Inflation shock Temporary demand shock Deflation trap Supply shock

Monetary economics
Lecture 5
The monetary model – closed economy setting (Part 2)

Jakub Janus

Krakow University of Economics

Department of Macroeconomics
[Link]@[Link]

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Inflation shock Temporary demand shock Deflation trap Supply shock

Outline

1 Inflation shock

2 Temporary demand shock

3 Deflation trap

4 Supply shock

2 / 19
Inflation shock Temporary demand shock Deflation trap Supply shock

Outline

1 Inflation shock

2 Temporary demand shock

3 Deflation trap

4 Supply shock

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Inflation shock Temporary demand shock Deflation trap Supply shock

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).

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Inflation shock Temporary demand shock Deflation trap Supply shock

Analysis: inflation shock (2)

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
Inflation shock Temporary demand shock Deflation trap Supply shock

Analysis: inflation shock (3)

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.

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Inflation shock Temporary demand shock Deflation trap Supply shock

Outline

1 Inflation shock

2 Temporary demand shock

3 Deflation trap

4 Supply shock

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Inflation shock Temporary demand shock Deflation trap Supply shock

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 .

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Inflation shock Temporary demand shock Deflation trap Supply shock

Analysis: temporary demand shock (3)

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
Inflation shock Temporary demand shock Deflation trap Supply shock

Analysis: temporary demand shock (2)

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
Inflation shock Temporary demand shock Deflation trap Supply shock

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
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Inflation shock Temporary demand shock Deflation trap Supply shock

Outline

1 Inflation shock

2 Temporary demand shock

3 Deflation trap

4 Supply shock

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Inflation shock Temporary demand shock Deflation trap Supply shock

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
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Inflation shock Temporary demand shock Deflation trap Supply shock

Analysis: deflation trap (2)

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 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.
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Inflation shock Temporary demand shock Deflation trap Supply shock

Analysis: deflation trap (3)

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′
𝑃𝐶(𝜋0𝐸 = 𝜋 𝑇 )
𝜋
𝑃𝐶(𝜋1𝐸 = 𝜋0 )

𝑃𝐶(𝜋2𝐸 = 𝜋1 )
𝜋𝑇 𝐴
𝐶′
𝐷′
𝑦
𝜋0 𝐵
𝐶 𝑀𝑅
𝜋1

𝜋2 𝐷

𝑦𝑒 15 / 19
Inflation shock Temporary demand shock Deflation trap Supply shock

Analysis: deflation trap (4)

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.

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Inflation shock Temporary demand shock Deflation trap Supply shock

Outline

1 Inflation shock

2 Temporary demand shock

3 Deflation trap

4 Supply shock

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Inflation shock Temporary demand shock Deflation trap Supply shock

Analysis: supply 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 (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.

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Inflation shock Temporary demand shock Deflation trap Supply shock

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
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