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## MONETARY POLICY

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**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 • 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**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?**Instruments, Goals, Targets, and the Fed’s Performance**• To discuss monetary policy if we distinguish among: • Instruments • Goals • Intermediate targets**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**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.**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.**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.**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**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.**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.**Instruments, Goals, Targets, and the Fed’s Performance**• Figure 32.1 summarizes monetary policy 1973-2003.**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.**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.**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.**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.**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**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.**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.**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.**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.**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.**Achieving Price Level Stability**• Aggregate demand fluctuates between ADLOW and ADHIGH. • Real GDP and the price level fluctuate between recession and boom.**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.**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.**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.**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.**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.**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**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.**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.**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.**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**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.**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.**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.**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.**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.**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.**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.**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.**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.**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**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.**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.**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.**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.**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**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.**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.