The Objectives of Monetary Policy Low, stable inflation Unstable inflation Adds to the risk of lending and borrowing Interferes with long-run financial

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The Objectives of Monetary Policy

• Low, stable inflation • Unstable inflation

• Adds to the risk of lending and borrowing• Interferes with long-run financial planning

• Surveys• People associate high rates of inflation with a

general breakdown of government and the economy

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• Full employment• The absence of cyclical unemployment

• Concerns about cyclical unemployment• Its opportunity cost

• The output that the unemployed could have produced if they were working

• Represents a social failure• Can cause significant hardship


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• Natural rate of unemployment• Unemployment rate when there is no cyclical

unemployment• When unemployment rate < natural rate

• GDP is greater than potential output• Economy’s self-correcting mechanism

• Will then create inflation


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• When unemployment rate > natural rate• GDP is below potential output• Economy’s self-correcting mechanism

• Will then put downward pressure on the price level


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Figure 1: The Fed’s Performance: 1950 to Mid-2006


Annual inflation rate—percent rise in December CPI-U from previous December. Data for 2009 is annualized through August 2009.

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Figure 1: The Fed’s Performance: 1950 to Mid-2006


Unemployment rate—average of monthly rates for each year. Data for 2009 is averaged through August 2009.

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Federal Reserve Policy: Theory and Practice

• Simplifying assumption• The Fed’s goal for the inflation rate is zero

• Responding to demand shocks• Maintaining the money supply• Maintaining the interest rate• Neutralizing the shock


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• Fully employed economy• Experiences a positive demand shock• And Fed’s policy is : constant money supply• Then:

• Output will overshoot its potential• Price level will rise in the short run• Price level will rise further in the long run


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PriceLevel

Real GDP$ Trillions

(b)Interest Rate

Money

(a)

Figure 2: A positive demand shock with a constant money supply


M1d

7%

MS

5% AM2

d

B

A positive demand shock would shift the AD curve rightward to AD2 in panel (b), causing both the price level and output to rise. If the Fed maintains a constant money supply, the rise in the price level causes the money demand curve to shift to M2

d in panel (a), driving the interest rate up from 5% to 7%. A higher interest rate causes some crowding out of consumption and investment spending, but not complete crowding out. In panel (b), output ends up higher than initially, and the price level rises as well (point H).

AS

110

10.0

100

11.5 12.5

AD1

E

AD2

H

F

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• Fully employed economy• Experiences a positive demand shock• And Fed’s policy is: constant interest rate• Then:

• An even greater overshooting of potential output than a constant money supply

• An even greater rise in the price level


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Figure 3: A positive demand shock with a constant interest rate


PriceLevel

Real GDP $ trillions

(b)Interest Rate

Money

(a)

M1d

M1S

5% A

M2d

A positive demand shock initially shifts the AD curve rightward to AD2 in panel (b), causing both the price level and output to rise. The rise in the price level shifts the money demand curve rightward to M2

d in panel (a), which would ordinarily cause the interest rate to rise. But if the Fed maintains a constant interest rate target, it will increase the money supply to prevent any rise in the interest rate. There will be no crowding out of consumption or investment spending, so the AD curve in panel (b) shifts further rightward (to AD3). As a result, the economy ends up at point J, with output and the price level rising by more than under a constant-money-supply policy.

AS

130

10.0

100

12.5

AD1

E

AD2

AD3

M2S

C

J

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• Fully employed economy• Experiences a demand shock• Fed’s best policy is: neutralization

• Prevent any shift in AD at all• Fed must change its interest rate target

• A positive demand shock • Requires an increase in the target

• A negative demand shock • Requires a decrease in the target


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Figure 4: A positive demand shock neutralized by monetary policy


PriceLevel

Real GDP$ Trillions

(b)Interest Rate

Money

(a)

M1d

9%

M1S

5% A

A positive demand shock begins to shift the AD curve rightward in panel (b), which would ordinarily cause both the price level and output to rise. But the Fed can neutralize the shock by increasing its interest rate target enough to cause complete crowding out of consumption and investment spending. To reach the new, higher interest rate target, the Fed must decrease the money supply in panel (a), moving the money market equilibrium to a point like . This reverses (or prevents) the shift in the AD curve, so the economy ends up at point in panel (b), at its initial output and price level.

AS

10.0

100

AD1

E

M2S

D

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• Responding to supply shocks - dilemma: • If the Fed tries to preserve price stability

• It will worsen unemployment• If the Fed tries to maintain high employment

• It will worsen inflation

• Even though supply shocks-usually temporary• The shocks themselves—and the Fed’s

response—can affect the economy for several quarters or even years


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Figure 5: Responding to Supply Shocks


PriceLevel

Real GDP

AS2

YFE

P1

Starting at point E, a negative supply shock shifts the AS curve upward to AS2. With a constant money supply, a new short-run equilibrium would be established at point R, with a higher price level ( P2 ) and a lower level of output ( Y2 ). The Fed could prevent inflation by decreasing the money supply and shifting AD to ADno inflation, but output would fall to Y3. At the other extreme, it could increase the money supply and shift the AD curve to ADno recession. This would keep output atthe full-employment level, but at the cost of a higher price level, P3.

AD1

Y2

P2

R

AS1

P3

E

ADno recession

ADno inflation

Y3

T

V

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• A negative supply shock • The Fed - short-run tradeoff:

• It can limit the recession, but only at the cost of more inflation

• It can limit inflation, but only at the cost of a deeper recession


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Expectations and Ongoing Inflation

• U.S. economy • Characterized by ongoing inflation• Even though the economy was at full

employment• Prices were continually rising

• Even when the unemployment rate is above its natural rate• Prices keep rising


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• How ongoing inflation arises• 1960s: positive demand shocks• The Fed: maintain a low interest rate target

• When inflation continues for some time• The public develops expectations that the

inflation rate in the future will be similar to the inflation rates of the recent past


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• A continuing, stable rate of inflation • Gets built into the economy• The built-in rate is usually the rate that has

existed for the past few years• Once there is built-in inflation

• The economy continues to generate inflation • Even after the self-correcting mechanism has

finally been allowed to do its job and bring us back to potential output


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• In an economy with built-in inflation• The AS curve will shift upward each year

• Even when output is at potential and unemployment is at its natural rate

• The upward shift of the AS curve will equal the built-in rate of inflation

• In the short run • The Fed can reduce the rate of inflation below

the built-in rate• But only at the cost of creating a recession


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Figure 6: Long-Run Equilibrium with Built-In Inflation


PriceLevel

Real GDP

AS2

YFE

P1

During the year, the aggregate supply curve shifts upward by the built-in rate of inflation. To keep the economy at full employment, the Fed shifts the AD curve rightward by increasing the money supply.AD1

AS1

P2

A

AD2

B

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• Phillips curve • A curve indicating the Fed’s choices between

inflation and unemployment in the short run• In the short run

• The Fed can move along the Phillips curve • By adjusting the rate at which the AD curve

shifts rightward


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Figure 7: The Phillips Curve


InflationRate

Unemployment RateU1

3%

PCbuilt-in inflation

= 6%

6%

F

E

UN

At E, the economy is in long-run equilibrium: unemployment at its natural rate (UN) and inflation at the built-in rate (6%).

To decrease the inflation rate to 3%, the Fed must accept higher unemployment (U1) in the short run.

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• The Fed • Moves the economy downward and rightward

along the Phillips curve• Unemployment rate increases• Inflation rate decreases

• A decrease in the inflation rate - long run• Lower built-in inflation rate• Phillips curve shifts downward


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Figure 8: The Phillips Curve Shifts Downward


InflationRate

Unemployment Rate

U1

3%


= 6%

6%

F

E

UN

Initially, the economy is at point E, with inflation equal to the built-in rate of 6%. If the Fed moves the economy to point F and keeps it there for some time, the public will eventually come to expect 3% inflation in the future. The built-in inflation rate will fall and the Phillips curve will shift downward to PC built-in

inflation=3%. The economy will move to point G in the long run, with unemployment at the natural rate and an actual inflation rate equal to the built-in rate of 3%.


= 3%

G

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• An increase in the inflation rate - long run• Higher built-in inflation rate• Phillips curve shifts upward

• Short run: tradeoff between inflation and unemployment• Lower unemployment

• At the cost of higher inflation• Lower inflation

• At the cost of higher unemployment


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Figure 9: The Phillips Curve Shifts Upward


InflationRate

Unemployment Rate

U2

6%


= 6%

9%H

E

UN

Initially, the economy is at point E, with inflation equal to the built-in rate of 6%. If the Fed moves the economy to point H and keeps it there for some time, the public will eventually come to expect 9% inflation in the future. The built-in inflation rate will rise and the Phillips curve will shift upward to PCbuilt-in inflation=9%. The economy will move to point J in the long run, with unemployment at the natural rate and an actual inflation rate equal to the built-in rate of 9%.


= 9%

J

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• Long run• Unemployment always returns to its natural

rate• No tradeoff

• Long-run Phillips curve• A vertical line • In the long run, unemployment must equal its

natural rate• Regardless of the rate of inflation


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Figure 10: The Long-Run Phillips Curve


InflationRate

Unemployment Rate

U1

3% PCbuilt-in inflation

= 6%

6%E

UN

The vertical line is the economy’s long-run Phillips curve, showing all combinations of unemployment and inflation the Fed can choose in the long run. The curve is vertical because in the long run, the unemployment rate must equal the natural rate. Starting at point E with 6% inflation, the Fed can choose unemployment at the natural rate with either a higher rate of inflation (point J ) or a lower rate of inflation (point G ). But points off of the vertical line are not sustainable in the long run.


= 3%

G


= 9%

U2

9%

F

H J

Long-Run Phillips Curve

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• The Fed• Tolerated measured inflation at 2 to 3% per

year • Because - true rate of inflation is lower• Because - low rates of inflation may help labor

markets adjust more easily


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Challenges for Monetary Policy

• Information problems• Changing and uncertain time lags

• Policies meant to stabilize the economy could instead destabilize it

• Uncertainty about natural rate of unemployment• Can create a period of higher-than-necessary

unemployment, or higher-than-desired inflation


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• Rules versus discretion• Following a rule could help the Fed manage

inflationary expectations• Make it easier to take actions

• Beneficial in the long run• Unpopular in the short run

• Taylor rule – proposed rule:• Require the Fed to change the interest rate

• By a specified amount • When real GDP or inflation deviates from target


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• Avoiding deflation• Expected deflation

• Creates a positive lower bound for the real federal funds rate = expected rate of deflation

• If the Fed wants to reduce real interest rates below that lower bound• It will have to use unconventional tools


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Should the Fed prevent (or pop) asset bubbles?• Argument for popping bubbles before they go

too far:• After each bubble: a rapid decline in wealth

relative to GDP• Fed chairs - argued against aggressive

intervention:• Trying to stop bubbles in their early stages has

high costs and doubtful benefits


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Figure 11: Household net worth as percentage of annual GDP, 1945–2009


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Should the Fed prevent (or pop) asset bubbles?• Reasons for not popping bubbles:

• Difficult to identify a bubble in advance• How would the Fed burst the bubble?

• Intervene in specific markets – leads to political pressure and threats to the Fed’s independence

• Raising the federal funds rate – will drive up all interest rates

• Not clear that the Fed could control a bubble• Because overly-optimistic investors might not

respond


Documents

The Objectives of Monetary Policy Low, stable inflation Unstable inflation Adds to the risk of lending and borrowing Interferes with long-run financial