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Chapter 14

Chapter 14. The Challenges of Monetary Policy. The goals of monetary policy , including economic growth, stable prices, full employment, and satisfactory external balance The source of numerical objectives for unemployment and inflation Changes in aggregate demand and policy

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Chapter 14

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  1. Chapter 14 The Challenges of Monetary Policy

  2. The goals of monetary policy, including economic growth, stable prices, full employment, and satisfactory external balance • The source of numerical objectives for unemployment and inflation • Changes in aggregate demand and policy • Changes in aggregate supply and policy

  3. The Goals of Monetary Policy • Macroeconomic policy consists of • monetary policy • the Fed’s use of its policy instruments to affect the cost and availability of funds in the economy • fiscal policy • alterations in government spending or taxes proposed and enacted by Congress and the President

  4. The Goals of Monetary Policy • In conducting monetary policy, the Fed works through the financial system • the Fed’s primary tools include control of the monetary base, the required reserve ratio and the discount rate • Monetary policy affects the borrowing, lending, spending, and saving decisions of households, business firms, the government, and the rest of the world

  5. The Goals of Monetary Policy • The specific goals of monetary policy are to design and implement policies that will achieve • sustainable economic growth • full employment • stable prices • a satisfactory external balance

  6. Long Run Sustainable Economic Growth determined by the growth and productivity of labor and capital Full Employment Stable Prices Satisfactory External Balance compatible with full employment and stable prices The Goals of Monetary Policy Short Run Achieving these goals in the short run helps to achieve maximum sustainable economic growth in the long run

  7. Economic Growth • If the nation’s standard of living is to rise over time, the productive capacity of the economy must expand • growth of the capital stock • growth of the labor force • a rise in productivity

  8. Economic Growth • The growth of the capital depends on the amount of investment spending undertaken by firms • the change in the capital stock (股本）= net investment spending • The productivity of capital is related to the amount of resources devoted to research and development and on the resulting technological advances

  9. Economic Growth • The growth of the labor supply flows from the growth of the population and from increases in labor force participation rates • The productivity of labor is thought to depend on the educational attainment and health of workers, the quantity and quality of capital available, and the competitive environment faced by firms and workers

  10. Economic Growth • In general, a thriving nation’s productive capacity grows over time • Macroeconomic policy influences the pace in a number of ways • tax policy can affect a firm’s desire to invest or engage in research and development, and can affect a household’s decision to work and save • interest rates also influence spending and saving decisions

  11. Economic Growth • A stable environment will also be more conducive to farsighted planning and decision making that enhance an economy’s long-run growth potential • high rates of capacity utilization and employment • output growing at a steady, sustainable rate

  12. LRAS' LRAS'' B C AD' AD'' $4,120 $4,244 Steady Noninflationary Growth Price Level LRAS A 1.00 AD $4,000 Real GDP (in Billions)

  13. Economic Growth • An unstable environment characterized by a series of inflationary booms and deflationary recessions is likely to inhibit economic growth • aggregate demand grows faster or slower than aggregate supply

  14. LRAS LRAS' LRAS'' 1.10 D 1.05 AD'' A 1.00 AD' AD $4,120 $4,000 $4,244 Unstable Growth Price Level I Real GDP (in Billions)

  15. Economic Growth • Short-run stabilization objectives are not separate from the long run goal of economic growth • short-run fluctuations around the trend influence the trend itself

  16. Stabilization of Unemployment, Inflation and the External Balance • In order for our economic to reach its full potential, all individuals must have the opportunity to become productive, employed members of society • output that could have been produced last year by those unemployed is lost forever

  17. Stabilization of Unemployment, Inflation and the External Balance • To understand why policymakers worry about inflation, it is useful to distinguish between expected inflation and unexpected inflation • Suppose that households expect the inflation rate to be 3% next year • workers will try to secure wage increases of at least 3% • net lenders will also take this into account

  18. Stabilization of Unemployment, Inflation and the External Balance • Suppose that the inflation rate next year turns out to be 5% • the real wage of workers will fall • firms will wish to expand production because their output price is rising relative to input prices • the real return on financial assets will be less than anticipated

  19. Stabilization of Unemployment, Inflation and the External Balance • Unexpected inflation redistributes income in arbitrary and unpredictable ways • from workers to firms • from lenders to borrowers • from those on fixed incomes to those with variable incomes that rise with inflation

  20. Stabilization of Unemployment, Inflation and the External Balance • In addition, many firms and households will pay proportionately more in taxes in an inflationary environment

  21. Stabilization of Unemployment, Inflation and the External Balance • Suppose that a household earns 4% on its surplus funds, the household is in the 25% tax bracket, and expected and unexpected inflation is zero • Its real after-tax return is

  22. Stabilization of Unemployment, Inflation and the External Balance • Suppose that expected and unexpected inflation is 2% so the nominal interest rate rises to 6% • The household’s real after-tax return is now

  23. Stabilization of Unemployment, Inflation and the External Balance • Since nominal returns are taxed (rather than real returns) inflation results in the government taking a larger portion of interest income • Inflation also reduces the real value of nominal money balances held • inflation acts as a tax on money holdings

  24. Stabilization of Unemployment, Inflation and the External Balance • Researchers have also found that as the inflation rate rises, the variability（可变性）of inflation tends to increase • the relationship among relative prices becomes more volatile and difficult to predict • pricing, production, saving, and investment decisions have to be made in a more uncertain environment • firms and households will be more cautious in making long-term commitments

  25. Stabilization of Unemployment, Inflation and the External Balance • Inflation can also affect a nation’s international competitiveness • if prices of goods in the U.S. rise relative to the prices of competing goods in the rest of the world, the demand for U.S. products will fall • production and employment in the U.S. will decline • U.S. firms could lose a portion of their share of world markets

  26. Stabilization of Unemployment, Inflation and the External Balance • Policymakers should also be on the alert (警惕）for deflation • a falling overall price level • Deflation can be worse than inflation because it can lead to debt deflation, defaults, and bankruptcies

  27. Numerical Objectives for Unemployment and Inflation • General guidelines for policymakers are contained in two statutes • the Employment Act of 1946（第一项指导政策制定者追求充分就业和低通货膨胀的经济增长的法案） • the Humphrey-Hawkins Full Employment and Balanced Growth Act of 1978 （要求政策制定者追求充分就业和低通货膨胀的经济增长的法案）

  28. Numerical Objectives for Unemployment and Inflation • Both statutes direct policymakers to pursue policies that are consistent with achieving full employment and noninflationary growth • leaves it to policymakers to determine the rate of unemployment consistent with full employment and nonaccelerating inflation

  29. Numerical Objectives for Unemployment and Inflation • In the early years of the 21st century, most estimates of sustainable employment imply an unemployment rate of about 4.0 to 4.5% • this is often called the natural rate of unemployment 自然失业率：与稳定的物价指数一致的失业率； • this is believed to be the unemployment rate that is consistent with stable prices • this is the unemployment rate that corresponds to the natural rate of output

  30. Numerical Objectives for Unemployment and Inflation • Over time, policymakers desire price stability and often stress that this should be the primary objective of monetary policy • price stability means 0% inflation to some analysts and 1 to 2% inflation to others • economists worry that when the inflation rate is 0%, the economy could slip into a deflation

  31. Numerical Objectives for Unemployment and Inflation • In setting the inflation goal over the short term, policymakers consider recent experience and attempt to balance their desire to reduce inflation with their desire to minimize the accompanying adverse effects on unemployment and economic growth

  32. Numerical Objectives for Unemployment and Inflation • In the long run, the goals of stable prices and full employment are believed to be perfectly compatible • Based on American historical experience, the potential long-run growth rate for real GDP has been estimated to be between 2.5 to 3% per year

  33. Changes in Aggregate Demand and Policy • The obvious goals of monetary policy are to achieve successive long-run equilibriums with sustainable noninflationary growth • occurs if both aggregate demand and aggregate supply are shifting out at the same rate

  34. LRAS' LRAS'' B C AD' AD'' $4,120 $4,244 Steady Noninflationary Growth Price Level LRAS A 1.00 AD $4,000 Real GDP (in Billions)

  35. Changes in Aggregate Demand and Policy • Unfortunately, the economy may often fall short of achieving these goals • policymakers may need to react to changes or to initiate changes that guide the economy in the right direction

  36. Changes in Aggregate Demand and Policy • Suppose that the economy is currently in long-run equilibrium • the expected price level is equal to the actual price level • the economy is operating at its natural rate of output ($1,500 billion)

  37. An Unexpected Increase in Aggregate Demand with No Fed Response LRAS Price Level SRAS A 1.00 AD $1,500 Real GDP (in Billions)

  38. Changes in Aggregate Demand and Policy • Suppose that aggregate demand increases unexpectedly • In the short-run, the economy will move to point B • output rises to $1,700 billion • the price level rises to 1.05

  39. B 1.05 AD’ $1,700 An Unexpected Increase in Aggregate Demand with No Fed Response LRAS Price Level SRAS A 1.00 AD $1,500 Real GDP (in Billions)

  40. Changes in Aggregate Demand and Policy • As producers attempt to continue to expand output, input prices will rise • short-run aggregate supply will decrease • The economy will return to a new long-run equilibrium at point C • a higher price level • no change in output

  41. SRAS’ C 1.10 B 1.05 AD’ $1,700 An Unexpected Increase in Aggregate Demand with No Fed Response LRAS Price Level SRAS A 1.00 AD $1,500 Real GDP (in Billions)

  42. Changes in Aggregate Demand and Policy • Policymakers could intervene and act to reduce aggregate demand • tighter monetary policy that reduces the growth rate of money and credit and raises interest rates • slower government spending or an increase in taxes

  43. Changes in Aggregate Demand and Policy • In either case, the level of spending and aggregate demand would be reduced • the economy would then return to long-run equilibrium at a lower price level • the economy moves from point A to point B and then back to point A

  44. B 1.05 AD’ $1,700 Possible Policymaker Response to an Unexpected Rise in Aggregate Demand LRAS Price Level SRAS A 1.00 AD $1,500 Real GDP (in Billions)

  45. Demand-Induced Recession • The initial effect of an unexpected decline in aggregate demand is an unanticipated rise in inventories • in response, business firms will cut production, employment, and prices • output prices tend to fall relative to input prices

  46. Demand-Induced Recession • Once again, suppose the economy is initially in long-run equilibrium • the expected price level is equal to the actual price level • the economy is operating at its natural rate of output • Aggregate demand unexpectedly declines • the economy moves from point A to point B • output and the price level both fall

  47. Demand-Induced Recession • The economy can take two possible paths back to long-run equilibrium • input prices can decline since the actual price level is lower than the expected price level • the short-run aggregate supply curve shifts right • the economy moves from point A to point B to point C • policymakers can boost aggregate demand • the economy moves from point A to point B and back to point A

  48. 0.95 B AD' Demand-Induced Recession Price Level LRAS SRAS A 1.00 AD Real GDP (in Billions)

  49. SRAS’ 0.95 B C 0.90 AD' Demand-Induced Recession Price Level LRAS SRAS A 1.00 AD Real GDP (in Billions)

  50. 0.95 B AD' Demand-Induced Recession Price Level LRAS SRAS A 1.00 AD Real GDP (in Billions)

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