Monetary Policy, the Phillips Curve, and Short-Run Macroeconomics

Monetary Policy and the Federal Funds Rate

Definition of the Federal Funds Rate (FFR): * The Federal Funds Rate is the key policy interest rate of the United States central bank. * It is defined as the interest rate at which commercial banks lend to one another on an overnight basis.
Historical Trends of the FFR (1960–2020): * During the early 1960s, the rate remained relatively low, generally below $5\,\%$ . * The rate saw extreme volatility and a sharp climb during the 1970s and early 1980s, peaking near $20\,\%$ around 1980–1981. * Following the early 80s peak, the rate trended downward, with significant drops during recessions (e.g., early 1990s, early 2000s). * The rate hit the "Zero Lower Bound" (ZLB) following the 2008 financial crisis and again during the 2020 COVID-19 pandemic.
The Transmission of Monetary Policy: * The Power of the Overnight Rate: Although the FFR is specifically for overnight nominal lending between banks, it influences the entire economy, including GDP and financial markets. * Term Structure of Interest Rates (Yield Curve): This concept explains how short-term rates relate to long-term rates. * Arbitrage: Investors expect the return on five consecutive one-year bonds to be approximately equal to the return on a single five-year bond. * By keeping the overnight rate low or high for extended periods, the Fed can influence long-term rates, such as mortgage rates and the 10-year Treasury bond rate. * Yield Curve Comparison (January 2022 vs. April 2023): * In January 2022, yields were low across all maturities (near $0\,\%$ for 1-month up to approximately $2\,\%$ for 30-year bonds). * By April 2023, the yield curve shifted upward and became inverted; short-term rates (1-month to 1-year) were near $4\,\%$ to $5\,\%$ , while long-term rates (10-year to 30-year) were lower, around $3.5\,\%$ to $4\,\%$ .
Federal Reserve Control Mechanisms: * Simple Implementation: The Fed announces a specific rate and maintains it by being willing to borrow or lend any amount at that specified rate. * Open Market Operations (OMO): * Increasing the Money Supply: The Fed buys Treasury securities, which drives the Federal Funds Rate down. * Decreases the Money Supply: The Fed sells Treasury securities, which drives the Federal Funds Rate up. * This mechanism is similarly utilized by the European Central Bank and the Bank of Canada.

Nominal versus Real Interest Rates and the IS-MP Diagram

Connecting Nominal and Real Rates: The Fed sets a nominal rate, but it influences the real interest rate ( $R$ ) through the Fisher equation and price stickiness.
The Fisher Equation: * $r_t = i_t - \pi_t$ * Where $r_t$ is the real interest rate, $i_t$ is the nominal interest rate, and $\pi_t$ represents inflation.
Failure of the Classical Dichotomy: The Fed can influence the real rate because all prices do not adjust immediately or in a coordinated fashion (sticky prices). Over the short run, movements in the nominal rate translate into movements in the real rate.
The IS-MP Diagram Structure: * The IS Curve: Represents aggregate demand; it is downward sloping relative to the real interest rate ( $R$ ). * The MP Curve: Represents Monetary Policy; it is usually a horizontal line at the real interest rate chosen by the central bank ( $R = \bar{r}$ ). * Equilibrium: Occurs where IS and MP intersect, determining short-run output ( $\tilde{Y}$ ).
Effects of Policy Changes and Shocks: * Raising the FFR: Shifts the MP curve upward ( $MP'$ ), leading to a higher real interest rate ( $R'$ ) and a decrease in short-run output (movement from point A to point B). * Fall in Demand (e.g., Housing Crash): Shifts the IS curve to the left ( $IS'$ ), reducing output. * Fed Response to Demand Shocks: To stabilize output at $0$ , the Fed lowers the nominal rate, shifting the MP curve downward ( $MP'$ ) to intersect the new IS curve at $0$ output gap (Movement A to B to C).

Financial Frictions and the 2008 Financial Crisis

The Financial Friction Formula: * $r = r_{ff} + \bar{f}$ * Where $r$ is the rate businesses/households pay, $r_{ff}$ is the Federal Funds Rate, and $\bar{f}$ is the financial friction (risk premium).
Behavior of $\bar{f}$ : * In normal economic times, $\bar{f}$ is small and often treated as zero. * During financial crises, $\bar{f}$ rises sharply.
Defining the Wedge: The friction creates a gap (wedge) between the Fed's policy rate and the actual borrowing costs for the economy. * Liquidity Problems: Assets become difficult to trade due to "thin markets." * Solvency Problems: The fear that trading partners (or their partners) may go bankrupt.
Industrial Data (Spread): The spread between the BAA corporate bond yield and the 10-year Treasury yield is a proxy for this friction, which spiked significantly in 2008.
Modeling the Financial Crisis: * 1. The housing bubble collapses, shifting the IS curve leftward ( $IS'$ ). * 2. The Fed responds by lowering the Federal Funds Rate to the ZLB ( $MP'$ ). * 3. The financial crisis causes $\bar{f}$ to spike, which effectively moves the real borrowing rate back up ( $MP''$ ), resulting in a deep recession with output gaps reaching $-4\,\%$ .

The Zero Lower Bound and Unconventional Monetary Policy

The Zero Lower Bound (ZLB): A situation where the central bank cannot lower the nominal interest rate below zero. This was reached between 2008–2016 and again in 2020.
The Federal Reserve Balance Sheet: * Assets: Treasury Securities, Agency Debt & Mortgage-backed Securities, and other assets. * Liabilities: Reserves, Federal Reserve Notes (currency), ON RRP (Overnight Reverse Repurchase Agreements), and Capital.
Unconventional Policy Tools: * Quantitative Easing (QE): An increase in securities holdings to provide liquidity and lower long-term rates (e.g., QE I, QE II, QE III, and the COVID-19 Response). * Quantitative Tightening (QT): The reduction of securities holdings (e.g., QT I and QT II). * Maturity Extension Program (MEP): Policies designed to alter the maturity profile of the Fed's holdings.

The Phillips Curve

Core Concept: The Phillips Curve links short-run output ( $\tilde{Y}$ ) to changes in inflation ( $\pi$ ).
Intuition and Stickiness: * Prices are sticky; firms adjust prices infrequently when inflation is low because they have thousands of decisions to make. * If a firm expects $5\,\%$ inflation, they intend to raise prices by $5\,\%$ . If demand is low, the firm may only raise prices by $3\,\%$ to attract customers. If all firms do this, inflation will be $3\,\%$ instead of the expected $5\,\%$ .
The Phillips Curve Equation: * $\pi_t = \pi_t^e + \bar{v}\tilde{Y}_t + \bar{o}$ * $\pi_t$ : Current inflation rate. * $\pi_t^e$ : Expected inflation rate. * $\tilde{Y}_t$ : Short-run output (demand gap). * $\bar{v}$ : Sensitivity of inflation to demand. * $\bar{o}$ : Cost shock or supply shock.
Inflation Expectations: * Adaptive Expectations: A simple assumption that people expect this year's inflation to match last year's inflation ( $\pi_t^e = \pi_{t-1}$ ).
Dynamic Phillips Curve: * $\Delta \pi_t = \bar{v}\tilde{Y}_t + \bar{o}$ * Booming economy (\tilde{Y} > 0) \implies \Delta \pi > 0. * Slumping economy (\tilde{Y} < 0) \implies \Delta \pi < 0.

Historical Applications of the Short-Run Model

The Volcker Disinflation (Early 1980s): * The Process: An "Engineered Recession." * 1. The Fed drastically raised interest rates ( $MP$ curve shifts up). * 2. This caused a severe recession (negative short-run output $Y$ ). * 3. The recession led to disinflation (actual inflation fell from approximately $10\,\%$ to $5\,\%$ ).
The Great Inflation of the 1970s: * Supply Side Shocks: OPEC oil embargo (1973–1974) and the 1979 Iranian Revolution. * Productivity Slowdown: A slowdown in productivity began in the early 1970s. Policy makers initially believed potential output was higher than it actually was. Because perceived output was less than perceived potential, they kept policy too loose, causing actual output ( $Y_{true}$ ) to be higher than true potential, driving inflation up (\Delta \pi > 0).
COVID-19 Recession and Post-Recovery Inflation: * COVID-19 Recession: Functioned as a combined supply and demand shock. Potential output ( $\bar{Y}_t$ ) fell due to illness risk and limited work-from-home options. Proportional declines in supply and demand left short-run output ( $\tilde{Y}$ ) largely unchanged, explaining the stable inflation seen during the initial recession and recovery (2020–2021). * Post-Recovery Inflation Factors: * Negative Cost (Supply) Shocks: Global supply chain disruptions (microchips, cars) and the Russian invasion of Ukraine (energy and agricultural price spikes). * Positive Demand Shocks: FFR at the Zero Lower Bound, QE, emergency government spending (stimulus checks), and pent-up consumer demand.
Inflation Accounting (2017–2023): Breakdown shows that by 2021–2022, supply chain issues and aggregate demand significantly contributed to goods inflation, with commodity price indices (Energy, Agriculture, Metals) remaining at historically high levels through 2023.

Questions & Review

Mechanism: Why do changes in the Fed Funds rate affect the real interest rate? (Answer relates to the failure of the Classical Dichotomy and the Fisher Equation).
Financial Friction: What is it, and when is it important? (Answer relates to risk premiums $\bar{f}$ and periods of crisis like 2008).
Equation Components: Explain the terms in the Phillips curve ( $\pi_t^e$ , $\tilde{Y}_t$ , $\bar{v}$ , $\bar{o}$ ).
Short-Run Model Applications: Use IS-MP and the Phillips curve to explain: 1. The rising inflation of the 1970s (Supply shocks and potential output mismeasurement). 2. The Volcker Disinflation (Raising $R$ to lower $\pi$ through recession). 3. The COVID-19 sequence (Initial potential output shock followed by supply chain and stimulus-driven demand shocks).