ECON-002 Lecture Notes - Lecture 22: Real Interest Rate, Inflation Targeting, Autonomous Consumption

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5 Jun 2017
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April 18th, 2017
Monetary Rule & Spending Balance Model
Monetary Rules in the Rest of World
-Monetary rule: description of how the Fed behaves;
-an “inflation targeting rule” because all these rules specify how the bank reacts to current
inflation and how it reacts to changes in target inflation
-countries that were known to be following inflation targeting rules: New Zealand, Canada,
UK, Australia, Sweden, Albania, etc.
-a lot of central banks follow Taylor’s rule (a monetary rule for inflation targeting)
Spending Balance Model (aka Keynesian Cross)
Assumptions:
-C: depends on Y
-I: does not depend on Y (+)
-it depends positively on GDP; when the economy has really strong grotwth on GDP,
investment increases because banks are encouraged to invest
-G: does not depend on Y
-X: does not depend on Y (-)
-it depends negatively on Y; when GDP grows, people buy more of everything, including
imported goods. Imports automatically go up when GDP is growing. Therefore Net Exports
becomes more negative as GDP grows
We will also assume that C, I, and X depend on the (short-run) real interest rate, with the same
explanations as for how C/Y*, I/Y*, and X/Y* depend on the long-run real interest rate.
The Consumption Function (how C depends on Y)
C = 50 + 0.6Y
-Even if your income was 0, you still would consume.
- Autonomous consumption (A) vs non-autonomous (B)
- C = A + bY
-Y is current income
- Slope is b: the Marginal Propensity to Consume (MPC)
Shifts:
-changes in intercept cause shifts: changes in consumer confidence, taxes, wealth, interest rate
-a tax increase reduces consumption (shift down)
-decline in consumer confidence leads to less consumption (shift down)
-if the stock market crashes, wealth decreases (shift down), and vice versa
-if the interest rate increases, consumption is reduced (shift down)
-Assumption: C = 200-50R+0.6Y and R = 3
Footnotes: 2 questions about shifts of the consumption function
1. How much do tax cuts shift it?
2. Does redistribution from rich to poor shift this function?
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