the new
Keynesian framework and its applications. Princeton University Press.
Other interesting sources

1 Bank underground - link
2 Econbrowser link
3 Conversable economist link
4 Marginal revolution link

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Outline
1 Overview
2 Course structure
3 Reading materials
4 Grading
5 Questions
10 / 13
Grading
Grading criteria:
Lecture: single-choice test at the end of semester
Around 50% of questions based on class
Around 50% of questions based on lectures
Class: attendance (max. two absences) + readings
Single-choice questions (15) entirely based on material covered during class and lecture
Passing threshold: 50%
Grade Points
5.0 [90; 100]
4.5 [80; 90)
4.0 [70; 80)
3.5 [60; 70)
3.0 [50; 60)
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Outline
1 Overview
2 Course structure
3 Reading materials
4 Grading
5 Questions
12 / 13
Are there any questions?
13 / 13
Introduction Theories of money demand RBC model NK model DSGE modelling
Monetary economics
Lecture 1 & 2
The evolution of modern theoretical monetary models
Jakub Janus

1 / 27
Outline
1 Introduction
2 Theories of money demand
The stylized money demand
Money-in-the-utility function
Cash-in-advance constraint
Overlapping generations models
Search-and-matching models
3 RBC model
Theoretical background
The role of money
4 NK model
The role of money
5 DSGE modelling
DSGE framework
Example: monetary shocks
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Outline
1 Introduction
3 RBC model
The role of money
4 NK model
The role of money
5 DSGE modelling
DSGE framework
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Introduction: two major problems with money
It may seem that money should have a central (active) role in all macroeconomic models
Money dominates most economic discussions; it appears to be almost synonymous with
economics
Yet, in theory, money is problematic, especially when the fiat currency is created both by central
banks and financial systems
There is a long tradition and competing theoretical frameworks used to incorporate money into
economic models
→ Here, we focus on modern approaches
Problems with money in theoretical macro

1 Why do economic agents hold money? (What exactly is the role of money?)
2 Can monetary changes affect real economic processes? (Is money non-neutral?)
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Outline
1 Introduction
3 RBC model
The role of money
4 NK model
The role of money
5 DSGE modelling
DSGE framework
5 / 27
The money demand functions (1)
Recall a (highly stylized) money demand function

(e.g., the IS-LM model)
The real money demand may be given as: i
Ms
Md = L(Y , i) × P (1)
For example:
Md = (kY − hi) × P (2) A

i1
There are various ”motives” to justify the non-zero
money demand at the positive opportunity cost of Md
holding money (transactional, precautionary,
portfolio-balancing) (M/P)1 M/P
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However, the general equilibrium model (e.g., the Arrow-Debreu model) does not need money to
approximate all major economic phenomena, such as consumption, investment, or growth, output
gaps, international trade, or even real interest rates.
Why?
1 Money will not change the behaviour of an optimizing representative household which is
interested in bundles of goods and services, rather than a monetary value
2 The rate of return dominance (the Hahn problem): the high opportunity cost of holding
money is hard to justify when agents are – more or less – rational
3 Money does not have an intrinsic value (even when we consider commodity money) over
other assets – it is redundant
4 Some kind of ’friction’ must appear in the economy must appear to make money useful.
But what exactly?
Hence, the basic dynamics of an economic system can all be successfully modelled as a barter
economy
Money is needed merely as a unit of account (numéraire) – a function that is not specific to
money. Value of goods could be measures using any asset. ’Money is a veil’.
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Theoretical challenges to monetary economics:

(i) Trade is monetary. One side of almost all transactions is the economy’s common medium of
exchange.
(ii) Money is (virtually) unique. Though each economy has a ‘money’ and the ‘money’ differs among
economies, almost all the transactions in most places most of the time use a single common
medium of exchange.
(iii) ‘Money’ is government-issued fiat money, trading at a positive value though it conveys directly
no utility or production.
(iv) Even transactions displaying a double coincidence of wants are transacted with money.
Starr, R. M. (2003). Why is there money? Endogenous derivation of ’money’ as the most liquid asset: a class of examples. Economic Theory,
21(2), 455-474.
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Lucas critique
We cannot rely on the reduced-form (ad hoc) money demand function and we need to provide explicit
microfoundations for the money-related behaviour of optimizing agents
Hence, the modern approach to money demand modelling should incorporate, at the same time:
a The optimizing core of a macro model (internal consistency)
b At least some of the functions of money (external consistency)
Medium of exchange (!)
Unit of account
Store of value
Here, we consider four modern micro-founded explanations
1 money-in-the-utility function
2 cash-in-advance constraint
3 overlapping generations models
4 search-and-matching models
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Money-in-the-utility function (1)

Basic premise: along with consumption and An standard utility function (Gali, 2015):
leisure, money enters the utility function as an ∞
additional argument X
E0 β t U(Ct , Nt ; Zt ) (3)
A unique kind of utility: transactional services of t=0
money EO – expectation operator

Cost (and time) of trading goods is reduced
β t – discounting factor
Even more important: purchasing power is C t and N t – consumption and
retained in periods of no trade labour
Alternative specifications An MIU function:
∞
Shopping-time model (McCallum) X Mt
E0 β t U(Ct , , Nt ; Zt ) (4)
Money-in-the-production function (Mankiw Pt
t=0
& Summers) Mt
Pt – real money
Sidrauski, M. (1967). Rational choice and patterns of growth in a
monetary economy. The American Economic Review, 57(2), 534-544. Galı́, J. (2015). Monetary policy, inflation, and the business
cycle: an introduction to the new Keynesian framework and its
applications. Princeton University Press.
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Money-in-the-utility function (2)
Mt
A key consideration regarding the MIU function: is U(Ct , Pt
, Nt ; Zt ) separable with regards to
consumption and money?
→ If yes: U(Ct , M
Pt
t
) = u(Ct ) + v ( M
Pt
t
), money works just as another good in a consumption basket.
The quantity of money does not have an impact on the general equilibrium (e.g., the optimal
level of consumption).
→ If no: U(Ct , M
Pt
t
) ̸= u(Ct ) + v ( Mt
Pt
), money does matter for the impact of changes in consumption
on the utility function. Best example: higher inflation rate distorts intertemporal choice made by
a representative household.
A serious problem with the MIU approach: money treated rather as a consumption good
(service) than a medium of exchange.
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Cash-in-advance constraint (1)
Suppose there are two types of available The basic CIA (the so-called Clower)
goods: constraint:
1 Cash goods – agents must hold cash Pt Ct ≤ Mt−1 (5)
before a purchase is made
2 Credit goods – cash balances are not Or, equivalently:
required; payments could be settled
after the purchase Pt−1
Ct ≤ mt−1 (6)
Pt
Agents decide on their money holdings
today, and the ’state of the world’ is where mt−1 are real money balances and Pt
revealed to them tomorrow is the price level.
Lucas Jr, R. E., & Stokey, N. L. (1983). Optimal fiscal and Modelling strategy: asset market opens
monetary policy in an economy without capital. Journal of
monetary Economics, 12(1), 55-93.
first and then the goods market opens
Svensson, L. E. (1985). Money and asset prices in a
cash-in-advance economy. Journal of political Economy, 93(5),
919-944.
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Cash-in-advance constraint (2)
CIA constraint have interesting predictions for monetary economics

Money demand is much stronger when we introduce uncertainty into the model – a
stochastic case (extreme example: bank runs)
Assets carrying higher yields, e.g., bonds, may also be more risky than cash (they have a
higher variance of returns)
A risk-averse household will choose a diversified portfolio of cash and risk-bearing assets (in
line with the modern portfolio theory)
Inflation (hence: nominal variables) have real welfare costs
A problem with CIA: the constraint used is extreme, implying that there are no alternative means
of carrying out certain transactions. How does the transaction technology look like?
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An alternative to the baseline general-equilibrium models

Agents live through two periods:
1 Young agents: work (receive an endowment) and consume
2 Old agents: only consume
Goods are perishable (they spoil over time)
The central problem: there is a dynamic inefficiency – a transfer from each young to current old
generation may be Pareto improving, which leads to over-saving behaviour of the young
Money alleviates this problem by providing an substitute for a storage technology
The OLG view of money highlights that:
Money has no intrinsic value, but it is accepted by everyone purely because of these
expectations
Essentially, money can be a bubble, it is a fragile construct
Blanchard, O., & Fischer, S. (1989). Lectures on macroeconomics. MIT press.
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Comes back to the original cashless economy

setting
Modelling: agents are randomly assigned to trade
– exchange takes place if it is mutually beneficial
→ A probabilistic game: does an asset that we accept
today retain value in the future?
Frictions present in the barter economy, in
particular: growing specialization, imperfect
storage, incomplete information – a named IOU
from a trading partner is hard to trace
In aggregate, if the probability of a barter trade is Kiyotaki, N., & Wright, R. (1993). A search-theoretic approach
larger than the probability of cash acceptance, to monetary economics. The American Economic Review, 63-77.
money is worthless
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Outline
1 Introduction
3 RBC model
The role of money
4 NK model
The role of money
5 DSGE modelling
DSGE framework
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The Real Business Cycle theory
Origins of the RBC model: the gap between micro- and macroeconomics
Aim: to build a coherent macro model with optimizing microeconomic agents
Search for a deep structure or deep parameters of the model
In the heart of the model, intertemporal optimization subject to the constraints of budget and
technology
Households – the Euler equation – optimal consumption, for example

1 βbt+1 1 Rt
= Et (7)
Ct bt Ct+1 Pt+1 /Pt
Rt
where Ct – consumption; βbt+1 – a time-varying discout factor; Pt+1 /Pt
– gross real interest
rate
The model has the so-called Walrasian features – prices are flexible, all markets are cleared
Kydland, F. E., & Prescott, E. C. (1982). Time to build and aggregate fluctuations. Econometrica: Journal of the Econometric Society,
1345-1370.
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The role of money in the RBC model
→ Non-monetary factors as the driving forces → Difficulties with the RBC theory
behind business cycles They omit a major source of output
1 Technological shocks – progress of movements observed empirically –
potential output is random monetary shocks
2 Labour supply shocks – workers adjust Counterintuitive: even pure financial shocks
their working hours to income prospects must be classified as technological
and opportunity costs
Technological innovations are often not
Money neutrality holds readily apparent – variations in the Solow
residual may capture other sources of
fluctuations
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Outline
1 Introduction
3 RBC model
The role of money
4 NK model
The role of money
5 DSGE modelling
DSGE framework
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The New Keynesian theory

RBC was a methodological state-of-the-art, but Modelling price rigidities
separated monetary economics from
macroeconomics
Rotemberg Calvo
New Keynesian Economics: a large research Price adjustment costs Staggered price contracts
programme aimed at introducing ’Keynesian’ Monetary menu costs are Price-setting only periodical
properties into the RBC model significant
Technically: loss function – Technically: a fraction of
Households and firms behave optimally: price adjustment are costly firms adjust prices each
households maximize the expected present period
value of utility, and firms maximize profits
A very specific feature of the model is New
Major developments
Keynesian Phillips Curve, e.g.,
Imperfect (monopolistic) competition
δ(1 − (1 − δ)ψ)
Sticky prices (and / or wages) πt = ψEt πt+1 + αxt (8)
1−δ
Galı́, J. (2015). Monetary policy, inflation, and the business cycle: an
introduction to the new Keynesian framework and its applications. Princeton
University Press.
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The role of money in the NK model
Inclusion of rigidities has first-order real effects

→ Monetary sphere becomes non-neutral for consumption, investment, output
The role of expectations is pronounced
→ Expectations on future inflation and real interest rates critical for consumption and investment
decisions – a forward-looking behaviour
Monetary shocks (i.e., distortions to the monetary policy rules) have real effects
→ The role of monetary policy
Another question: how to measure monetary policy effectiveness? (Lecture 3)
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Outline
1 Introduction
3 RBC model
The role of money
4 NK model
The role of money
5 DSGE modelling
DSGE framework
22 / 27
The DSGE framework in a nutshell

Dynamic stochastic general equilibrium (DSGE)
modelling
Framework: a set of equations describing
various parts of the economy – households,
firms (both intermediate and final-goods
producing), gov’t, central banks, financial
sector, foreign sector, etc.
Solution: equilibrium derived from first
principles (microfoundations)
Results: the so-called perturbation method –
shocks to model equations
Impulse response functions (IRFs), variance
decompositions, historical decompositions of
shocks
Sbordone, A. M., Tambalotti, A., Rao, K., & Walsh, K. J.
(2010). Policy analysis using DSGE models: an introduction.
Economic policy review, 16(2). 23 / 27
Monetary policy in the DSGE framework
In practice, a central bank takes into account a Variables and parameters

rich set of data, projections, and judgements it and πt – nominal interest rate and
However, in the model set-up, it is most often inflation rate
rte , πtT , yte – baseline values of the real
assumed that policymakers follow a simple rule,
interest rate, inflation, and output
as suggested by Taylor (1993) εti – monetary policy shock
A typical example of a Taylor rule ϕπ , ϕy , ρ – coefficients of the central
bank reaction function
it =ρit−1 + (1 − ρ)[rte + πtT + Central bank behaviour
+ ϕπ (πt − πtT )+ (9) If inflation or output rise above their
baseline levels, the nominal interest is
+ ϕy (yt − yte )] + εit
raised above it baseline value,
ite ≡ rte + πtT
Taylor, J. B. (1993). Discretion versus policy rules in practice. In ϕπ and ϕy parameters define the reaction
Carnegie-Rochester conference series on public policy (Vol. 39, pp. to inflation and output gaps
195-214). North-Holland.
The speed of adjustment depends on ρ –
the so-called interest-rate smoothing
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Example: the effects of monetary shocks (1) – specification
Here we consider an example of a medium-size DSGE model
Total of 46 variables
4 stochastic shocks: technology, gov’t spending, mark-up, monetary
11 steady-state variables (equilibrium)
9 forward-looking variable (the dynamic aspect)
Two specifications (parametrizations):

A standard NK model; Calvo nominal rigidities in the price-setting behaviour of enterprises
A no-friction NK model (equivalent to a plain-vanilla RBC); rigidities switched off
Simulations conducted in Dynare, a GE module for Matlab
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Example: the effects of monetary shocks (2) – IRFs

Output Consumption
0
0
% dev from SS
% dev from SS
-0.1 -0.2
-0.2
-0.3 -0.4
-0.4
-0.6
-0.5
10 20 30 40 10 20 30 40
Quarters Quarters
Investment Inflation
NK
0 NK-RBC
0.2
-0.5
% dev from SS
% dev from SS
0
-1
-0.2
-1.5
-0.4
-2
10 20 30 40 10 20 30 40
Quarters Quarters
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Example: the effects of monetary shocks (3) - variance decomposition
Table 1: NK
εA εG εMS εM
Output 27.58 3.46 10.23 58.73
Consumption 13.80 0.58 6.48 79.14
Investment 64.57 2.55 14.51 18.38
Inflation 33.41 0.11 8.62 57.86
Table 2: NK-RBC
εA εG εMS εM
Output 72.14 2.35 25.51 0.00
Consumption 67.76 1.56 30.68 0.00
Investment 79.08 2.87 18.05 0.00
Inflation 29.82 0.38 7.99 61.81
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Introduction Narrative approach Structural VARs High-frequency identification
Monetary economics
Lecture 3
The evolution of modern empirical monetary models
Jakub Janus

1 / 15
Outline
1 Introduction
2 Narrative approach
3 Structural VARs
4 High-frequency identification
2 / 15
Outline
1 Introduction
3 Structural VARs
3 / 15
Introduction
Lucas (1996) - the Nobel lecture

This tension between two incompatible ideas – that changes in money are neutral unit changes and
that they induce movements in employment and production in the same direction – has been at the
center of monetary theory at least since Hume wrote.
Capturing the response of real variables to monetary policy is tricky.

Example: a central bank may lower the interest rate to counteract the effects of an adverse
demand shock. The results of a central bank action are contaminated by this shock.
Hence, we need to: (a) control for confounding factors, (b) identify an exogenous variation in
monetary policy. (Correlations are useless!)
→ We need to identify monetary disturbances, distinguish them from other economic shocks,
measure their frequency and magnitude, estimate their effects.
Walsh, C. E. (2017). Monetary theory and policy. MIT press.
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Outline
1 Introduction
3 Structural VARs
5 / 15
The narrative approach - origins

Early attempts: the so-called St. Louis equations (regressions of nominal income on money), e.g.,:
X X X
ytn = y0n + ai At−i + bi mt−i + hi zt−i + ut (1)
i=0 i=0 i=0
where mt−i is a monetary aggregate.

Friedman & Schwartz (1963): is there a causal link between money growth and output
fluctuations?
Empirical strategy: based on almost 100 years of US data, timing of changes in money growth
rates.
In particular three narrative episodes: (a) the Fed was raising the discount rate in 1920, (b) same
action in 1931, and (c) raise of the reserve requirement in 1937.
Results: real economic activity (including the Great Depression) was affected by money growth
but with long and variable lags
→ Problem: how to control for reverse causality? (e.g., Tobin)
Friedman, M., & Schwartz, A. J. (1963). A monetary history of the United States, 1867-1960. Princeton University Press.
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Romer and Romer narrative approach

”Monetary policy is not conducted as a
randomized experiment”
However, we know how a monetary policy
committee (MPC) process works
→ Solution: isolate rate changes that are the
result of deliberate decisions by the Federal
Reserve
1 Consider MPC meetings for which there
is a forecast prepared
2 Remove the portions of interest rates
changes that represent a usual response
to forecasts
3 The resulting shocks should be largely
free of endogeneity
Romer, C. D., & Romer, D. H. (2004). A new measure of

monetary shocks: Derivation and implications. American
Economic Review, 94(4), 1055-1084.
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Outline
1 Introduction
3 Structural VARs
8 / 15
Monetary policy in vector autoregressions

A multivariate structural VAR that includes economic / financial variables, as well as a monetary
policy measure (Sims, 1980)
p
X
Ayt = ν + Bk yt−k + ut , (2)
k=1
where yt is the vector of observables, matrix A describes contemporaneous relationships of
variables in the system, ν is the vector of constants, while Bk is the matrix of coefficients on
lagged variables.
Identification problem: raw data alone are insufficient to capture monetary shocks (e.g., changes
in the policy rate or money supply). Restrictions on matrix A are needed.
Standard answer – recursive identification, variables ordered: (i) slow moving (e.g., GDP), (ii)
monetary policy variables (e.g., central bank rate), (iii) fast moving (e.g., financial market
variables), i.e.,
′
yt = st , it , ft (3)
Limitations to VARs with recursive identification: potentially implausible timing restrictions,
puzzling results (e.g., the price puzzle)
Christiano, L. J., Eichenbaum, M., & Evans, C. L. (1999). Monetary policy shocks: What have we learned and to what end?. Handbook of
macroeconomics, 1, 65-148. 9 / 15
VARs: further developments (examples)
Factor-augmented VAR Other types of identification – example that allows for

contemporaneous interactions between MP and stock market
Xt = ΛFt + et (4a)
Identification achieved via long-term restrictions (no long-run
Ft = A(L)Ft−1 + ut (4b) effect of MP on equity prices)
where Xt is a vector of observables, 
yt

S11

0 0 0 0

εyt

while vector Ft contains unobserved  pit  S21 S22 0 0 0   εp it 
factors 0   εct 
∆ct  = B(L) S31 S32 S33 0 (5)
    
Data-rich environment: numerous ∆st  S41 S42 S43 S44 S45   εSP
t

MP
(potentially hundreds) financial and it S51 S52 S53 S54 S55 εt
economic variables are assumed to be
functions of several factors However:
Bernanke, B. S., Boivin, J., & Eliasz, P. (2005). Measuring B41 (1)S15 + B42 (1)S25 +
the effects of monetary policy: a factor-augmented vector (6)
autoregressive (FAVAR) approach. The Quarterly journal B43 (1)S35 + B44 (1)S45 + B45 (1)S55 = 0
of economics, 120(1), 387-422. Bjornland, H. C., & Leitemo, K. (2009). Identifying the interdependence between US
monetary policy and the stock market. Journal of Monetary Economics, 56(2), 275-282.
10 / 15
Major results of a VAR analysis (examples)

Impulse response functions Variance decompositions Historical decompositions
→ Show changes in variables of → Display the share of changes → Show historical contribution of
interest to (orthogonal) shocks in variables of interest due to shocks to variables
shocks
Baumeister, C., & Hamilton, J. D.

(2018). Inference in structural vector
autoregressions when the identifying
assumptions are not fully believed:
Re-evaluating the role of monetary policy
in economic fluctuations. Journal of
Monetary Economics, 100, 48-65.
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Outline
1 Introduction
3 Structural VARs
12 / 15
High-frequency identification – idea
Idea: to identify high-frequency surprises around monetary policy announcements

Example: Price revisions in 30-minute windows around central bank communication
Next, use surprises as external instruments to measure policy effects, possibly in a larger system
(such as a VAR)
HFI exploits the fact that a large amount of monetary news is revealed at the time of policy
meeting, beyond what is anticipated by market participants. (All information that is public is
already incorporated into financial markets.)
It resembles a discontinuity-based identification scheme – major changes around announcements
Advantages: clean identification, exploits information in various market segments
Drawbacks: reduced statistical power, monetary policy shocks are small relative to other
disturbances
Nakamura, E., & Steinsson, J. (2018). High-frequency identification of monetary non-neutrality: the information effect. The Quarterly Journal
of Economics, 133(3), 1283-1330.
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High-frequency identification – external instruments
The external instrument approach Two types of policy effects:
∆Rt = α + β(itn )u + εt (7) Monetary policy effect –

communication of (unexpected)
where: policy measures
Information effects (or: signalling
∆Rt – change in an asset return (e.g.,
channel) – changes in monetary policy
gov’t bond) on a monetary policy
stance carry information on central
announcement day
bank’s assessment of the economy
(itn )u – unanticipated movement in
the interest rate on the same date Evidence responses of economic variables to
both types of policy shocks are different
Aim: to isolate variation in itn due to pure
monetary policy surprise Monetary and information effects both
influence the currency monetary policy
Gertler, M., & Karadi, P. (2015). Monetary policy surprises,
credit costs, and economic activity. American Economic Journal:
stance
Macroeconomics, 7(1), 44-76.
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Example of HFI: euro area monetary policy
Timeline of a typical ECB monetary event Behaviour of 2Y OIS rates around the
announcement window
Altavilla, C., Brugnolini, L., Gürkaynak, R. S., Motto, R., &

Ragusa, G. (2019). Measuring euro area monetary policy.
Journal of Monetary Economics, 108, 162-179.
15 / 15
Overview of the three-equation model The demand side The supply side Monetary policy reaction function
Monetary economics
Lecture 4
The monetary model – closed economy setting (Part 1)
Jakub Janus

1 / 15
Outline
1 Overview of the three-equation model
2 The demand side
3 The supply side
4 Monetary policy reaction function
2 / 15
Outline
2 The demand side
3 The supply side
3 / 15
The three-equation model: an overview
Central bank raises the interest rate,

which dampens aggregate demand.
Supply
side
is grater than rising inflation

Targets low
Medium-run
Demand Actual and stable Central
is equal to equlibrium constant inflation
side employment inflation bank
employment
is less than falling inflation
Central bank reduces the interest rate,

which raises aggregate demand.
4 / 15
The three-equation model: main building blocks
The demand side: IS (investment-savings) equation
yt = A − art−1 (1)
The supply side: PC (Phillips curve) equation
πt = πtE + α(yt − ye ) (2)
Central bank: MR (monetary policy rule / reaction function) equation
(yt − ye ) = −αβ(πt − π T ) (3)
→ Shocks introduced into the system

→ Feedback loops among the IS, PC, and MR parts of the model
Carlin, W., & Soskice, D. W. (2015). Macroeconomics: Institutions, instability, and the financial system. Oxford University Press.
5 / 15
Outline
2 The demand side
3 The supply side
6 / 15
The demand side: IS equation

The dynamic IS equation
yt = A − art−1
𝑟
where: yt – level of output, rt−1 – real interest
rate (lagged one period). 𝐵
The term A comes from the aggregate demand 𝑟1
equation:
𝑟0
A ≡ k(c0 + a0 + G ) 𝐴 𝐶
where: c0 – autonomous consumption, a0 –

autonomous investment, G – government 𝐼𝑆1
spending, and k – the multiplier. 𝐼𝑆0
The real interest rate is given by the Fisher
𝑦
equation
rt ≡ it − πtE
where: it – nominal interest rate, πtE –
expected inflation rate. 7 / 15
Outline
2 The demand side
3 The supply side
8 / 15
The supply side: PC equation
The PC equation: 𝑃𝐶0

𝑃𝐶1
πt = πtE + α(yt − ye ) 𝜋
Alternatively, assuming adaptive expectations

(i.e., πtE = πt−1 ) 𝜋1
𝐵
πt = πt−1 + α(yt − ye )
𝜋0
𝐴 𝐶
where: πt – the inflation rate, ye – equilibrium
level of output.
The PC coefficient, α, is decisive for the
monetary policy reaction function: constraints
stemming from the inflation–output trade–off 𝑦
9 / 15
Outline
2 The demand side
3 The supply side
10 / 15
Monetary policy
Monetary policy as a demand management policy, implemented to stabilize the economy

Macroeconomic policy regimes from the 1990s – inflation targeting monetary policy regime
→ Central bank is responsible to stabilize the economy by adopting a specific target for the annual
rate of inflation, most commonly around 2%
If the economy suffers a shock, how would the policy maker respond so as to stabilize it at its
constant inflation rate?
Some monetary policy considerations

Deviations of inflation rate from low, stable values generate social cost
The unemployment (output gap)–inflation trade-offs are crucial for central banks
Monetary policy is viewed as more neutral than fiscal (e.g., no political process, no tax
distortions) and independent central bank tends to be more credible and free of political pressures
11 / 15
Central bank behaviour
Crucial characteristic of a modern monetary Introducing the monetary sphere into the model
model is that the central bank is forward 1 Define the central bank’s preferences in
looking terms of utility (or: loss) function
It forecasts the inflation based on economic 2 Define the constraints faced by the policy
developments make from the supply side of the economy
It takes into account lags between changes (the PC curve)
in policy instruments and their impact on 3 Derive the best response monetary rule
economic activity (MR) in the output-inflation space
Central bank tries to stabilize the economy 4 Use the IS curve relationship to achieve
monetary policy goals
1 Keep the economy close to
equilibrium output Taylor, J. B. (1993). Discretion versus policy rules in practice. In
Carnegie-Rochester conference series on public policy (Vol. 39,
2 Keep inflation close to its target pp. 195-214). North-Holland.
ME 4 Appendix
12 / 15
The central bank loss function

The central bank tries to minimize the (quadratic) loss function:
2
L = (yt − ye )2 + β πt − π T (4)
T
where π – the inflation target, β – the relative weight attached to the loss from inflation.
The function captures the cost of being away from the inflation target and from equilibrium
output.
Balanced: =1 Inflation averse: >1 Unemployment averse: <1
When πt = π T and yt = ye the circle shrinks to a single point (called the bliss point).
13 / 15
The central bank loss function and the Phillips curve
𝜋
Initially: πtE = πt−1 = π T = 2. The CB can 𝑃𝐶(𝜋𝑡𝐸 = 4)
achieve the bliss point (point A). 𝑇 𝐵
𝜋 =4 𝑃𝐶(𝜋𝑡𝐸 = 3)
Inflation shock: inflation is higher than the 𝑃𝐶(𝜋𝑡𝐸 = 2)
𝐷
target. The CB is faced with the PC 𝜋𝑇 = 3
constraint, πtE = 4. A trade-off appears:

𝜋𝑇 = 2 𝐶 𝐴
If CB wants a level of output of ye next
period, it has to accept an inflation rate
above the target, πt = 4 ̸= π T (point B).
If CB wishes to hit the inflation target
next period, it must accept a lower level
of output, y1 ̸= ye (point C ). 𝑦1 𝑦𝑒 𝑦
Given the CB preference, it can minimize
the distance to A by choosing an
intermediate solution (point D).
14 / 15
Monetary rule derivation
𝜋
𝑃𝐶(𝜋𝑡𝐸 = 4)
𝜋𝑇 = 4 𝑃𝐶(𝜋𝑡𝐸 = 3)
Derivations of the monetary rule:
𝑃𝐶(𝜋𝑡𝐸 = 2)
Step 1 Finding the tangencies between the 𝜋𝑇 = 3 𝐶
loss circles and the Phillips curves 𝐵
(points A, B, and C ) 𝐴
𝜋𝑇 = 2
Step 2 Joining the tangencies to show the
monetary rule curve
Finally, the MR equation: 𝑀𝑅
T 𝑦1 𝑦𝑒 𝑦
(yt − ye ) = −αβ(πt − π )
→ Next, use the 3-equation model to analyse a range of shocks and monetary issues.
15 / 15
Inflation shock Temporary demand shock Deflation trap Supply shock
Monetary economics
Lecture 5
The monetary model – closed economy setting (Part 2)
Jakub Janus

1 / 19
Outline
1 Inflation shock
2 Temporary demand shock
3 Deflation trap
4 Supply shock
2 / 19
Outline
1 Inflation shock
3 Deflation trap
4 Supply shock
3 / 19
Analysis: inflation shock (1)
Start The economy is initially at the central bank bliss point, yt = ye and πt = π T .
The interest rate associated with the medium-run equilibrium: the stabilising rate of
interest, rs .
Period 0 Inflation shock appears – an exogenous shift in the Phillips curve (PC). Example: a natural (or
man-made) disaster reduces agricultural output and raises food prices.
The economy moves into a higher inflation rate, from A to B, out of the central bank’s MR.
Monetary policy response: the CB sets the interest rate at r0 .
Period 1 The higher interest rate reduces aggregate demand (e.g., by dampening investment). However,
this effect is lagged. The economy moves to point C . The central bank forecasts the PC in the
next period. The PC shifts when inflation expectations are updated. The central bank reduces
the interest rate.
Period 2 The economy moves to point D and adjustment processes repeat themselves. The effects of the
shock end when the economy is back at point Z , with values of variables equal to the initial
ones. It may take a number of periods (it may be very gradual).
4 / 19

a. 3- equation model b. impulse response functions
𝑟 𝑠ℎ𝑜𝑐𝑘
𝜋
𝑟0 𝐶 𝜋0
𝑟1 𝐷
𝜋𝑇
𝐴, 𝑍
𝑟𝑆
𝑡𝑖𝑚𝑒
𝑦
𝐼𝑆
𝑦
𝜋 𝑃𝐶(𝜋1𝐸 = 𝜋0 ) 𝑦𝑒
𝜋0
𝐵
𝑃𝐶(𝜋2𝐸 = 𝜋1 )
𝑦1
𝑃𝐶(𝜋0𝐸 = 𝜋 𝑇 )
𝜋1 𝐶 𝑡𝑖𝑚𝑒
𝑟
𝜋2
𝐷
𝜋𝑇 𝐴, 𝑍 𝑟0
𝑀𝑅 𝑟𝑆
𝑦1 𝑦2 𝑦𝑒 𝑦 𝑡𝑖𝑚𝑒 5 / 19
Summary: how does the central bank stabilize the economy after an inflation shock?
Step 1 The central bank must choose the position on the new Phillips curve (after the upward
shift) that minimizes their loss function. The central bank will have to reduce output below
equilibrium to squeeze inflation out of the system.
Step 2 The central bank uses the IS curve to find the increase in the real interest rate required to
get the economy back onto the MR curve. Next, the central bank gradually reduces the
interest rate until output rises back to equilibrium and inflation falls back at target.
6 / 19
Outline
1 Inflation shock
3 Deflation trap
4 Supply shock
7 / 19
Analysis: temporary demand shock (1)
Start The economy is initially at the central bank bliss point, yt = ye and πt = π T , as well as the
stabilising rate of interest, rs .
Period 0 A temporary demand shock appears – the shock shifts the IS curve to IS ′ , but it only remains at
IS ′ for one period. Example: a temporary increase in consumption or government spending.
The shock increases both output (y0 > ye ) and inflation (π0 > π T ).
Point B is not on the central bank’s MR curve. The central bank forecasts the PC in the
next period and sets the higher interest rate using the original IS curve.
Period 1 The new, higher interest rate has had time to affect aggregate demand. The output is reduced
and the economy moves to point C . The central bank reduces the interest rate along the MR
curve.
Period 2 The economy moves to point D, as the lower interest rate simulates demand. This increases the
output to y2 and inflation falls to π2 . The same process now repeats itself until the economy is
back at the equilibrium at Z .
8 / 19

a. 3- equation model b. impulse response functions
𝑟 𝑠ℎ𝑜𝑐𝑘
𝜋
𝑟0 𝐶 𝜋0
𝑟1 𝐷
𝜋𝑇
𝐴, 𝑍 𝐵
𝑟𝑆
𝐼𝑆 ′ 𝑡𝑖𝑚𝑒
𝑦
𝐼𝑆
𝑦0
𝑦
𝜋 𝑃𝐶(𝜋1𝐸 = 𝜋0 ) 𝑦𝑒
𝑃𝐶(𝜋2𝐸 = 𝜋1 )
𝐸 𝑇
𝑃𝐶(𝜋0 = 𝜋 ) 𝑦1
𝜋0 𝐵
𝜋1 𝐶 𝑡𝑖𝑚𝑒
𝑟
𝜋2
𝐷
𝜋𝑇 𝐴, 𝑍 𝑟0
𝑟𝑆
𝑀𝑅
𝑦1 𝑦2 𝑦𝑒 𝑦 𝑡𝑖𝑚𝑒 9 / 19

The role of forecasting and lags in For comparison: permanent aggregate
monetary economics. demand shock.
𝑟
The central bank has to predict both the 𝑟0
𝐶
PC and IS curves. The forecasting of the 𝑟1 𝐷

IS curve means predicting the length of the 𝑟𝑆′ 𝑍
shocks – is it temporary or permanent?
𝐴 𝐵
The persistence of the (demand) shock 𝑟𝑆
affects the central bank’s preferred

𝐼𝑆 𝐼𝑆 ′
reaction. The initial increase in the interest
𝑦
rate (i.e., from rs to r0 ) is visibly greater in 𝜋 𝑃𝐶(𝜋1𝐸 = 𝜋0 )
𝑃𝐶(𝜋2𝐸 = 𝜋1 )
the case of the permanent shock. 𝑃𝐶(𝜋0𝐸 = 𝜋 𝑇 )
𝜋0 𝐵
Also, a permanent shock leads to a higher 𝜋1 𝐶
stabilizing rate of interest in the new 𝜋2
𝐷
equilibrium (rs′ ). 𝜋𝑇 𝐴, 𝑍
𝑀𝑅
𝑦1 𝑦2 𝑦𝑒 𝑦 10 / 19
Interlude: the role of risk and uncertainty in monetary models

Risk exists when individuals make decisions about the future based on known probabilities.
Uncertainty exists when it is impossible to assign probabilities to known outcomes and there are
some outcomes which may be unknown.
However, agents still attach subjective probabilities (their informed opinions) to different
scenarios.
→ Hence, the inflation expectation formation (i.e., the Phillips curve) is critical for the monetary
analysis.
Expectation anchoring to the central bank’s target (π T ) in the PC :
h i
πt = χπ T + (1 − χ)πt−1 + α (yt − ye ) (1)
Three basic cases to consider:

a χ = 0 – fully backward-looking expectations
b χ = 1 – expectations firmly anchored at π T
c χ ∈ (0, 1) – expectations partially anchored at π T
11 / 19
Outline
1 Inflation shock
3 Deflation trap
4 Supply shock
12 / 19
Analysis: deflation trap (1)

Recall the Fisher equation, which shows the Example: the zero lower bound on nominal
relationship between the real and nominal interest rates.
interest rates and the expected rate of
inflation:
it = rt + πtE 𝑟
When responding to any economic shock,
the central bank adjusts the nominal 𝐴 min 𝑟 = −𝜋
𝑟1
interest rate in order to affect the real rate
and the aggregate demand.
𝑟𝑆
There is, however, a limit to the extent to
which the central bank can reduce the
nominal interest rate. If the lowest nominal
interest rate that can be set is exactly zero, 𝐼𝑆
then the minimum real interest rate that
can be achieved is: 𝑦0 𝑦𝑒
𝑦
min rt ≥ −πtE
13 / 19

stabilising rate of interest, rs .
Period 0 A deflationary shock appears – triggered by a strong, permanent, negative demand shock
As the shock hits, both output (y0 < ye ) and inflation rate (π0 < π T ) are reduced.
Moreover, π0 < 0 in point B.
Monetary policy response: the central bank forecasts the PC curve to shift to
PC (π1E = π0 ). Optimally, it would like to set the interest rate of r0′ at point C . However,
this is below the lower bound (The lowest interest rate it can achieve is r0 = −π0 ).
Period 1 With lower interest rate, the economy moves to point C . The output is still below equilibrium at
y1 , which causes the inflation to fall further to π1 . Faced with the new PC , the central bank
would like to locate at point D ′ , back on their MR curve. However, this would require setting an
interest rate of r1′ and the lowest interest rate to achieve is r1 = −π1 .
Period 2 The economy moves to point D, as the higher interest rate dampens demand. This reduces
output to y2 and inflation falls further to π2 . The economy enters a downward spiral of a
deflation trap. Both output and inflation are falling and conventional monetary policy is
powerless to stop them.
14 / 19

𝑟
𝐵 𝐴
𝑟𝑆
Potential fiscal
boost
min 𝑟 = 𝑟1 = −𝜋1 𝐷
𝑚𝑖𝑛 𝑟 = 𝑟0 = −𝜋0 𝐺
𝐶
𝑦0 𝑦2 𝑦1 𝑦
𝑟′0 𝐶′
𝐼𝑆
𝐷′
𝑟1′
𝐼𝑆′
𝜋
𝑃𝐶(𝜋1𝐸 = 𝜋0 )
𝑃𝐶(𝜋2𝐸 = 𝜋1 )
𝜋𝑇 𝐴
𝐶′
𝐷′
𝑦
𝜋0 𝐵
𝐶 𝑀𝑅
𝜋1
𝜋2 𝐷
𝑦𝑒 15 / 19
Deflation according to its macroeconomic The downward spiral of the deflation trap
consequences may be alleviated by fiscal policies (see
point G ) or by a spontaneous recovery.
1 Good – driven by a positive supply
shock, productivity growth, benign for Central bank toolbox used to overcome the
economic growth. zero lower bound:
2 Bad – specific nominal rigidities play a 1 Management of expectations: forward
role in undermining economic activity
guidance and creation of more
or other concomitant developments
positive inflation expectations
result in serious economic weakness. 2 Balance sheet policies: quantitative /
3 Ugly – deflationary forces conspired
qualitative easing, long-term
with the asymmetries to create a
refinancing operations
spiral of self-reinforcing disruptions.
Sims, E. R., & Wu, J. C. (2020). Central banks’ ever-expanding
Borio, C. E., & Filardo, A. J. (2004). Back to the future? tool kit. NBER Reporter, (4), 16-19.
Assessing the deflation record. BIS Working Papers, 152.
16 / 19
Outline
1 Inflation shock
3 Deflation trap
4 Supply shock
17 / 19
Analysis: supply shock (1)
stabilising rate of interest, rs (before the shock).
Period 0 A permanent, positive supply shock appears – this fundamentally changes the equilibrium level of
output in the economy, increasing it from ye to ye′ .
The Phillips curve shifts down to PC (π0E = π T , ye′ ), reflecting the change in the equilibrium.
Monetary policy response: if the shock is rightly identified, the central bank shifts the MR
curve outward to ensure their bliss point corresponds to the new equilibrium.
Period 1 Output increases and the economy moves to point C , with output above the new stationary
point at y1 and inflation at π1 . The central bank forecasts the new PC and they would like to
locate at point D, on the MR ′ curve. Therefore, the interest rate is set at r1 .
Period 2 The economy moves to point D, as the higher interest rate dampens demand (with a one period
lag). This reduces output to y2 and inflation to π2 . The same process now repeats itself until
point Z is reached.
18 / 19
Analysis: supply shock (2)

𝑟
𝑟𝑆 𝐴
𝑟𝑆′ 𝑍
𝑟1 𝐷
𝑟0 𝐶
𝐼𝑆
𝑦
𝑃𝐶(𝜋0𝐸 = 𝜋𝑇 , 𝑦𝑒 )
𝜋
𝑃𝐶(𝜋0𝐸 = 𝜋𝑇 , 𝑦𝑒′ )
𝑃𝐶(𝜋2𝐸 = 𝜋1 , 𝑦𝑒′ )
𝐴 𝑍
𝜋𝑇
𝐷 𝑃𝐶(𝜋1𝐸 = 𝜋0 , 𝑦𝑒′ )
𝜋2
𝜋1 𝐶
𝜋0 𝐵
𝑀𝑅′
𝑀𝑅
𝑦𝑒 𝑦′𝑒 𝑦2 𝑦1 𝑦
19 / 19
Introduction Foreign exchange market The UIP condition The AD-ERU open-economy equilibrium The RX curve
Monetary economics
Lecture 6
The monetary model – open economy extensions (Part 1)
Jakub Janus

1 / 22
Outline
1 Introduction
2 Foreign exchange market
3 The UIP condition
4 The AD-ERU open-economy equilibrium
5 The RX curve
2 / 22
Outline
1 Introduction
3 The UIP condition
5 The RX curve
3 / 22
Building blocks of the open monetary model
Extension of the 3-equation monetary IS-PC-MR model to an open-economy setting

Here, we consider small, open economy with flexible exchange rates and inflation-targeting
central bank
→ Main extension: Forward-looking (rational) foreign exchange (FX) markets
This involves opening up the model to both international trade (i.e., imports and exports) and
international capital flows (i.e., trade in home and foreign bonds)
Two potential stabilization channels in the open economy

1 The interest rate channel – the central bank’s response to shocks
2 The exchange rate channel – the reaction of FX markets to shocks
4 / 22
Outline
1 Introduction
3 The UIP condition
5 The RX curve
5 / 22
Basic definitions – exchange rates
The nominal exchange rate of the home economy:

no. units of home currency
e≡
one unit of foreign currency
An increase in e means that the home currency can buy fewer units of foreign currency, so the
home currency has depreciated (or: weakened).
The real exchange rate, or the relative price level between two economies:
price of foreign goods expressed in home currency P ∗e
Q≡ =
price of home goods P
where P ∗ is the foreign price level and P is the home price level.
An increase in Q reflects the fall in price of home goods relative to the price of foreign goods
6 / 22
FX market
Global flows of capital play crucial role: the existence of the FX market + the ability of home and foreign
agents to buy home and foreign assets
Assumptions:
1 Perfect international capital mobility, nominal world interest rate, i ∗
2 The home economy is assumed to be small, it cannot impact i ∗
3 Households can hold two types of assets: money and bonds (domestic or foreign)
4 Foreign and home bonds differ only in the expected return (perfect substitutability)
International risk sharing

The notion that agents share risk (i.e., buy insurance) by acquiring foreign assets (next to domestic assets).
Such portfolio diversification may be explained by a non-perfect correlation in business cycles across countries.
d
Exchange rates are linked to domestic and foreign marginal utility growth or discount factors, mt+1 f
and mt+1 by
et+1 f d
the equation: ln e = lnmt+1 − mt+1 . The index international risk sharing is given as:
t
et+1
σ 2 ln
et
1− f d
σ 2 lnmt+1 + σ 2 lnmt+1
Brandt, M. W., Cochrane, J. H., & Santa-Clara, P. (2006). International risk sharing is better than you think, or exchange rates are too
smooth. Journal of monetary economics, 53(4), 671-698.
7 / 22
Outline
1 Introduction
3 The UIP condition
5 The RX curve
8 / 22
The UIP dynamics - an example
1 Home interest rate i1 is above the Arbitrage in the international bond market
world rate (expected to prevail for
one year) b. Exchange rate loss from
a. Interest rate gain from
holding domestic bonds holding domestic bonds
2 When interest rate differential
opens, home FX rate appreciates 𝑖, 𝑖 ∗ 𝐹𝑜𝑟 𝑜𝑛𝑒 𝑝𝑒𝑟𝑖𝑜𝑑 𝑒
(jumps) to lne1 𝑖′ 𝑒
𝑖′ − 𝑖 𝑒 − 𝑒′
3 The expected depreciation over the 𝑖, 𝑖 ∗
𝑒′
𝐻𝑜𝑚𝑒 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦
𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑒𝑠
year is equal to the interest rate 𝐻𝑜𝑚𝑒 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦
𝑓𝑜𝑟 𝑜𝑛𝑒 𝑝𝑒𝑟𝑖𝑜𝑑
differential 𝑖𝑚𝑚𝑖𝑑𝑖𝑎𝑡𝑒𝑙𝑦 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎

𝑎𝑝𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑒𝑠
𝑡0 𝑡1 𝑡𝑖𝑚𝑒 𝑡0 𝑡1 𝑡𝑖𝑚𝑒
If it is not the case, there would be
unexploited opportunities for
profit-making.
9 / 22
The UIP condition

The nominal uncovered interest parity (UIP) condition:
E
et+1 − et
it − i ∗ = (1)
| {z } et
interest gain (loss)
| {z }
expected depreciation (appreciation)
∗
where: i – home interest rate, i – foreign interest rate, e – nominal exchange rate of the home
country, e E – expected exchange rate
E
et+1 −et E
Or: in the natural log of the exchange rate, et
≈ lnet+1 − lnet , the UIP:
it − i ∗ = E
lnet+1 − lnet (2)
| {z } | {z }
interest gain (loss) expected depreciation (appreciation)
Note: possibility time-varying risk premium (excess return on currencies),

ρt = it − i ∗ − (lnet+1
E
− lnet )
Dąbrowski, M. A., & Janus, J. (2023). Does the interest parity puzzle hold for Central and Eastern European economies?. Open Economies
Review, 1-36.
10 / 22
The UIP condition
FX market participants are forward looking,

they make their best estimates with
information available in each time period 𝑖
Point A, the home interest rate equals the

world interest rate (i = i ∗ ) and exchange 𝑖1
𝐵
rate expectations are fulfilled lne0 = lne1E ∗
𝑖1 − 𝑖
Point B, represents situation where home’s ∗ 𝐴
𝑖 = 𝑖0 = 𝑖2
interest rate of i1 is above the world
interest rate. Exchange rate jumps to lne1 . ln 𝑒2𝐸 − ln 𝑒1
The expected depreciation over a one year
period is equal to lne2E − lne0 .
In general, changes in home’s interest rate 𝑈𝐼𝑃
cause a movement along the UIP curve (for ln 𝑒1 ln 𝑒0 = ln 𝑒1𝐸 ln 𝑒
a given lne E and i ∗ )
11 / 22
Changes in the UIP relation
For a given expected exchange rate, a change in

the world interest rate (i ∗ ) shifts the UIP curve 𝑈𝐼𝑃
𝑖
For a given world interest rate, any change in 𝑈𝐼𝑃′
the expected exchange rate (lne E ) shifts the
UIP curve 𝐵 𝐴
𝑖0∗ = 𝑖2∗
Example: a fall in the world interest rate that
lasts for one period 𝐶
𝑖1∗
Point B: immediate appreciation of the home
exchange rate
Note: the same shift would be achieved if
traded suddenly change their exchange rate
expectations and expect currency appreciation
𝑙𝑜𝑔 𝑒1 𝑙𝑜𝑔 𝑒0 = 𝑙𝑜𝑔 𝑒1𝐸 log 𝑒
Hypothetical, point C : the central bank in the
home country closely follows the interest rate
move by the foreign central bank
12 / 22
The real UIP condition

The UIP condition in real terms:
rt − r ∗ = qt+1
E
− qt (3)
where rt and qt are real interest rates and exchange rate, respectively
If home’s real interest rate is higher than the world’s then its real exchange rate is expected to
depreciate (the reverse is also true)
The real UIP derivation

The Fisher equation
it = rt + πtE
The real exchange rate definition
qt = lnPt∗ + lnet − lnPt
The expected inflation rate

E E
πt+1 = lnPt+1 − lnPt
13 / 22
Outline
1 Introduction
3 The UIP condition
5 The RX curve
14 / 22
Supply-side equilibrium and the ERU curve

The WS wage-setting (labour supply) equation
𝑊
WS W 𝑃 𝑊𝑆
w = = B(N, zw )
P
𝑃𝑆
where: N – level of employment, zw – wage-push variables.
The PS price-setting (labour demand) equation 𝑊𝑆 < 𝑃𝑆 𝑠𝑜 𝑑𝑜𝑤𝑛𝑤𝑎𝑟𝑑 𝑊𝑆 > 𝑃𝑆 𝑠𝑜 𝑢𝑝𝑤𝑎𝑟𝑑
𝑝𝑟𝑒𝑠𝑠𝑢𝑟𝑒 𝑜𝑛 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑝𝑟𝑒𝑠𝑠𝑢𝑟𝑒 𝑜𝑛 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛
PS W 𝑦𝑒
w = = λF (µ, zp ) 𝑦
P
𝑞
where: W P
– real wage, λ – labour productivity (output per 𝐸𝑅𝑈
worker), µ – the mark-up constant, zp – price push variables. 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 ↑
The WS–PS interaction determines medium-run equilibrium:
real wage, employment, and production 𝑇𝑜 𝑙𝑒𝑓𝑡 𝑜𝑓 𝐸𝑅𝑈, 𝑇𝑜 𝑟𝑖𝑔ℎ𝑡 𝑜𝑓 𝐸𝑅𝑈,
𝑑𝑜𝑤𝑛𝑤𝑎𝑟𝑑 𝑝𝑟𝑒𝑠𝑠𝑢𝑟𝑒 𝑢𝑝𝑤𝑎𝑟𝑑 𝑝𝑟𝑒𝑠𝑠𝑢𝑟𝑒
The ERU curve (equilibrium rate of employment) equation 𝑜𝑛 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑜𝑛 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛
can be written as:
y = ye (z W , z P )
𝑦𝑒 𝑦
where z W and z P are the sets of supply-side factors the shift
the WS and PS curves, respectively
15 / 22
The AD curve in open economy
Incorporates the demand side and the UIP condition in the medium-run equilibrium
Open economy IS curve:
yt = At − art−1 + bqt−1 (4)
as in the closed-economy case, A includes the multiplier and demand shifts variables, such as
government spending, consumption, and investment, but also foreign trade
The real UIP condition
rt − r ∗ = qt+1
E
− qt (5)
∗
In the medium-run equilibrium, the real exchange rate is constant and hence r = r
This produces the aggregate demand (AD) equation:
y = A − ar ∗ + bq (6)
Note: no time subscripts, because to be on the AD curve, r has to be equal to r ∗ and q is

constant
16 / 22
What determines the medium-run real exchange rate?
a. Positive supply shock b. Positive demand shock

→ real depreciation → real appreciation
𝐸𝑅𝑈 𝐸𝑅𝑈′ 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 ↑
𝐸𝑅𝑈 𝐴𝐷(𝑟 = 𝑟 ∗ )
𝑞 𝑞
𝐴𝐷(𝑟 = 𝑟 ∗ )
𝐴𝐷(𝑟 = 𝑟 ∗ )′
ഥ
𝑞′ 𝐴
𝐵 𝑞ത
𝑞ത 𝐴 ഥ 𝐵
𝑞′
𝑦𝑒 𝑦𝑒′ 𝑦 𝑦𝑒
𝑊 𝑊𝑆 𝑊
𝑃 𝑃 𝑊𝑆
𝐵
𝑤′ 𝑃𝑆′
𝐴 𝐴, 𝐵 𝑃𝑆
𝑤 𝑃𝑆 𝑤
𝑁𝑒 𝑁𝑒′ 𝑁 𝑁𝑒 𝑁 17 / 22
Supply and demand shocks: implications for medium-run equilibrium
A supply shock, such as a a wave of new technology raises productivity and the PS shifts up. This shifts
the ERU to the right. At the new equilibrium, the real exchange rate is depreciated to q¯′ .
A demand shock, such as an investment book, shifts the AD curve. The real exchange rate is appreciated
at q¯′ , but the output is unchanged in the new equilibrium.
Shock
Fall in union bargaining Increase in autonomous
Rise in productivity
power consumption
Equlibrium employment lower lower no change
Real exchange rate depreciation depreciation appreciation
Real wage higher no change no change
18 / 22
Outline
1 Introduction
3 The UIP condition
5 The RX curve
19 / 22
The RX curve extension to the model (1)
Monetary analysis in the open economy

(1) The AD–ERU model to characterize the medium-run equilibrium
(2) The 3-equation (IS–PC –MR) model to explain shocks
+ The RX curve to take into account the reaction of the foreign exchange market to shocks
The new RX , interest rate – exchange rate relationship

Combines both channels – stabilization under flexible exchange rates
In the closed economy, the central bank reacts to shocks by choosing the real interest rate (r )
In the open economy, it needs to take into the account the effects of changes in the exchange
rate on aggregate demand, captured in the RX curve
20 / 22
The RX curve extension to the model (2)

The RX equation may be written as:
b

y1 − ye = − a + (r0 − r ∗ ) (7)
1−λ
𝑟 𝐼𝑆(𝑞
ഥ)
1
where λ = 1+α2 β
Features of the RX curve:
1 It shifts when either r ∗ (world interest rate) or ye
(equilibrium output )change
2 It is flatter than the IS curve, and flatter: 𝑟∗ 𝐴
a When a is larger – higher interest-rate 𝑅𝑋

sensitivity of output
b When b is larger – higher exchange-rate
𝑦𝑒 𝑦
sensitivity of output
3 It is flatter, the steeper the MR curve, i.e.:
a When α is small – a flat Phillips curve
b When β is small – steeper loss function
circles
The UIP condition holds at all points of the RX curve. 21 / 22
The open-economy model: a brief summary

The supply side: PC (Phillips curve) equation
πt = πtE + α(yt − ye )
Central bank: MR (monetary policy rule / reaction function) equation

(yt − ye ) = −αβ(πt − π T )
The demand side: open-economy IS (investment-savings) equation

yt = At − art−1 + bqt−1
The RX curve
b

y1 − ye = − a + (r0 − r ∗ )
1−λ
The medium-run (AD-ERU) side
y = ye (z W , z P )
y = A − ar ∗ + bq
22 / 22
Inflation shock Demand shock Exchange rate overshooting
Monetary economics
Lecture 7
The monetary model – open economy extensions (Part 2)
Jakub Janus

1 / 15
Outline
1 Inflation shock
2 Demand shock
3 Exchange rate overshooting
2 / 15
Outline
1 Inflation shock
2 Demand shock
3 / 15
Analysis: inflation shock (1) – open economy

Start The economy is initially at the central bank bliss point, yt = ye and πt = π T , as well as the real rate of
interest equal to the world one, r = r ∗ . We consider a small open economy with flexible exchange rates.
Period 0 Inflation shock appears – an exogenous shift in the Phillips curve (PC). Example: a natural (or
man-made) disaster reduces agricultural output and raises food prices.
The shock increases the inflation rate (π0 > π T ).
Point B is not on the central bank’s MR curve. The central bank forecasts the PC in the next period
and their best policy would be to locate the new interest rate at point C , back on their MR curve.
However, the FX market foresee the interest rate above the world interest rate. The UIP implies an
immediate appreciation of home’s currency and subsequent depreciation for the period when r > r ∗ .
Hence, the central bank sets the interest rate at r0 on the RX curve, taking into account the
appreciation in the exchange rate that will occur since the IS curve shifts to IS(q0 ).
Period 1 The new interest rate and exchange rate have had time to affect aggregate demand. These forces
combine to reduce output and the economy moves to point C , with output below equilibrium at y1 and
inflation at π1 . The central bank forecasts the PC curve in the next period, PC (π2E ) = π1 . In setting the
interest rate, they again take into account the response of the FX market. They reduce the interest rate
to r1 and the exchange rate depreciates to q1 (point D) on the RX curve.
Period 2 The output moves to point D, stimulated by the lower interest rate and depreciated exchange rate, y2 and
inflation falls to π2 . The IS curve has shifted to the right. The adjustment path of a small open economy
continues until it is back at equilibrium at point Z .
4 / 15
Analysis: inflation shock (2) – open economy

𝑟 𝐼𝑆(𝑞
ഥ)
𝐼𝑆(𝑞0 )
𝑟0 𝐶
𝐷
𝑟1
𝐴, 𝑍
Adjustments in the AD–ERU part of the model:
𝑟∗
𝑅𝑋
For the whole of the adjustment process, the
economy is to the left (outside) of the ERU and
𝑦
𝜋 𝐸
𝐵 𝑃𝐶(𝜋1 = 𝜋0 )
AD curves, which leads to downward pressure on
𝜋0
𝑃𝐶(𝜋2𝐸 = 𝜋1 ) inflation, as long as r > r ∗
𝜋1 𝐶 In point Z , r = r ∗ , so there is no pressure for the

𝜋2
𝐷 exchange rate to change
𝜋𝑇 𝐴, 𝑍
𝑀𝑅
The final positions of the AD and ERU curves are
unaffected
𝑦
𝑞
𝐸𝑅𝑈 𝐴𝐷(𝑟 = 𝑟∗ )
𝑞ത 𝐴, 𝑍
𝐷
𝑞1
𝑞0
𝐶
𝑦1 𝑦2 𝑦𝑒 𝑦 5 / 15
Analysis: inflation shock (3) – open vs. closed economy
Recall the closed economy reaction to inflation shock

Differences between the closed economy and open economy adjustment paths:
1 The initial interest rate hike (to r0 ) in response to the inflation shock is greater in the closed
economy. This is because the appreciation of the exchange rate shoulders some of the burden of
adjustment in the open economy. Smaller interest rate changes are needed because the exchange
rate channel operates as well.
2 The IS curve shifts in each period in the open economy but remains fixed in the closed economy.
Because net exports are part of the intercept term of the open economy IS, so the IS curve shifts
due to the real exchange rate changes.
3 The closed economy moves along the IS curve on its path back to the equilibrium. The open
economy moves along the flatter RX curve, which takes into account the response of the FX
market to differentials between home and world interest rates. The UIP condition holds at all points
of the RX curve.
6 / 15
Analysis: inflation shock (4) – open vs. closed economy

a. Closed economy b. Open economy
𝑟 𝑟 𝐼𝑆(𝑞
ഥ)
𝐼𝑆(𝑞0 )
𝑟0 𝐶
𝑟0 𝐶
𝑟1 𝐷
𝑟1 𝐷
𝐴, 𝑍
𝑟𝑆 𝑟∗ 𝐴, 𝑍
𝑅𝑋
𝐼𝑆
𝑦 𝑦
𝜋 𝑃𝐶(𝜋1𝐸 = 𝜋0 ) 𝜋 𝐸
𝜋0
𝐵 𝐵 𝑃𝐶(𝜋1 = 𝜋0 )
𝑃𝐶(𝜋2𝐸 = 𝜋1 ) 𝜋0
𝑃𝐶(𝜋2𝐸 = 𝜋1 )
𝑃𝐶(𝜋0𝐸 = 𝜋 𝑇 ) 𝑃𝐶(𝜋0𝐸 = 𝜋 𝑇 )
𝜋1 𝐶 𝐶
𝜋1
𝜋2 𝜋2
𝐷 𝐷
𝜋𝑇 𝐴, 𝑍 𝜋𝑇 𝐴, 𝑍
𝑀𝑅 𝑀𝑅
𝑦1 𝑦2 𝑦𝑒 𝑦 𝑦
𝑞
𝐸𝑅𝑈 𝐴𝐷(𝑟 = 𝑟∗ )
𝑞ത 𝐴, 𝑍
𝐷
𝑞1
𝑞0
𝐶
𝑦1 𝑦2 𝑦𝑒 𝑦
7 / 15
Outline
1 Inflation shock
2 Demand shock
8 / 15
Analysis: demand shock (1)

Start The economy is initially at the central bank bliss point, yt = ye and πt = π T , as well as the real rate of
interest equal to the world one, r = r ∗ . We consider a small open economy with flexible exchange rates.
Period 0 A negative permanent demand shock appears. Example: a sustained decline in consumption demand,
investment demand, or government spending.
The shock shifts the IS curve to IS(A′ , q̄). Output falls to y0 and inflation falls to π0 .
Point B is not on the central bank’s MR curve. Faced with forecast PC , the central bank would like
to locate at point C . In order to reach this point, the central bank reduces the interest rate.
The FX market foresee that r0 < r ∗ for a number of periods. The UIP condition implies immediate
depreciation of home’s currency.
Period 1 The new interest rate and exchange rate q0 affect aggregate demand with a lag. The lower interest rate
boosts investment and the depreciated exchange rate increases net exports. The economy moves to point
C , with output above equilibrium at y1 and inflation at π1 . Due to the depreciation of the exchange rate,
the IS curve shifts to IS(A′ , q0 ), further to the right than the original IS curve.
Period 2 The adjustment processes continue until the economy is at point Z . The IS curve will gradually shift to
the left and the economy will move up the RX and MR curves, as the central bank adjusts the interest
rate up from r0 to r ∗ and the exchange rate appreciates from q0 to q̄ ′ , due to the UIP. In the new
medium-run equilibrium, the IS curve is indexed by lower autonomous demand (as a results of the
permanent negative demand shock) and a depreciated real exchange rate, IS(A′ , q̄ ′ ). This is because the
permanent fall in autonomous demand needs to be offset by higher net exports for the economy to reach
new equilibrium after the shock.
9 / 15

𝐼𝑆(𝐴, 𝑞
ഥ)
𝑟 𝐼𝑆(𝐴′, 𝑞
ഥ′) 𝐼𝑆(𝐴′, 𝑞0 ) Adjustments in the AD–ERU part of the model:
The adjustment process involves shift of the AD
𝐵 𝐴, 𝑍
𝑟∗
curve. A permanent negative demand shock
𝑟0
𝐶 causes a leftward shifts of the AD curve. The
𝑅𝑋 ERU curve is left unchanged.
𝐼𝑆(𝐴′, 𝑞
ഥ)
𝑦
Point C is below the new AD(r = r ∗ ) curve,
𝜋
𝑃𝐶(𝜋0𝐸 = 𝜋 𝑇 ) because the home’s interest rate is below the
𝑃𝐶(𝜋1𝐸 = 𝜋0 ) world one, the exchange rate is q0 and it is
𝐴, 𝑍
𝜋𝑇 expected to appreciate to q̄. The UIP implies:
𝜋1 𝐶
𝑀𝑅
holders of home bonds are losing out in terms of
𝜋0 𝐵 the interest return, but gaining from the
appreciation of home currency.
𝑦
The initial depreciation of the real exchange rate
𝐴𝐷(𝑟 = 𝑟∗ )′
𝑞 𝐸𝑅𝑈 (from q̄ to q0 ) was larger than than the
𝑞0 𝐶 𝐴𝐷(𝑟 = 𝑟∗ )
equilibrium appreciation (from q̄ to q̄ ′ , points A
ത′
𝑞
𝑍
to Z ), the so-called exchange rate overshooting.
𝑞ത 𝐵
𝐴
𝑦0 𝑦𝑒 𝑦1 𝑦 10 / 15
Period Closed economy Open economy

0 CB works out stabilizing interest rate in the new equ- CB and FX market work out real exchange rate in the new equilibrium, q̄, r = r ∗
ilibrium, r S AD-ERU model
CB works out implications of the shock for the Phillips curve and for its choice of output in period one on the MR curve
CB and FX market work out the path over time of the CB’s desired output level
along the MR to the new equilibrium
CB sets r0 using the IS curve to achieve its desired CB sets r0 using the RX curve to achieve its desired output gap in the next period;
output gap in the next period q jumps to q0 , as the FX market take advantage of the arbitrage opportunities
brought about by the interest rate differential; both parties take into account the
response of the other when formulating their best response
1 r0 affects the real economy, shifting output to y1 , r0 and q0 affect the economy; this shifts output to y1 on the MR curve, which
which is on the MR curve and minimizes the CB’s minimizes the CB’s loss function; the IS curve shifts as the real exchange rate
loss function affects demand for net exports
2+ CB adjusts r to move economy along MR (and IS) CB adjusts r (and FX market adjusts q) to move economy along MR (and RX) to
to equilibrium equilibrium
11 / 15
Outline
1 Inflation shock
2 Demand shock
12 / 15
The exchange rate overshooting phenomenon
Nominal and real exchange rates jump by Theory developed to explain the volatility of
more than the equilibrium adjustment in exchange rates following the collapse of the
response to shocks Bretton Woods system in the late 1960s
The overshooting exists because of the Exchange rate are extremely sensitive to
combination of three factors: arriving news
1 An internationally integrated financial It is also true for other financial assets
market By contrast, the prices of most goods,
2 Rational expectations in the FX market, services, and labour do not jump: price and
which leads to jumps on the exchange wage rigidities (stickiness)
rate
Differences between financial and real sphere
3 Sluggish adjustment of wages and prices
produce overshooting
in the economy, which requires the
central bank to keep the interest rate Rogoff, K. (2002). Dornbusch’s Overshooting Model after
Twenty-Five Years: International Monetary Fund’s Second Annual
above (or below) the world interest rate Research Conference Mundell-Fleming Lecture. IMF Staff Papers,
after a shock appears 49, 1-34.
13 / 15
The overshooting mechanism

Recall the real UIP condition:
rt − r ∗ = qt+1
E
− qt
When rt > r ∗ , qt must jump relative to its expected value
If the interest rate differential is expected to prevail for one year, the initial jump will be:
(q̄ − q0 ) = (r0 − r ∗ ) + (q̄ − q̄ ′ )
| {z } | {z } | {z }
Initial jump Interest rate differential Equilibrium change
where (q̄ − q̄ ′ ) is the equilibrium change comes from the new medium-run exchange rate value
The exchange rate overshooting is:
(q̄ ′ − q0 ) = (q̄ − q0 ) − (q̄ − q̄ ′ ) = (r0 − r ∗ )
| {z } | {z } | {z } | {z }
Overshooting Initial jump Equilibrium change Interest rate differential
Overshooting following inflation and demand shocks

Inflation shock: no change in the equilibrium real exchange rate, so all of the initial jump from q̄ to q0 is
the exchange rate overshooting, because q̄ = q̄ ′
Demand shock: overshooting of (q̄ ′ − q0 ) over the real exchange rate equilibrium adjustment
14 / 15
Real and nominal exchange rate paths following an inflation shock
↑ 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛
Adjustments following the inflation shock
Simplifying assumption (the target inflation
(1) Overshooting of the
of zero)
107 𝑃𝑟𝑖𝑐𝑒 𝑙𝑒𝑣𝑒𝑙 real exchange rate
(2) Initial overshooting of The initial nominal appreciation in period 0
the nominal exchange rate is less than the real appreciation
𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝑒𝑥𝑐ℎ𝑎𝑛𝑔𝑒 𝑟𝑎𝑡𝑒
102 (3) Equilibrium nominal Reason: recall that real exchange rate
depreciation
100
definition
𝑡𝑖𝑚𝑒
↓ ↑
𝑅𝑒𝑎𝑙 𝑒𝑥𝑐ℎ𝑎𝑛𝑔𝑒 𝑟𝑎𝑡𝑒 P∗e ↓ QP
Q≡ ←→ e = ∗
P P
1 2 3
Along the path back to equilibrium, the

nominal depreciation is stronger than real
Reasons: (a) the output gap must be closed
(the IS curve), (b) home’s real interest rate
is above the world’s (UIP)
15 / 15

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Overview Course structure Reading materials Grading Questions

Krakow University of Economics

On-line materials and organization

Organization of the course

Course objectives and effects

Macmillan, New York.

Keynesian framework and its applications. Princeton University Press.

Other interesting sources

3 Conversable economist link

4 Marginal revolution link

Are there any questions?

Krakow University of Economics

Introduction: two major problems with money

Problems with money in theoretical macro

The money demand functions (1)

Recall a (highly stylized) money demand function

Md = (kY − hi) × P (2) A

The money demand functions (2)

The money demand functions (3)

Theoretical challenges to monetary economics:

The money demand functions (4)

Money-in-the-utility function (1)

money EO – expectation operator

Money-in-the-utility function (2)

Cash-in-advance constraint (1)

Cash-in-advance constraint (2)

CIA constraint have interesting predictions for monetary economics

Overlapping generations models

An alternative to the baseline general-equilibrium models

Comes back to the original cashless economy

The Real Business Cycle theory

The role of money in the RBC model

The New Keynesian theory

The role of money in the NK model

Inclusion of rigidities has first-order real effects

The DSGE framework in a nutshell

Monetary policy in the DSGE framework

In practice, a central bank takes into account a Variables and parameters

Example: the effects of monetary shocks (1) – specification

Here we consider an example of a medium-size DSGE model

Two specifications (parametrizations):

Example: the effects of monetary shocks (2) – IRFs

Example: the effects of monetary shocks (3) - variance decomposition

Krakow University of Economics

Lucas (1996) - the Nobel lecture

Capturing the response of real variables to monetary policy is tricky.

The narrative approach - origins

where mt−i is a monetary aggregate.

Romer and Romer narrative approach

Romer, C. D., & Romer, D. H. (2004). A new measure of

Monetary policy in vector autoregressions

VARs: further developments (examples)

Factor-augmented VAR Other types of identification – example that allows for

Major results of a VAR analysis (examples)

Baumeister, C., & Hamilton, J. D.

High-frequency identification – idea

Idea: to identify high-frequency surprises around monetary policy announcements

High-frequency identification – external instruments

The external instrument approach Two types of policy effects: