Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations...

Short Run FluctuationsDavid Romer

University of California, BerkeleyJanuary 2013

Notes by Eran Yashiv, Tel Aviv UniversityJanuary 8, 2014

ROMER (JAN 2013) () JANUARY 9, 2014 1 / 28

IS-MP MODEL

IS as usual

MP is a consequence of Taylor Rule behavior

i = ei+ β1(π � π�) + β2(Y�Y) (1)

i� π = r = ei� β1π� � β2Y| {z }a

+ (β1 � 1)| {z }b

π + β2|{z}c

r = a+ bπ + cY

r = r(π, Y)+

IS-MP MODEL

IS as usualMP is a consequence of Taylor Rule behavior

i = ei+ β1(π � π�) + β2(Y�Y) (1)

i� π = r = ei� β1π� � β2Y| {z }a

+ (β1 � 1)| {z }b

π + β2|{z}c

r = a+ bπ + cY

r = r(π, Y)+

IS-MP MODEL

i = ei+ β1(π � π�) + β2(Y�Y) (1)

i� π = r = ei� β1π� � β2Y| {z }a

+ (β1 � 1)| {z }b

π + β2|{z}c

r = a+ bπ + cY

r = r(π, Y)+

IS-MP MODEL

i = ei+ β1(π � π�) + β2(Y�Y) (1)

i� π = r = ei� β1π� � β2Y| {z }a

+ (β1 � 1)| {z }b

π + β2|{z}c

r = a+ bπ + cY

r = r(π, Y)+

IS-MP MODEL

MECHANISM

Money market in initial equilibrium

P0= L(i0, Y0)

= L(r0 + πe0, Y0)

Now M0 rises to M1

Thus P and πe rise so

P1> L(r0 + πe

1, Y0)

IS-MP MODEL

MECHANISM

P0= L(i0, Y0)

= L(r0 + πe0, Y0)

Now M0 rises to M1

P1> L(r0 + πe

1, Y0)

IS-MP MODEL

MECHANISM

P0= L(i0, Y0)

= L(r0 + πe0, Y0)

Now M0 rises to M1

P1> L(r0 + πe

1, Y0)

IS-MP MODEL

MECHANISM

P0= L(i0, Y0)

= L(r0 + πe0, Y0)

Now M0 rises to M1

P1> L(r0 + πe

1, Y0)

IS-MP MODEL

MECHANISM

P0= L(i0, Y0)

= L(r0 + πe0, Y0)

Now M0 rises to M1

P1> L(r0 + πe

1, Y0)

IS-MP MODEL

For equilibrium r falls and/or Y rises according to

IS-MP MODEL

For equilibrium r falls and/or Y rises according to

IS-MP MODEL

CLASSICAL MODEL CASE

If all prices are completely and instantaneously flexible, the pricelevel jumps when the money stock rises by the same proportion asthe increase in the money supply.

Thus the supply of real balances, M/P, does not change.In addition, the fact that the entire response of prices occursimmediately when the money supply increases means that pricesare not going to adjust any more.Thus expected inflation does not change.That is, when all prices are completely flexible, a change in thenominal money supply does not affect either the supply or thedemand for real balances at a given real interest rate and output.Thus the money market remains in equilibrium at the old levels ofthe real interest rate and output.In this case, there is no movement along the IS curve, and thecentral bank is powerless to affect the real interest rate.

IS-MP MODEL

If all prices are completely and instantaneously flexible, the pricelevel jumps when the money stock rises by the same proportion asthe increase in the money supply.Thus the supply of real balances, M/P, does not change.

In addition, the fact that the entire response of prices occursimmediately when the money supply increases means that pricesare not going to adjust any more.Thus expected inflation does not change.That is, when all prices are completely flexible, a change in thenominal money supply does not affect either the supply or thedemand for real balances at a given real interest rate and output.Thus the money market remains in equilibrium at the old levels ofthe real interest rate and output.In this case, there is no movement along the IS curve, and thecentral bank is powerless to affect the real interest rate.

IS-MP MODEL

If all prices are completely and instantaneously flexible, the pricelevel jumps when the money stock rises by the same proportion asthe increase in the money supply.Thus the supply of real balances, M/P, does not change.In addition, the fact that the entire response of prices occursimmediately when the money supply increases means that pricesare not going to adjust any more.

Thus expected inflation does not change.That is, when all prices are completely flexible, a change in thenominal money supply does not affect either the supply or thedemand for real balances at a given real interest rate and output.Thus the money market remains in equilibrium at the old levels ofthe real interest rate and output.In this case, there is no movement along the IS curve, and thecentral bank is powerless to affect the real interest rate.

IS-MP MODEL

If all prices are completely and instantaneously flexible, the pricelevel jumps when the money stock rises by the same proportion asthe increase in the money supply.Thus the supply of real balances, M/P, does not change.In addition, the fact that the entire response of prices occursimmediately when the money supply increases means that pricesare not going to adjust any more.Thus expected inflation does not change.

That is, when all prices are completely flexible, a change in thenominal money supply does not affect either the supply or thedemand for real balances at a given real interest rate and output.Thus the money market remains in equilibrium at the old levels ofthe real interest rate and output.In this case, there is no movement along the IS curve, and thecentral bank is powerless to affect the real interest rate.

IS-MP MODEL

If all prices are completely and instantaneously flexible, the pricelevel jumps when the money stock rises by the same proportion asthe increase in the money supply.Thus the supply of real balances, M/P, does not change.In addition, the fact that the entire response of prices occursimmediately when the money supply increases means that pricesare not going to adjust any more.Thus expected inflation does not change.That is, when all prices are completely flexible, a change in thenominal money supply does not affect either the supply or thedemand for real balances at a given real interest rate and output.

Thus the money market remains in equilibrium at the old levels ofthe real interest rate and output.In this case, there is no movement along the IS curve, and thecentral bank is powerless to affect the real interest rate.

IS-MP MODEL

If all prices are completely and instantaneously flexible, the pricelevel jumps when the money stock rises by the same proportion asthe increase in the money supply.Thus the supply of real balances, M/P, does not change.In addition, the fact that the entire response of prices occursimmediately when the money supply increases means that pricesare not going to adjust any more.Thus expected inflation does not change.That is, when all prices are completely flexible, a change in thenominal money supply does not affect either the supply or thedemand for real balances at a given real interest rate and output.Thus the money market remains in equilibrium at the old levels ofthe real interest rate and output.

In this case, there is no movement along the IS curve, and thecentral bank is powerless to affect the real interest rate.

IS-MP MODEL

If all prices are completely and instantaneously flexible, the pricelevel jumps when the money stock rises by the same proportion asthe increase in the money supply.Thus the supply of real balances, M/P, does not change.In addition, the fact that the entire response of prices occursimmediately when the money supply increases means that pricesare not going to adjust any more.Thus expected inflation does not change.That is, when all prices are completely flexible, a change in thenominal money supply does not affect either the supply or thedemand for real balances at a given real interest rate and output.Thus the money market remains in equilibrium at the old levels ofthe real interest rate and output.In this case, there is no movement along the IS curve, and thecentral bank is powerless to affect the real interest rate.

AD-IA MODEL

AGGREGATE DEMAND

AD curve is downward sloping in π �Y space and not P�Yspace

When inflation rises, the CB raises the interest rate and shifts theMP curve

AD-IA MODEL

AGGREGATE DEMAND

AD curve is downward sloping in π �Y space and not P�YspaceWhen inflation rises, the CB raises the interest rate and shifts theMP curve

AD-IA MODEL

AGGREGATE SUPPLY

Inflation at a point in time is given. This is shown by thehorizontal line, whereby inflation at a point in time does notdepend on output at that time.

AD-IA MODEL

AGGREGATE SUPPLY

Inflation at a point in time is given. This is shown by thehorizontal line, whereby inflation at a point in time does notdepend on output at that time.

AD-IA MODEL

Inflation behavior:

At a point in time, the rate of inflation is given.When output is above its natural rate, inflation rises.When output is below its natural rate, inflation falls.When output equals its natural rate, inflation is constant.

AD-IA MODEL

Inflation behavior:At a point in time, the rate of inflation is given.

When output is above its natural rate, inflation rises.When output is below its natural rate, inflation falls.When output equals its natural rate, inflation is constant.

AD-IA MODEL

Inflation behavior:At a point in time, the rate of inflation is given.When output is above its natural rate, inflation rises.

When output is below its natural rate, inflation falls.When output equals its natural rate, inflation is constant.

AD-IA MODEL

Inflation behavior:At a point in time, the rate of inflation is given.When output is above its natural rate, inflation rises.When output is below its natural rate, inflation falls.

When output equals its natural rate, inflation is constant.

AD-IA MODEL

Inflation behavior:At a point in time, the rate of inflation is given.When output is above its natural rate, inflation rises.When output is below its natural rate, inflation falls.When output equals its natural rate, inflation is constant.

AD-IA MODEL

MECHANISM

AD-IA MODEL

LONG RUN EQUILBRIUM

ZERO LOWER BOUND (ZLB)

IS-MP MODEL

IS as usual

Now Taylor Rule behavior is

(r(π, Y)

+, if r+πe � 0

0� πe, otherwise(3)

We shall formulate expectations as given by

πe = πe(π) (4)

IS-MP MODEL

IS as usualNow Taylor Rule behavior is

(r(π, Y)

+, if r+πe � 0

πe = πe(π) (4)

IS-MP MODEL

(r(π, Y)

+, if r+πe � 0

πe = πe(π) (4)

IS-MP MODEL

(r(π, Y)

+, if r+πe � 0

πe = πe(π) (4)

IS-MP MODEL

(r(π, Y)

+, if r+πe � 0

πe = πe(π) (4)

Changes in inflation:

AD CURVE IN ZLB

One part downward sloping as usual - above ZLB

AD CURVE IN ZLB

One part downward sloping as usual - above ZLB

What happens at ZLB?

A lower level of inflation means that the upward-sloping part ofthe MP curve shifts down and the flat part shifts up.But now this means that the IS and MP curves intersect on the flatpart of the MP curve.As a result, output when inflation is π3 is less than when inflationis π2

The AD curve now slopes up.

What happens at ZLB?A lower level of inflation means that the upward-sloping part ofthe MP curve shifts down and the flat part shifts up.

But now this means that the IS and MP curves intersect on the flatpart of the MP curve.As a result, output when inflation is π3 is less than when inflationis π2

What happens at ZLB?A lower level of inflation means that the upward-sloping part ofthe MP curve shifts down and the flat part shifts up.But now this means that the IS and MP curves intersect on the flatpart of the MP curve.

As a result, output when inflation is π3 is less than when inflationis π2

What happens at ZLB?A lower level of inflation means that the upward-sloping part ofthe MP curve shifts down and the flat part shifts up.But now this means that the IS and MP curves intersect on the flatpart of the MP curve.As a result, output when inflation is π3 is less than when inflationis π2

DYNAMICS: LARGE, LONG-LASTING FALL IN AD(THE GREAT RECESSION)

The behavior of inflation is determined by whether output isabove, below, or equal to normal.

Here, output is below normal,and so inflation starts to fall.The IA curve begins to shift down.But because we are on the upward-sloping part of the AD curve,the fall in inflation does not help to return output to normal.Instead it causes output to fall further.The reason is that the real interest rate is no longer determined bywhat the central bank would like it to be.Instead, it is determined by the combination of expected inflationand the zero lower bound on the nominal interest rate.With the real interest rate equal to 0� πe and with πe lower wheninflation is lower, a fall in inflation raises the real interest rateSo it causes output to fall further.And, unfortunately, the process continues.

The behavior of inflation is determined by whether output isabove, below, or equal to normal.Here, output is below normal,and so inflation starts to fall.

The IA curve begins to shift down.But because we are on the upward-sloping part of the AD curve,the fall in inflation does not help to return output to normal.Instead it causes output to fall further.The reason is that the real interest rate is no longer determined bywhat the central bank would like it to be.Instead, it is determined by the combination of expected inflationand the zero lower bound on the nominal interest rate.With the real interest rate equal to 0� πe and with πe lower wheninflation is lower, a fall in inflation raises the real interest rateSo it causes output to fall further.And, unfortunately, the process continues.

The behavior of inflation is determined by whether output isabove, below, or equal to normal.Here, output is below normal,and so inflation starts to fall.The IA curve begins to shift down.

But because we are on the upward-sloping part of the AD curve,the fall in inflation does not help to return output to normal.Instead it causes output to fall further.The reason is that the real interest rate is no longer determined bywhat the central bank would like it to be.Instead, it is determined by the combination of expected inflationand the zero lower bound on the nominal interest rate.With the real interest rate equal to 0� πe and with πe lower wheninflation is lower, a fall in inflation raises the real interest rateSo it causes output to fall further.And, unfortunately, the process continues.

The behavior of inflation is determined by whether output isabove, below, or equal to normal.Here, output is below normal,and so inflation starts to fall.The IA curve begins to shift down.But because we are on the upward-sloping part of the AD curve,the fall in inflation does not help to return output to normal.

Instead it causes output to fall further.The reason is that the real interest rate is no longer determined bywhat the central bank would like it to be.Instead, it is determined by the combination of expected inflationand the zero lower bound on the nominal interest rate.With the real interest rate equal to 0� πe and with πe lower wheninflation is lower, a fall in inflation raises the real interest rateSo it causes output to fall further.And, unfortunately, the process continues.

The behavior of inflation is determined by whether output isabove, below, or equal to normal.Here, output is below normal,and so inflation starts to fall.The IA curve begins to shift down.But because we are on the upward-sloping part of the AD curve,the fall in inflation does not help to return output to normal.Instead it causes output to fall further.

The reason is that the real interest rate is no longer determined bywhat the central bank would like it to be.Instead, it is determined by the combination of expected inflationand the zero lower bound on the nominal interest rate.With the real interest rate equal to 0� πe and with πe lower wheninflation is lower, a fall in inflation raises the real interest rateSo it causes output to fall further.And, unfortunately, the process continues.

The behavior of inflation is determined by whether output isabove, below, or equal to normal.Here, output is below normal,and so inflation starts to fall.The IA curve begins to shift down.But because we are on the upward-sloping part of the AD curve,the fall in inflation does not help to return output to normal.Instead it causes output to fall further.The reason is that the real interest rate is no longer determined bywhat the central bank would like it to be.

Instead, it is determined by the combination of expected inflationand the zero lower bound on the nominal interest rate.With the real interest rate equal to 0� πe and with πe lower wheninflation is lower, a fall in inflation raises the real interest rateSo it causes output to fall further.And, unfortunately, the process continues.

The behavior of inflation is determined by whether output isabove, below, or equal to normal.Here, output is below normal,and so inflation starts to fall.The IA curve begins to shift down.But because we are on the upward-sloping part of the AD curve,the fall in inflation does not help to return output to normal.Instead it causes output to fall further.The reason is that the real interest rate is no longer determined bywhat the central bank would like it to be.Instead, it is determined by the combination of expected inflationand the zero lower bound on the nominal interest rate.

With the real interest rate equal to 0� πe and with πe lower wheninflation is lower, a fall in inflation raises the real interest rateSo it causes output to fall further.And, unfortunately, the process continues.

The behavior of inflation is determined by whether output isabove, below, or equal to normal.Here, output is below normal,and so inflation starts to fall.The IA curve begins to shift down.But because we are on the upward-sloping part of the AD curve,the fall in inflation does not help to return output to normal.Instead it causes output to fall further.The reason is that the real interest rate is no longer determined bywhat the central bank would like it to be.Instead, it is determined by the combination of expected inflationand the zero lower bound on the nominal interest rate.With the real interest rate equal to 0� πe and with πe lower wheninflation is lower, a fall in inflation raises the real interest rate

So it causes output to fall further.And, unfortunately, the process continues.

The behavior of inflation is determined by whether output isabove, below, or equal to normal.Here, output is below normal,and so inflation starts to fall.The IA curve begins to shift down.But because we are on the upward-sloping part of the AD curve,the fall in inflation does not help to return output to normal.Instead it causes output to fall further.The reason is that the real interest rate is no longer determined bywhat the central bank would like it to be.Instead, it is determined by the combination of expected inflationand the zero lower bound on the nominal interest rate.With the real interest rate equal to 0� πe and with πe lower wheninflation is lower, a fall in inflation raises the real interest rateSo it causes output to fall further.

And, unfortunately, the process continues.

The behavior of inflation is determined by whether output isabove, below, or equal to normal.Here, output is below normal,and so inflation starts to fall.The IA curve begins to shift down.But because we are on the upward-sloping part of the AD curve,the fall in inflation does not help to return output to normal.Instead it causes output to fall further.The reason is that the real interest rate is no longer determined bywhat the central bank would like it to be.Instead, it is determined by the combination of expected inflationand the zero lower bound on the nominal interest rate.With the real interest rate equal to 0� πe and with πe lower wheninflation is lower, a fall in inflation raises the real interest rateSo it causes output to fall further.And, unfortunately, the process continues.

Thus, we have a crucial result.

The zero lower bound eliminates a key force that usually helps tokeep the economy stable.When the economy is functioning normally, below-normal outputcauses inflation to fall, leading the central bank to cut the realinterest rate and push output back toward normal.At the zero lower bound, however, falls in inflation lead not tocuts but to rises in the real interest rate.As a result, they are destabilizing rather than stabilizing.A premise of our example is that the shift of the IS curve is notpermanent.At some point,it shifts back to the right.In particular, we assume that it shifts to the right by enough thatat the current level of inflation, the economy is once again on theupward-sloping portion of the AD

Thus, we have a crucial result.The zero lower bound eliminates a key force that usually helps tokeep the economy stable.

When the economy is functioning normally, below-normal outputcauses inflation to fall, leading the central bank to cut the realinterest rate and push output back toward normal.At the zero lower bound, however, falls in inflation lead not tocuts but to rises in the real interest rate.As a result, they are destabilizing rather than stabilizing.A premise of our example is that the shift of the IS curve is notpermanent.At some point,it shifts back to the right.In particular, we assume that it shifts to the right by enough thatat the current level of inflation, the economy is once again on theupward-sloping portion of the AD

Thus, we have a crucial result.The zero lower bound eliminates a key force that usually helps tokeep the economy stable.When the economy is functioning normally, below-normal outputcauses inflation to fall, leading the central bank to cut the realinterest rate and push output back toward normal.

At the zero lower bound, however, falls in inflation lead not tocuts but to rises in the real interest rate.As a result, they are destabilizing rather than stabilizing.A premise of our example is that the shift of the IS curve is notpermanent.At some point,it shifts back to the right.In particular, we assume that it shifts to the right by enough thatat the current level of inflation, the economy is once again on theupward-sloping portion of the AD

Thus, we have a crucial result.The zero lower bound eliminates a key force that usually helps tokeep the economy stable.When the economy is functioning normally, below-normal outputcauses inflation to fall, leading the central bank to cut the realinterest rate and push output back toward normal.At the zero lower bound, however, falls in inflation lead not tocuts but to rises in the real interest rate.

As a result, they are destabilizing rather than stabilizing.A premise of our example is that the shift of the IS curve is notpermanent.At some point,it shifts back to the right.In particular, we assume that it shifts to the right by enough thatat the current level of inflation, the economy is once again on theupward-sloping portion of the AD

Thus, we have a crucial result.The zero lower bound eliminates a key force that usually helps tokeep the economy stable.When the economy is functioning normally, below-normal outputcauses inflation to fall, leading the central bank to cut the realinterest rate and push output back toward normal.At the zero lower bound, however, falls in inflation lead not tocuts but to rises in the real interest rate.As a result, they are destabilizing rather than stabilizing.

A premise of our example is that the shift of the IS curve is notpermanent.At some point,it shifts back to the right.In particular, we assume that it shifts to the right by enough thatat the current level of inflation, the economy is once again on theupward-sloping portion of the AD

Thus, we have a crucial result.The zero lower bound eliminates a key force that usually helps tokeep the economy stable.When the economy is functioning normally, below-normal outputcauses inflation to fall, leading the central bank to cut the realinterest rate and push output back toward normal.At the zero lower bound, however, falls in inflation lead not tocuts but to rises in the real interest rate.As a result, they are destabilizing rather than stabilizing.A premise of our example is that the shift of the IS curve is notpermanent.

At some point,it shifts back to the right.In particular, we assume that it shifts to the right by enough thatat the current level of inflation, the economy is once again on theupward-sloping portion of the AD

Thus, we have a crucial result.The zero lower bound eliminates a key force that usually helps tokeep the economy stable.When the economy is functioning normally, below-normal outputcauses inflation to fall, leading the central bank to cut the realinterest rate and push output back toward normal.At the zero lower bound, however, falls in inflation lead not tocuts but to rises in the real interest rate.As a result, they are destabilizing rather than stabilizing.A premise of our example is that the shift of the IS curve is notpermanent.At some point,it shifts back to the right.

In particular, we assume that it shifts to the right by enough thatat the current level of inflation, the economy is once again on theupward-sloping portion of the AD

Thus, we have a crucial result.The zero lower bound eliminates a key force that usually helps tokeep the economy stable.When the economy is functioning normally, below-normal outputcauses inflation to fall, leading the central bank to cut the realinterest rate and push output back toward normal.At the zero lower bound, however, falls in inflation lead not tocuts but to rises in the real interest rate.As a result, they are destabilizing rather than stabilizing.A premise of our example is that the shift of the IS curve is notpermanent.At some point,it shifts back to the right.In particular, we assume that it shifts to the right by enough thatat the current level of inflation, the economy is once again on theupward-sloping portion of the AD

POLICY

Fiscal policy: shift IS to the right

Lower other interest rates – promote C and I and shift IS to theright

POLICY

Fiscal policy: shift IS to the rightLower other interest rates – promote C and I and shift IS to theright

Raise expected inflation:

1 the increase in expected inflation is reducing the real cost ofborrowing

2 the fact that expected inflation is higher means that businessesand households believe that the dollars with which they willrepay loans will be less valuable

3 this reduction in the real interest rate stimulates demand.

Policies to raise expected inflation create an important tension:

1 What matters for behavior today is expectations of futureinflation.

2 Thus when the central bank finds itself in a liquidity trap, it maywant firms and households to believe that inflation will be higherin the future.

3 But when the future arrives, what inflation actually turns out to becannot influence decisions that were made earlier.

4 Thus if the central bank dislikes inflation, it will be tempted to notproduce the high inflation it had said it would.

5 But if firms and households recognize this temptation, they maynot believe the central bank’s original statements that futureinflation will be high.

6 In other words, statements about future inflation may not becredible, and so may be ineffective.

Statements about Future Interest Rates:

Since ultimately the central bank influences expectations bychanging people’s views about future interest rates,A straightforward way to try to affect expectations is by makingstatements about future interest rates.This was central to the Federal Reserve’s strategy once it broughtthe short-term, safe interest rate down to almost zero late 2008.

Statements about Future Interest Rates:Since ultimately the central bank influences expectations bychanging people’s views about future interest rates,

A straightforward way to try to affect expectations is by makingstatements about future interest rates.This was central to the Federal Reserve’s strategy once it broughtthe short-term, safe interest rate down to almost zero late 2008.

Statements about Future Interest Rates:Since ultimately the central bank influences expectations bychanging people’s views about future interest rates,A straightforward way to try to affect expectations is by makingstatements about future interest rates.

This was central to the Federal Reserve’s strategy once it broughtthe short-term, safe interest rate down to almost zero late 2008.

Statements about Future Interest Rates:Since ultimately the central bank influences expectations bychanging people’s views about future interest rates,A straightforward way to try to affect expectations is by makingstatements about future interest rates.This was central to the Federal Reserve’s strategy once it broughtthe short-term, safe interest rate down to almost zero late 2008.

Unfortunately, such statements may have little impact onexpected inflation. There are two problems.

First, the various statements seem to say that if the FederalReserve followed its usual policies, it would want low interestrates for a long time.In terms of our model, this seems to describe not a change in itsinterest rate rule in the future, but a prediction about what itsexisting rule would call for in the future.There is no evident reason that such a prediction would raiseexpected inflation.Indeed, the Federal Reserve’s pessimistic predictions about futureeconomic conditions could lead economic actors to lower theirexpectations of inflation.

Unfortunately, such statements may have little impact onexpected inflation. There are two problems.First, the various statements seem to say that if the FederalReserve followed its usual policies, it would want low interestrates for a long time.

In terms of our model, this seems to describe not a change in itsinterest rate rule in the future, but a prediction about what itsexisting rule would call for in the future.There is no evident reason that such a prediction would raiseexpected inflation.Indeed, the Federal Reserve’s pessimistic predictions about futureeconomic conditions could lead economic actors to lower theirexpectations of inflation.

Unfortunately, such statements may have little impact onexpected inflation. There are two problems.First, the various statements seem to say that if the FederalReserve followed its usual policies, it would want low interestrates for a long time.In terms of our model, this seems to describe not a change in itsinterest rate rule in the future, but a prediction about what itsexisting rule would call for in the future.

There is no evident reason that such a prediction would raiseexpected inflation.Indeed, the Federal Reserve’s pessimistic predictions about futureeconomic conditions could lead economic actors to lower theirexpectations of inflation.

Unfortunately, such statements may have little impact onexpected inflation. There are two problems.First, the various statements seem to say that if the FederalReserve followed its usual policies, it would want low interestrates for a long time.In terms of our model, this seems to describe not a change in itsinterest rate rule in the future, but a prediction about what itsexisting rule would call for in the future.There is no evident reason that such a prediction would raiseexpected inflation.

Indeed, the Federal Reserve’s pessimistic predictions about futureeconomic conditions could lead economic actors to lower theirexpectations of inflation.

Unfortunately, such statements may have little impact onexpected inflation. There are two problems.First, the various statements seem to say that if the FederalReserve followed its usual policies, it would want low interestrates for a long time.In terms of our model, this seems to describe not a change in itsinterest rate rule in the future, but a prediction about what itsexisting rule would call for in the future.There is no evident reason that such a prediction would raiseexpected inflation.Indeed, the Federal Reserve’s pessimistic predictions about futureeconomic conditions could lead economic actors to lower theirexpectations of inflation.

The second problem is that because the statements only makepredictions and offer no commitments, they do little to overcomethe credibility problem.

That is, they create no noticeable cost to raising interest rates inthe future, and thus provide businesses and households with littlereason to be confident that the Federal Reserve will actuallychange its behavior once the economy recovers.

The second problem is that because the statements only makepredictions and offer no commitments, they do little to overcomethe credibility problem.That is, they create no noticeable cost to raising interest rates inthe future, and thus provide businesses and households with littlereason to be confident that the Federal Reserve will actuallychange its behavior once the economy recovers.

Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations...

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1 The full dynamic short-run model Chairman Bernanke J. M. Keynes.