Economics 100B: Macroeconomics
Monetary Policy III:
Economic Fluctuations and Policy Response
March 8, 2022
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R.J. Hawkins (2020) – A Monetary Policy Model. On bCourses as
MonetaryPolicyModelNotes-v7.pdf.
Mishkin – Chapter 12 for discussion of shocks not the model.
Lecture 14 – Monetary Policy III: R. J. 100B: Macroeconomics 1/ 17
Optimal Monetary Policy
Today’s Agenda:
1 The monetary policy model in gap form.
2 An inflation shock.
3 A temporary positive demand shock.
4 Repeated shocks.
5 Shocks: an empirical review.
Lecture 14 – Monetary Policy III: R. J. 100B: Macroeconomics 2/ 17
Optimal Monetary Policy
Optimal policy as three gap equations:
The optimal path:
y − y P = − γ β π − π T = ⇒ y = − β γ π
The rate gap:
π−π =⇒r= π tttt
The IS curve:
y −yP=−ζ (r −r∗)=⇒y =−ζ r t+1 yt t+1yt
Lecture 14 – Monetary Policy III: R. J. 100B: Macroeconomics 3/ 17
Optimal Monetary Policy
Optimal policy as three gap equations:
Operationally, a shock at t = 0 evolves as follows: y andπ setr.
y follows from r via the IS curve. 10
π follows from y via the optimal path. 11
π setsr. 11
y follows from r via the IS curve. 21
Econ 100B: Macroeconomics
Lecture 14 – Monetary Policy III: R. J. Monetary Policy: Impulse Response
An inflation shock at t = 0.
For t < 0: equilibrium. At t = 0:
Positive π0 shock. No y shock.
r responds to π . 00
1.2 1 0.8 0.6 0.4 0.2 0
1.2 1 0.8 0.6 0.4 1 1 0.2 0 -0.2 For t > 1: relaxation to -0.4 -0.6
-2 0 2 4 6 8 10
TIME (year)
y responded to r .
π down due to y . equilibrium.
-2 0 2 4 6 8 10
TIME (year)
Econ 100B: Macroeconomics 5/ 17
Lecture 14 – Monetary Policy III: R. J. APS (percent) SHOCK (percent)
Optimal Monetary Policy: Impulse Response
Temporary demand shock at t = 0.
For t < 0: equilibrium. At t = 0:
Positive π0 shock. Positive y shock.
r responds to π . 00
1.2 1 0.8 0.6 0.4 0.2 0
1.2 1 0.8 0.6 0.4 1 1 0.2 0 -0.2 For t > 1: relaxation to -0.4 -0.6
-2 0 2 4 6 8 10
TIME (year)
y responded to r .
π down due to y . equilibrium.
-2 0 2 4 6 8 10
TIME (year)
Econ 100B: Macroeconomics 6/ 17
Lecture 14 – Monetary Policy III: R. J. APS (percent) SHOCK (percent)
Optimal Monetary Policy: Impulse Response Analysis
Comparing macroeconomic models with impulse response functions.
Output from the Macroeconomic Model Data Base (MMB)
Lecture 14 – Monetary Policy III: R. J. 100B: Macroeconomics 7/ 17
Optimal Monetary Policy
A sequence of inflation shocks.
3 2.5 2 1.5 1 0.5 0
4 t1 t 3 2 1 0 -1 -2 -3
For t < 0: equilibrium.
For 0 ≤ t ≤ 4 a sequence of shocks.
πt shock.
r responds to π .
-2 0 2 4 6 8 10
TIME (year)
y responds to r.
For t > 4: relaxation to equilibrium.
0 2 4 6 8 10
TIME (year)
Econ 100B: Macroeconomics 8/ 17
Lecture 14 – Monetary Policy III: R. J. APS (percent) SHOCK (percent)
Optimal Monetary Policy: Denmark
1985 1987 1989
Source: stats.oecd.org
TIME (year)
1995 1997 1999
Lecture 14 – Monetary Policy III: R. J. 100B: Macroeconomics 9/ 17
RATE (% and %/year)
Fluctuations (shocks) and Policy Response
70 75 80 85 90 95 00 05
Source: FRED / BLS
TIME (year)
Lecture 14 – Monetary Policy III: R. J. 100B: Macroeconomics 10/ 17
INFLATION (%/year)
Aggregate Demand Shocks
Aggregate demand shocks:
Aggregate demand shocks are events that move the IS curve. Positive, or favorable, demand shocks initially cause economic
output to increase.
Negative, or unfavorable, demand shocks initially cause economic output to decrease.
Lecture 14 – Monetary Policy III: R. J. 100B: Macroeconomics 11/ 17
Aggregate Demand Shocks
1980 – 1986 Negative Demand Shock Y = Y − ζY r
In the early 1980s the Federal Reserve significantly tightened monetary policy resulting in a negative aggregate demand shock.
80 81 82 83 84 85 86 87 88 89 90
Source: FRED / BLS
TIME (year)
Lecture 14 – Monetary Policy III: R. J. 100B: Macroeconomics 12/ 17
INFLATION (%/year)
Aggregate Demand Shocks
2000 – 2002 Negative Demand Shock
Y = Y − ζY r
00 01 02 03 04 05 06
Source: FRED / BLS
the dot-com bubble burst.
consumer confidence declined.
TIME (year)
business confidence declined.
interest rates on corporate
bonds increased.
Econ 100B: Macroeconomics 13/ 17
Lecture 14 – Monetary Policy III: R. J. AP (%)
INFLATION (%/year)
Aggregate Demand Shocks
2003 – 2006 Positive Demand Shock
Y = Y − ζY r
00 01 02 03 04 05 06
Source: FRED / BLS
TIME (year)
taxes were reduced.
banks loosened credit standards, creating a lending boom.
Econ 100B: Macroeconomics 14/ 17
Lecture 14 – Monetary Policy III: R. J. AP (%)
INFLATION (%/year)
Aggregate Supply Shocks
Aggregate supply shocks:
Aggregate supply shocks are events that change the Phillips curve or the production function.
Positive, or favorable, supply shocks initially cause inflation to decrease.
Negative, or unfavorable, supply shocks initially cause inflation to increase.
Lecture 14 – Monetary Policy III: R. J. 100B: Macroeconomics 15/ 17
Temporary Aggregate Supply Shocks
1973 – 1975 and 1978 – 1980 Negative Supply Shocks πt = πt−1 + γ yt − yP + ρt y u πCPI
70 71 72 73 74 75 76 77 78 79 80
Source: FRED / BLS
TIME (year)
oil prices rose dramatically (OPEC, ’73; Fall of Shah, ’79). crop failures caused food prices to soar (’73 and ’78). wage and price controls were lifted (’73 and ’74).
Econ 100B: Macroeconomics 16/ 17
Lecture 14 – Monetary Policy III: R. J. AP (%)
INFLATION (%/year)
The Origin of Business Cycles
Aggregate Demand and Supply Shocks
Business cycles are caused by sequential shocks to: the production function (supply shock)
the IS curve (demand shock)
the Phillips curve (supply shock)
that lead to changes in aggregate output and inflation.
Lecture 14 – Monetary Policy III: R. J. 100B: Macroeconomics 17/ 17
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