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MONETARY POLICY

16. MONETARY POLICY. CHAPTER. Objectives. After studying this chapter, you will be able to Distinguish among the instruments, ultimate goals, and intermediate targets of monetary policy and review the Fed’s performance

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MONETARY POLICY

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  1. 16 MONETARY POLICY CHAPTER

  2. Objectives • After studying this chapter, you will be able to • Distinguish among the instruments, ultimate goals, and intermediate targets of monetary policy and review the Fed’s performance • Describe and compare the performance of a monetarist fixed rule and Keynesian feedback rules for monetary policy • Explain why the outcome of monetary policy crucially depends on the Fed’s credibility • Describe and compare the new monetarist and new Keynesian feedback rules for monetary policy

  3. What Can Monetary Policy Do? • In 2001, real GDP shrank and unemployment increased. • Alan Greenspan cut the interest rate to stimulate production and jobs. • Were these actions the right ones? • Can and should monetary policy try to counter recessions? • Or should monetary policy focus on price stability?

  4. Instruments, Goals, Targets, and the Fed’s Performance • To discuss monetary policy if we distinguish among: • Instruments • Goals • Intermediate targets

  5. Instruments, Goals, Targets, and the Fed’s Performance • The instruments of monetary policy are • Open market operations • The discount rate • Required reserve ratios • The goals of monetary policy are the Fed’s ultimate objectives and are • Price level stability • Sustainable real GDP growth close to potential GDP

  6. Instruments, Goals, Targets, and the Fed’s Performance • The Fed’s instruments work with an uncertain, long, and variable time lag. • To assess its actions, the Fed watches intermediate targets. • The possible intermediate targets are • Monetary aggregates (M1 and M2, the monetary base) • The federal funds rate • The Fed’s intermediate target is the federal funds rate.

  7. Instruments, Goals, Targets, and the Fed’s Performance • Price Level Stability • Unexpected swings in the inflation rate bring costs for borrowers and lenders and employers and workers. • What Is Price Level Stability? • Alan Greenspan defined price level stability as a condition in which the inflation rate does not feature in people’s economic calculations. • An inflation rate between 0 and 3 percent a year is generally seen as being consistent with price level stability.

  8. Instruments, Goals, Targets, and the Fed’s Performance • Sustainable Real GDP Growth • Natural resources and the willingness to save and invest in new capital and new technologies limit sustainable growth. • Monetary policy can contribute to potential GDP growth by creating a climate that favors high saving and investment rates. • Monetary policy can help to limit fluctuations around potential GDP.

  9. Instruments, Goals, Targets, and the Fed’s Performance • The Fed’s Performance: 1973–2003 • The Fed’s performance depends on • Shocks to the price level • Monetary policy actions

  10. Instruments, Goals, Targets, and the Fed’s Performance • Shocks to the price level during the 1970s and 1980s made the Fed’s job harder • World oil price hikes • Large and increasing budget deficits • Productivity slowdown • These shocks intensified inflation and slowed real GDP growth.

  11. Instruments, Goals, Targets, and the Fed’s Performance • Shocks in the 1990s made the Fed’s job easier. • Falling world oil prices • Decreasing budget deficits (and eventually a budget surplus) • New information economy brought more rapid productivity growth.

  12. Instruments, Goals, Targets, and the Fed’s Performance • Figure 32.1 summarizes monetary policy 1973-2003.

  13. Instruments, Goals, Targets, and the Fed’s Performance • There is a tendency for the federal funds rate to fall as an election approaches and usually the incumbent President or his party’s successor wins the election. • Two exceptions • In 1980, interest rates increased, the economy slowed, and Jimmy Carter lost his reelection bid. • In 1992, interest rates increased, and George Bush lost his reelection bid.

  14. Instruments, Goals, Targets, and the Fed’s Performance • Presidents take a keen interest in what the Fed is up to. • And as the 2004 election approached, the White House was watching anxiously, hoping that the Fed would continue to favor a low federal funds rate and keep the economy expanding.

  15. Instruments, Goals, Targets, and the Fed’s Performance • Figure 32.2 provides a neat way of showing how well the Fed has done in shooting at its target.

  16. Achieving Price Level Stability • There are two price level problems • When the price level is stable, the problem is to prevent inflation from breaking out. • When inflation is already present, the problem is to reduce its rate and restore price level stability while doing the least possible damage to real GDP growth.

  17. Achieving Price Level Stability • The monetary policy regimes that can be used to stabilize aggregate demand are • Fixed-rule policies • Feedback-rule policies • Discretionary policies

  18. Achieving Price Level Stability • Fixed-Rule Policies • A fixed-rule policy specifies an action to be pursued independently of the state of the economy. • An everyday example of a fixed rule is a stop sign--“Stop regardless of the state of the road ahead.” • A fixed-rule policy proposed by Milton Friedman is to keep the quantity of money growing at a constant rate regardless of the state of the economy.

  19. Achieving Price Level Stability • Feedback-Rule Policies • A feedback-rule policy specifies how policy actions respond to changes in the state of the economy. • A yield sign is an everyday feedback rule—“Stop if another vehicle is attempting to use the road ahead, but otherwise, proceed.” • A monetary policy feedback-rule is one that pushes the interest rate ever higher in response to rising inflation and strong real GDP growth and ever lower in response to falling inflation and recession.

  20. Achieving Price Level Stability • Discretionary Policies • A discretionary policy responds to the state of the economy in a possibly unique way that uses all the information available, including perceived lessons from past “mistakes.” • An everyday discretionary policy occurs at an unmarked intersection--each driver uses discretion in deciding whether to stop and how slowly to approach. • Most macroeconomic policy actions have an element of discretion because every situation is to some degree unique.

  21. Achieving Price Level Stability • A Monetarist Fixed Rule with Aggregate Demand Shocks • If monetary policy follows a monetarist fixed rule in the face of an aggregate demand shock: • Aggregate demand fluctuates • Real GDP and the price level fluctuate between recession and boom.

  22. Achieving Price Level Stability • Figure 32.3 shows this outcome. • On the average, the economy is on aggregate demand curve AD0 and short-run aggregate supply curve SAS. • The price level is 105, and real GDP is $10 trillion.

  23. Achieving Price Level Stability • Aggregate demand fluctuates between ADLOW and ADHIGH. • Real GDP and the price level fluctuate between recession and boom.

  24. Achieving Price Level Stability • A Keynesian Feedback Rule with Aggregate Demand Shocks • The Keynesian feedback rule raises the interest rate when aggregate demand increases and cuts the interest rate when aggregate demand decreases.

  25. Achieving Price Level Stability • Figure 32.4 illustrates the behavior of the price level and real GDP under this feedback-rule policy if the policy is implemented well.

  26. Achieving Price Level Stability • When aggregate demand decreases to ADLOW, the Fed cuts the interest rate to send aggregate demand back to AD0. • When aggregate demand increases to ADHIGH, the Fed raises the interest rate to send aggregate demand back to AD0.

  27. Achieving Price Level Stability • The ideal feedback rule will keep aggregate demand close to AD0 so that the price level remains almost constant and real GDP remains close to potential GDP. • A feedback policy might be implemented badly with greater fluctuations in the price level and real GDP than with a fixed rule.

  28. Achieving Price Level Stability • Policy Lags and the Forecast Horizon • The effects of policy actions taken today are spread out over the next two years or even more. • The Fed cannot forecast that far ahead. • The Fed can’t predict the precise timing and magnitude of the effects of its policy actions. • A feedback policy that reacts to today’s economy might be wrong for the economy at that uncertain future date when the policy’s effects are felt.

  29. Achieving Price Level Stability • Stabilizing Aggregate Supply Shocks • Two types of shock occur to bring fluctuations in aggregate supply • Productivity growth fluctuations • Fluctuations in cost-push pressure

  30. Achieving Price Level Stability • Monetarist Fixed Rule with a Productivity Shock • A productivity growth slowdown decreases long-run aggregate supply. • With a fixed rule, aggregate demand is unchanged • Real GDP decreases and the price level rises.

  31. Achieving Price Level Stability • Figure 32.5 shows this outcome. • With no shock, aggregate demand is AD0 and long-run aggregate supply is LAS0. • The price level is 105 and real GDP is $10 trillion at point A.

  32. Achieving Price Level Stability • A productivity growth slowdown shifts the long-run aggregate supply curve leftward to LAS1. • With a fixed rule, aggregate demand remains at AD0. • Real GDP decreases to $9.5 trillion and the price level rises to 120 at point B.

  33. Achieving Price Level Stability • Feedback Rules with Productivity Shock • Real GDP stability conflicts with price stability in the face of a productivity shock. • So there are two possible feedback rules • Rule to stabilize real GDP • Rule to stabilize the price level

  34. Achieving Price Level Stability • Feedback Rule to Stabilize Real GDP • Suppose that the Fed’s feedback rule is: When real GDP decreases, cut the interest rate to increase aggregate demand. • This policy brings a rise in the price level but does not prevent the decrease in real GDP. • Figure 32.6 shows this outcome.

  35. Achieving Price Level Stability • When real GDP decreases to $9.5 trillion, the Fed cuts the interest rate and increases aggregate demand to AD1. • Real GDP remains at $9.5 trillion and the price level rises to 125 at point C. • This case the attempt to stabilize real GDP has no effect on real GDP but destabilizes the price level.

  36. Achieving Price Level Stability • Feedback Rule to Stabilize the Price Level • Suppose that the Fed’s feedback rule is: When the price level rises, raise the interest rate to decrease aggregate demand. • In this case, the price level is stable and real GDP is unaffected by the monetary policy • Again, Figure 32.6 shows the outcome.

  37. Achieving Price Level Stability • When the price level rises above 105, the Fed increases the interest rate and decreases aggregate demand to AD2. • The price level remains at 105 and real GDP remains at $9.5 trillion at point D.

  38. Achieving Price Level Stability • When a productivity shock occurs, a feedback rule that targets the price level delivers a more stable price level and has no adverse effects on real GDP.

  39. Achieving Price Level Stability • Monetarist Fixed Rule with a Cost-Push Inflation Shock • If the Fed follows a monetarist fixed rule, it holds aggregate demand constant when a cost-push inflation shock occurs. • Real GDP decreases and the price level rises—stagflation.

  40. Achieving Price Level Stability • Figure 32.7(a) shows this outcome. • The economy starts out at full employment at point A. • A cost-push inflation shock shifts the SAS curve leftward from SAS0 to SAS1.

  41. Achieving Price Level Stability • The Fed takes no policy action and the aggregate demand curve remains at AD0. • The price level rises to 115, and real GDP decreases to $9.5 trillion at point B. • The economy has experienced stagflation.

  42. Achieving Price Level Stability • There is a recessionary gap that eventually lowers the money wage rate and returns the economy to full employment. • But this adjustment takes a long time.

  43. Achieving Price Level Stability • Feedback Rules with Cost-Push Inflation Shock • Again, there are two feedback rules • Rule to stabilize real GDP • Rule to stabilize the price level

  44. Achieving Price Level Stability • Feedback rule to stabilize real GDP • When a cost-push inflation shock occurs, the Fed cuts the interest rate and increases aggregate demand. • The price level rises and real GDP returns to potential GDP. • If the Fed keeps responding to repeated cost-push shocks in this way, a cost-push inflation takes hold. • Figure 32.7(b) shows this outcome.

  45. Achieving Price Level Stability • When a cost-push inflation shock sends the economy to point B, the Fed cuts the interest rate and increases aggregate demand to AD1. • The price level rises to 120, and real GDP returns to $10 trillion at point C. • The economy has experienced cost-push inflation that could become an ongoing inflation.

  46. Achieving Price Level Stability • Feedback Rule to Stabilize the Price Level • A cost-push inflation shock leads the Fed to raise the interest rate and decreases aggregate demand. • The Fed avoids cost-push inflation but at the cost of deep recession. • Figure 32.7(c) shows this outcome.

  47. Achieving Price Level Stability • A cost-push inflation shock sends the economy to point B • The Fed raises the interest rate and decreases aggregate demand to AD2. • The price level falls to 105, and real GDP decreases to $8.5 trillion at point D. • The Fed has avoided cost-push inflation but at the cost of recession.

  48. Policy Credibility • A policy that is credible works much better than one that surprises. • Contrast two cases • A surprise inflation reduction • A credible announced inflation reduction

  49. Policy Credibility • A Surprise Inflation Reduction • Figure 32.8(a) shows the economy at full employment on aggregate demand curve AD0 and short-run aggregate supply curve SAS0. • Real GDP is $10 trillion, and the price level is 105.

  50. Policy Credibility • The expected inflation rate is 10 percent. • So next year, aggregate demand is expected to be AD1 and the money wage rate increases to shift the short-run aggregate supply curve SAS1.

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