Download - Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

Transcript
Page 1: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

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

Page 2: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

IS-MP MODEL

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

Y

r = a+ bπ + cY

r = r(π, Y)+

(2)

ROMER (JAN 2013) () JANUARY 9, 2014 2 / 28

Page 3: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

IS-MP MODEL

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

Y

r = a+ bπ + cY

r = r(π, Y)+

(2)

ROMER (JAN 2013) () JANUARY 9, 2014 2 / 28

Page 4: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

IS-MP MODEL

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

Y

r = a+ bπ + cY

r = r(π, Y)+

(2)

ROMER (JAN 2013) () JANUARY 9, 2014 2 / 28

Page 5: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

IS-MP MODEL

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

Y

r = a+ bπ + cY

r = r(π, Y)+

(2)

ROMER (JAN 2013) () JANUARY 9, 2014 2 / 28

Page 6: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

IS-MP MODEL

ROMER (JAN 2013) () JANUARY 9, 2014 3 / 28

Page 7: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

IS-MP MODEL

MECHANISM

Money market in initial equilibrium

M0

P0= L(i0, Y0)

= L(r0 + πe0, Y0)

Now M0 rises to M1

Thus P and πe rise so

M1

P1> L(r0 + πe

1, Y0)

ROMER (JAN 2013) () JANUARY 9, 2014 4 / 28

Page 8: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

IS-MP MODEL

MECHANISM

Money market in initial equilibrium

M0

P0= L(i0, Y0)

= L(r0 + πe0, Y0)

Now M0 rises to M1

Thus P and πe rise so

M1

P1> L(r0 + πe

1, Y0)

ROMER (JAN 2013) () JANUARY 9, 2014 4 / 28

Page 9: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

IS-MP MODEL

MECHANISM

Money market in initial equilibrium

M0

P0= L(i0, Y0)

= L(r0 + πe0, Y0)

Now M0 rises to M1

Thus P and πe rise so

M1

P1> L(r0 + πe

1, Y0)

ROMER (JAN 2013) () JANUARY 9, 2014 4 / 28

Page 10: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

IS-MP MODEL

MECHANISM

Money market in initial equilibrium

M0

P0= L(i0, Y0)

= L(r0 + πe0, Y0)

Now M0 rises to M1

Thus P and πe rise so

M1

P1> L(r0 + πe

1, Y0)

ROMER (JAN 2013) () JANUARY 9, 2014 4 / 28

Page 11: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

IS-MP MODEL

MECHANISM

Money market in initial equilibrium

M0

P0= L(i0, Y0)

= L(r0 + πe0, Y0)

Now M0 rises to M1

Thus P and πe rise so

M1

P1> L(r0 + πe

1, Y0)

ROMER (JAN 2013) () JANUARY 9, 2014 4 / 28

Page 12: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

IS-MP MODEL

For equilibrium r falls and/or Y rises according to

ROMER (JAN 2013) () JANUARY 9, 2014 5 / 28

Page 13: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

IS-MP MODEL

For equilibrium r falls and/or Y rises according to

ROMER (JAN 2013) () JANUARY 9, 2014 5 / 28

Page 14: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

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.

ROMER (JAN 2013) () JANUARY 9, 2014 6 / 28

Page 15: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

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.

ROMER (JAN 2013) () JANUARY 9, 2014 6 / 28

Page 16: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

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.

ROMER (JAN 2013) () JANUARY 9, 2014 6 / 28

Page 17: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

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.

ROMER (JAN 2013) () JANUARY 9, 2014 6 / 28

Page 18: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

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.

ROMER (JAN 2013) () JANUARY 9, 2014 6 / 28

Page 19: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

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.

ROMER (JAN 2013) () JANUARY 9, 2014 6 / 28

Page 20: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

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.

ROMER (JAN 2013) () JANUARY 9, 2014 6 / 28

Page 21: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

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

ROMER (JAN 2013) () JANUARY 9, 2014 7 / 28

Page 22: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

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

ROMER (JAN 2013) () JANUARY 9, 2014 7 / 28

Page 23: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

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.

ROMER (JAN 2013) () JANUARY 9, 2014 8 / 28

Page 24: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

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.

ROMER (JAN 2013) () JANUARY 9, 2014 8 / 28

Page 25: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

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.

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

Page 26: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

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.

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

Page 27: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

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.

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

Page 28: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

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.

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

Page 29: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

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.

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

Page 30: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

AD-IA MODEL

MECHANISM

ROMER (JAN 2013) () JANUARY 9, 2014 10 / 28

Page 31: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

AD-IA MODEL

LONG RUN EQUILBRIUM

ROMER (JAN 2013) () JANUARY 9, 2014 11 / 28

Page 32: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

ZERO LOWER BOUND (ZLB)

IS-MP MODEL

IS as usual

Now Taylor Rule behavior is

r =

(r(π, Y)

+, if r+πe � 0

0� πe, otherwise(3)

We shall formulate expectations as given by

πe = πe(π) (4)

ROMER (JAN 2013) () JANUARY 9, 2014 12 / 28

Page 33: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

ZERO LOWER BOUND (ZLB)

IS-MP MODEL

IS as usualNow Taylor Rule behavior is

r =

(r(π, Y)

+, if r+πe � 0

0� πe, otherwise(3)

We shall formulate expectations as given by

πe = πe(π) (4)

ROMER (JAN 2013) () JANUARY 9, 2014 12 / 28

Page 34: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

ZERO LOWER BOUND (ZLB)

IS-MP MODEL

IS as usualNow Taylor Rule behavior is

r =

(r(π, Y)

+, if r+πe � 0

0� πe, otherwise(3)

We shall formulate expectations as given by

πe = πe(π) (4)

ROMER (JAN 2013) () JANUARY 9, 2014 12 / 28

Page 35: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

ZERO LOWER BOUND (ZLB)

IS-MP MODEL

IS as usualNow Taylor Rule behavior is

r =

(r(π, Y)

+, if r+πe � 0

0� πe, otherwise(3)

We shall formulate expectations as given by

πe = πe(π) (4)

ROMER (JAN 2013) () JANUARY 9, 2014 12 / 28

Page 36: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

ZERO LOWER BOUND (ZLB)

IS-MP MODEL

IS as usualNow Taylor Rule behavior is

r =

(r(π, Y)

+, if r+πe � 0

0� πe, otherwise(3)

We shall formulate expectations as given by

πe = πe(π) (4)

ROMER (JAN 2013) () JANUARY 9, 2014 12 / 28

Page 37: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

ZERO LOWER BOUND (ZLB)

ROMER (JAN 2013) () JANUARY 9, 2014 13 / 28

Page 38: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

ZERO LOWER BOUND (ZLB)

Changes in inflation:

ROMER (JAN 2013) () JANUARY 9, 2014 14 / 28

Page 39: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

ZERO LOWER BOUND (ZLB)

AD CURVE IN ZLB

One part downward sloping as usual - above ZLB

ROMER (JAN 2013) () JANUARY 9, 2014 15 / 28

Page 40: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

ZERO LOWER BOUND (ZLB)

AD CURVE IN ZLB

One part downward sloping as usual - above ZLB

ROMER (JAN 2013) () JANUARY 9, 2014 15 / 28

Page 41: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

ZERO LOWER BOUND (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.

ROMER (JAN 2013) () JANUARY 9, 2014 16 / 28

Page 42: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

ZERO LOWER BOUND (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.

ROMER (JAN 2013) () JANUARY 9, 2014 16 / 28

Page 43: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

ZERO LOWER BOUND (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.

ROMER (JAN 2013) () JANUARY 9, 2014 16 / 28

Page 44: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

ZERO LOWER BOUND (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.

ROMER (JAN 2013) () JANUARY 9, 2014 16 / 28

Page 45: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

ZERO LOWER BOUND (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.

ROMER (JAN 2013) () JANUARY 9, 2014 16 / 28

Page 46: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

ZERO LOWER BOUND (ZLB)

ROMER (JAN 2013) () JANUARY 9, 2014 17 / 28

Page 47: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

ZERO LOWER BOUND (ZLB)

ROMER (JAN 2013) () JANUARY 9, 2014 18 / 28

Page 48: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

ZERO LOWER BOUND (ZLB)

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

ROMER (JAN 2013) () JANUARY 9, 2014 19 / 28

Page 49: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

ZERO LOWER BOUND (ZLB)

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.

ROMER (JAN 2013) () JANUARY 9, 2014 20 / 28

Page 50: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

ZERO LOWER BOUND (ZLB)

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.

ROMER (JAN 2013) () JANUARY 9, 2014 20 / 28

Page 51: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

ZERO LOWER BOUND (ZLB)

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.

ROMER (JAN 2013) () JANUARY 9, 2014 20 / 28

Page 52: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

ZERO LOWER BOUND (ZLB)

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.

ROMER (JAN 2013) () JANUARY 9, 2014 20 / 28

Page 53: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

ZERO LOWER BOUND (ZLB)

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.

ROMER (JAN 2013) () JANUARY 9, 2014 20 / 28

Page 54: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

ZERO LOWER BOUND (ZLB)

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.

ROMER (JAN 2013) () JANUARY 9, 2014 20 / 28

Page 55: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

ZERO LOWER BOUND (ZLB)

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.

ROMER (JAN 2013) () JANUARY 9, 2014 20 / 28

Page 56: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

ZERO LOWER BOUND (ZLB)

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.

ROMER (JAN 2013) () JANUARY 9, 2014 20 / 28

Page 57: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

ZERO LOWER BOUND (ZLB)

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.

ROMER (JAN 2013) () JANUARY 9, 2014 20 / 28

Page 58: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

ZERO LOWER BOUND (ZLB)

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.

ROMER (JAN 2013) () JANUARY 9, 2014 20 / 28

Page 59: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

ZERO LOWER BOUND (ZLB)

ROMER (JAN 2013) () JANUARY 9, 2014 21 / 28

Page 60: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

ZERO LOWER BOUND (ZLB)

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

ROMER (JAN 2013) () JANUARY 9, 2014 22 / 28

Page 61: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

ZERO LOWER BOUND (ZLB)

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

ROMER (JAN 2013) () JANUARY 9, 2014 22 / 28

Page 62: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

ZERO LOWER BOUND (ZLB)

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

ROMER (JAN 2013) () JANUARY 9, 2014 22 / 28

Page 63: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

ZERO LOWER BOUND (ZLB)

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

ROMER (JAN 2013) () JANUARY 9, 2014 22 / 28

Page 64: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

ZERO LOWER BOUND (ZLB)

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

ROMER (JAN 2013) () JANUARY 9, 2014 22 / 28

Page 65: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

ZERO LOWER BOUND (ZLB)

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

ROMER (JAN 2013) () JANUARY 9, 2014 22 / 28

Page 66: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

ZERO LOWER BOUND (ZLB)

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

ROMER (JAN 2013) () JANUARY 9, 2014 22 / 28

Page 67: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

ZERO LOWER BOUND (ZLB)

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

ROMER (JAN 2013) () JANUARY 9, 2014 22 / 28

Page 68: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

ZERO LOWER BOUND (ZLB)

POLICY

Fiscal policy: shift IS to the right

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

ROMER (JAN 2013) () JANUARY 9, 2014 23 / 28

Page 69: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

ZERO LOWER BOUND (ZLB)

POLICY

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

ROMER (JAN 2013) () JANUARY 9, 2014 23 / 28

Page 70: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

ZERO LOWER BOUND (ZLB)

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.

ROMER (JAN 2013) () JANUARY 9, 2014 24 / 28

Page 71: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

ZERO LOWER BOUND (ZLB)

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.

ROMER (JAN 2013) () JANUARY 9, 2014 24 / 28

Page 72: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

ZERO LOWER BOUND (ZLB)

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.

ROMER (JAN 2013) () JANUARY 9, 2014 24 / 28

Page 73: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

ZERO LOWER BOUND (ZLB)

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.

ROMER (JAN 2013) () JANUARY 9, 2014 24 / 28

Page 74: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

ZERO LOWER BOUND (ZLB)

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.

ROMER (JAN 2013) () JANUARY 9, 2014 25 / 28

Page 75: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

ZERO LOWER BOUND (ZLB)

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.

ROMER (JAN 2013) () JANUARY 9, 2014 25 / 28

Page 76: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

ZERO LOWER BOUND (ZLB)

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.

ROMER (JAN 2013) () JANUARY 9, 2014 25 / 28

Page 77: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

ZERO LOWER BOUND (ZLB)

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.

ROMER (JAN 2013) () JANUARY 9, 2014 25 / 28

Page 78: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

ZERO LOWER BOUND (ZLB)

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.

ROMER (JAN 2013) () JANUARY 9, 2014 25 / 28

Page 79: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

ZERO LOWER BOUND (ZLB)

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.

ROMER (JAN 2013) () JANUARY 9, 2014 25 / 28

Page 80: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

ZERO LOWER BOUND (ZLB)

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.

ROMER (JAN 2013) () JANUARY 9, 2014 25 / 28

Page 81: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

ZERO LOWER BOUND (ZLB)

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.

ROMER (JAN 2013) () JANUARY 9, 2014 26 / 28

Page 82: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

ZERO LOWER BOUND (ZLB)

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.

ROMER (JAN 2013) () JANUARY 9, 2014 26 / 28

Page 83: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

ZERO LOWER BOUND (ZLB)

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.

ROMER (JAN 2013) () JANUARY 9, 2014 26 / 28

Page 84: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

ZERO LOWER BOUND (ZLB)

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.

ROMER (JAN 2013) () JANUARY 9, 2014 26 / 28

Page 85: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

ZERO LOWER BOUND (ZLB)

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.

ROMER (JAN 2013) () JANUARY 9, 2014 27 / 28

Page 86: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

ZERO LOWER BOUND (ZLB)

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.

ROMER (JAN 2013) () JANUARY 9, 2014 27 / 28

Page 87: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

ZERO LOWER BOUND (ZLB)

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.

ROMER (JAN 2013) () JANUARY 9, 2014 27 / 28

Page 88: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

ZERO LOWER BOUND (ZLB)

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.

ROMER (JAN 2013) () JANUARY 9, 2014 27 / 28

Page 89: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

ZERO LOWER BOUND (ZLB)

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.

ROMER (JAN 2013) () JANUARY 9, 2014 27 / 28

Page 90: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

ZERO LOWER BOUND (ZLB)

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.

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

Page 91: Short Run Fluctuations David Romer University of ...yashiv/romer2013b.pdf · Short Run Fluctuations David Romer University of California, Berkeley January 2013 Notes by Eran Yashiv,

ZERO LOWER BOUND (ZLB)

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.

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