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Understanding MP Curve and AD Curve in Macroeconomics

Explore the relationship between short-term nominal interest rates set by the Fed, inflation, and output levels through MP Curve and AD Curve in macroeconomics. Learn how the Fed's policies impact economic variables and the implications of the Taylor Principle.

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Understanding MP Curve and AD Curve in Macroeconomics

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  1. Chapter 21: MP Curve and AD Curve Fed’s primary policy tool is very short-term nominal interest rates, i. (controlled by adding and draining reserves from banking system) Recall Fisher Equation r = i – (DP/P)et+1 Where r affects NX and I. Assume (DP/P) and (DP/P)et+1 are constant in the short-run (sticky prices). (there is a long lag time between D (DM/M) and D (DP/P) ). r = i – (DP/P)et+1 by changing i, the Fed controls r in the short run.

  2. MP Curve MP (monetary policy) curve – Indicates the relationship between r the Fed sets and the DP/P. r = r + l (DP/P)et+1 r = autonomous component, set by the FOMC, not related to DP/P. l = parameter showing responsiveness of r to DP/P. Automatic/endogenous/normal Fed response to higher DP/P. Movement along curve. MP Curve has an upward slope which is explained by the Taylor Principle Assume Fed’s goal is for stable DP/P. The FOMC will increase i more than any increase in (DP/P)et+1 => increase in r r = i – (DP/P)et+1 The Taylor Principle will prevent the following feedback loop.  DP/P =>  r =>  Y => DP/P =>  r =>  Y => DP/P 0.5% 1.5% 1.0%

  3. AD Curve AD (aggregate demand) Curve – Indicates the relationship between DP/P and Y when the G/S market is in equilibrium. Movement along curve explained by the following:  DP/P => FOMC  r =>  NX,  I =>  planned spending =>  Y Factors that shift AD curve. • All the factors that shift the IS curve (C, I, G, NX, f, T) • The factor that shifts the MP curve, r, autonomous tightening or easing of MP.

  4. AD Curve (substitute MP Curve into IS Curve) Y = [C + I + G + NX – d f – MPC T] * 1 – (d + x) * [r + l (DP/P)et+1 ] 1 - [mpc(1-t)] 1 - [mpc(1-t)]

  5. Shift AD Curve • Assume 2% DP/P and 2% r •  G (at any given interest rate) => multi  Y DP/P A 2.0% B AD Curve Y MP Curve r = r + l (DP/P)et+1 r % r % A 2.0% 2.0% B A IS Curve Y 2% DP/P $14 T $15 T

  6. Shift AD Curve (due to D r ) • Assume 2% DP/P • The debt crisis => Fed’s “Financial Repression” => r falls from 1 to -2. (autonomous easing of MP) => r falls from 2 to -1 =>  I,  NX, =>  Y, at every given DP/P . DP/P 2.0% B A AD Curve Y MP Curve r = r + l (DP/P)et+1 r % r % IS Curve 2 = 1 + 0.5(2) 2.0% A 2.0% A -1 = -2 + 0.5(2) 2% $15 T $14 T Y DP/P -1.0% -1.0% B B

  7. Econ 330 Chapter 21 HomeworkDue Friday, May 2 Chapter 21 Questions & Applied Problems 3, 4, 6, 21, 23, 25

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