# Money and Banking

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Lesson 41
DERIVING THE MONETARY POLICY REACTION CURVE
To ensure that deviations of inflation from the target are only temporary, monetary
policymakers respond to change in inflation by changing the real interest rate in the same
direction.
The monetary policy reaction curve is set so that when current inflation equals target
inflation, the real interest rate equals the long-run real interest rate.
The slope of the curve depends on policymakers' objectives;
When central bankers decide how aggressively to pursue their inflation target, and how
willing they are to tolerate temporary changes in inflation, they determine the slope of the
curve
Figure: The Monetary Policy Reaction Curve
A. The Monetary Policy Reaction Curve
Monetary policy makers react to changes in current inflation by changing the real interest rate.
Increases in current inflation lead them to raise the real interest rate, while decreases lead them to
lower it. The monetary policy reaction curve is located so that the central bank's target inflation is
consistent with the long-run real interest rate, which equates aggregate demand with potential
output.
Real interest
rate (r)
Monetary Policy
Reaction Curve
Long Run
Real Interest
Rate (r*)
Inflation ()
Target
Inflation (T)
B. Movements along the Monetary Policy Reaction Curve
The long run real interest rate in an economy is roughly 2.5% and the central bank's implicit
inflation target is approximately 2%. The monetary policy reaction curve implies that a 1%age
point increase in inflation calls for a half %age point increase in the real interest rate--- a
movement along the monetary policy reaction curve. That means that an increase in inflation
from 2 to 3 % calls for an increase in the real interest rate from 2.5 to 3 %.
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Real interest
r increases from
Monetary Policy
rate (r)
2.5% to 3%
Reaction Curve
3%
Long Run Real
Interest Rate
 Increases
(r*=2. 5%)
from 2% to
3%
Inflation ()
Target
3%
Inflation
(T=2%)
Shifting the Monetary Policy Reaction Curve
Policymakers who are aggressive in keeping current inflation near target will have a steep
curve, meaning that a small change in inflation will be met with a large change in the real
interest rate
A relatively flat curve means that central bankers are less concerned than they might be
with keeping current inflation near target over the short term.
The monetary policy reaction curve is set so that when current inflation equals target
inflation, the
Real interest rate equals the long-run real interest rate.
r = r* when  = T.
When policymakers adjust the real interest rate they are either moving along a fixed
monetary policy reaction curve or shifting the curve.
A movement along the curve is a reaction to a change in current inflation; a shift in the
curve represents a change in the level of the real interest rate at every level of inflation.
Figure A: Monetary Policy Reaction Curve
Real Interest
Monetary
policy
rate (r)
reaction curve of a
central bank that is
aggressive in keeping
Long Run Real
current inflation close
Interest Rate (r*)
to its target in the
short run
Inflation ()
Target Inflation
(T)
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Figure B: Monetary Policy Reaction Curve
Real Interest
rate (r )
Monetary
Policy
Reaction Curve of a
central bank that is
Long run real
keeping
current
interest rate (r*)
inflation
near
its
target in the short run
Inflation ()
Target
If either target inflation or theIlolagi-on nreal interest rate change, then the entire curve will
n t ru ( T)
nf
shift
With a higher inflation target, the central bank will set a lower current real interest rate at
every level of current inflation, shifting the monetary policy reaction curve to the right (a
reduction would have the opposite effect).
Figure A: An increase in the Central Bank's Inflation Target
An increase in the central bank's inflation target from an initial level of o to the new
level of 1 shifts the monetary policy reaction curve to the right, lowering the real
interest rate at every level of current inflation.
Real Interest
Old
New
Rate (r)
Long Run Real
Interest Rate
(r*)
New Target
Inflation (1)
Inflation ()
Initial Target
Inflation (o)
The long-run real interest rate is determined by the structure of the economy;
If it were to rise as a result of an increase in government purchases (or some other
component of aggregate demand that is not sensitive to the real interest rate) then the
monetary policy reaction curve would shift left
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Figure B: An increase in the Long-run real interest rate
An increase in the economy's long run real interest rate from ro
to r1 shifts the monetary policy reaction curve to the left, raising
the real interest rate at every level of current inflation
Real interest rate
New
(r)
Old
New Long run
real interest rate
(r1)
Initial Long Run
real interest rate
(ro)
Inflation ()
Target Inflation
(T)
Any shift in the monetary policy reaction curve can be characterized as either a change in
target inflation or a shift in the long-run real interest rate
The Monetary Policy Reaction Curve
The relationship between current inflation and the real interest rate set by
What is it?
monetary policy makers
Drawn so that, when current inflation equals target inflation,
What determines its
policymakers will set the real interest rate equal to the long run real
location?
interest rate
Policymaker's attitude toward inflation. The more aggressive
What determines its
policymakers are in keeping current inflation close to target level, and
slope?
the less tolerant they are of temporary changes in inflation, the steeper
the slopes
In response to changes in either the long run real interest rate or the
When does it shift?
central bank's inflation target. An increase in the long run real interest
rate shifts the curve to the left. An increase in the inflation target shifts
the curve to the right.
The Aggregate Demand Curve
When current inflation rises
Monetary policymakers raise the real interest rate, moving upward along the monetary
policy reaction curve
The higher real interest rate reduces consumption, investment, and net exports causing
aggregate demand (output) to fall.
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The link between Current Inflation and Aggregate Demand
When current inflation rises , policy makers react by raising the real interest rate, which reduces
consumption, investment, and net exports. The result is a reduction in aggregate demand.
Real
Aggregate
Current
Interest
Demand
Inflation
Monetary Policy
Consumption,
Rate
Investment.
reacts by tightening
Net exports all
fall
Changes in current inflation move the economy along a downward-sloping aggregate demand
curve
This is in addition to the effect of higher inflation on real money balances noted earlier
The slope of the aggregate demand curve tells us how sensitive current output is to a given
change in current inflation.
The aggregate demand curve will be relatively
Flat if current output is very sensitive to inflation (a change in current inflation causes a large
movement in current output)
Steep if current output is not very sensitive to inflation
Figure A: When the monetary policy reaction curve is steep, the central bank is
aggressive in keeping current inflation near its target level, the aggressive demand curve
is flat.
Inflation ()
Flat Aggregate Demand
Output (Y)
Figure B: When the monetary policy reaction curve is flat, the central bank is less concerned
about keeping current inflation near its target level; the aggregate demand curve is steep.
Inflation ()
Steep Aggregate Demand
Output (Y)
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Three factors influence the sensitivity of current output to inflation:
The strength of the effect of inflation on real money balances,
The extent to which monetary policymakers react to a change in current inflation,
The size of the response of aggregate demand to changes in the interest rate
The second factor relates to the slope of the monetary policy reaction curve
If policymakers react aggressively to a movement of current inflation away from its
target level with a large change in the real interest rate, the monetary policy reaction
curve will be steep and the aggregate demand curve is flat
If policymakers respond more cautiously, the monetary policy reaction curve is flat and
the aggregate demand curve is steep
The slope of the aggregate demand curve depends in part on the preferences of the
central bank;
How aggressive policymakers are in responding to deviations of inflation from the
target level
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