Chapter Seventeen

1. Chapter Seventeen Monetary Policy: Goals and Tradeoffs

2. Monetary Policy:Goals and Tradeoffs • The Fed faces a tradeoff between inflation and unemployment • Changes in monetary policy often have opposite effects on each • The Fed’s goals are assessed in terms of • Output • Unemployment rate • Inflation rate

3. Stabilization Policy • Expansionary monetary policy causes the economy to grow faster in the short run • Increases in the money supply • Output is higher, unemployment lower, and inflation rate is higher over time • Contractionary monetary policy causes the economy to grow more slowly in the short run. • Decreases in the money supply • Output is lower, unemployment higher, and inflation rate is lower over time

4. Stabilization Policy • Expansionary Monetary Policy M ↑ ; Y ↑ short run; P ↑ long run • Contractionary Monetary Policy M ↓ ; Y ↓ short run; P ↓ long run

5. Stabilization Policy If monetary policy is used successfully to temper business cycle fluctuations, cycles stay closer to the trend line

6. Stabilization Policy If monetary policy is not used successfully to temper business cycle fluctuations, then the fluctuations are more severe

7. Lags in Stabilization Policy • Stabilization policy may not work if lags are severe • Types of lags • Data Lag • Recognition Lag • Decision Lag • Implementation Lag • Effectiveness Lag (long and variable lag) • 6 to 9 months before maximum impact on output • 12 to 18 months before maximum impact on inflation

8. Goals of Monetary Policy • Goals at founding of Fed (Federal Reserve Act, 1913) • Provide an elastic currency (gold standard and interest rates) • Afford means of rediscounting commercial paper (discount loans) • Establish a more effective supervision of banking

9. Goals of Monetary Policy (cont’d) • Goals from Employment Act of 1946 • Fed should use its tools to increase employment and production (based on Keynesian theory) • Goals from Humphrey-Hawkins Act of 1978 • Promote full employment and production, increase real income and balanced growth, and reasonable price stability . . .

10. Goals of Monetary Policy (cont’d) • Today • Short run: maximize output to keep unemployment low • Long run: maintain a low rate of inflation • Focus on three variables • Output • Unemployment rate • Inflation rate

11. Output • A major goal of the Fed is to maximize output • Output above potential means more work than people desire in the long run • Output below potential means unemployed resources, inefficiency • The problem: determining level of potential output in practice is difficult

12. Output (cont’d) Figure 17.4 U.S. Output Growth Since 1960 Gray bars denote recessions, when output growth always falls below zero

13. Potential Output • Potential output is the amount that would be produced by the economy if all resources were being used efficiently • Monetary policy alone does not determine output growth; potential output concept was developed to help account for these additional factors • While actual output can exceed potential in the short run, it is not sustainable

14. Potential Output (cont’d) Figure 17.5 Actual and Potential U.S. Output Since 1960 Actual output sinks below potential the most during recessions

15. Unemployment • The actual unemployment rate is ideally equal to the natural rate of unemployment • The natural rate of unemployment is that rate when the economy is producing output equal to its potential • Natural rate of unemployment reflects structural unemployment and frictional unemployment, so it is never zero

16. Unemployment (cont’d) • Costs of high unemployment (above the natural rate) • Loss of output • Societal costs, including crime • Costs of low unemployment (below the natural rate) • Difficult to match workers and jobs • Wage inflation

17. Unemployment (cont’d) • A key issue in stabilization policy is determining the natural rate of unemployment in real time. • Not directly observable • Estimates created long after the fact

18. Unemployment (cont’d) Figure 17.6 U.S. Unemployment Rate Since 1960 Unemployment has only fallen below 4% in the expansion of the 1960s and again in 2000

19. Unemployment (cont’d) Figure 17.7 Actual and Natural Rate of U.S. Unemployment Since 1960 Unemployment may rise high above the natural rate during recession

20. Inflation • Again not determined exclusively by monetary policy • The consumer price index (CPI) is most widely used to measure inflation • Exclude food and energy prices, to get handle on long-term trend in short run

21. Inflation (cont’d) Figure 17.8 U.S. CPI Inflation Rate Since 1960 During the last 20 years, inflation has declined

22. Costs of Inflation • Costs of Unanticipated Inflation • Prices are set wrong • Wealth redistribution between borrowers and lenders • Leads to greater uncertainty about the future inflation rate • Unanticipated inflation problems are worse the higher the inflation rate, because people are less able to tell the direction the rate will go

23. Costs of Inflation (cont’d) • Costs of Anticipated Inflation • Inflation is an implicit tax on holding money • Firms face menu costs of changing prices • Hurts people on fixed nominal incomes • Interacts with tax system to hurt saving and investment • Housing market distorted by mortgage tilt problem • The real value of nominal mortgage payments declines over time

24. Costs of Inflation (cont’d) Figure 17.9 The Mortgage-Tilt Problem Inflation erodes the real value of a constant-dollar mortgage payment

25. The Ideal Inflation Rate • The ideal inflation rate is the rate that policymakers would like to achieve because it minimizes the costs to society of changing prices • Also referred to as inflation targeting because it represents the Fed’s long-term goal for the inflation rate

26. The Fed’s Objective Function • Assigns numbers to enable policymakers to assess alternative policies • Output Gap: measures what output level would be necessary if there were no recessions • Unemployment Gap: measures how close the unemployment rate is to the natural rate • Inflation Gap: measures how close the inflation rate is to the ideal rate

27. Output Gap • Output gap = percentage deviation of output from potential output • Positive output gap means output above potential output; negative means output is below potential

28. Costs of Inflation (cont’d) Figure 17.10 U.S. Output Gap Since 1960 Output gaps decline and become negative in recession

29. Unemployment Gap • Unemployment gap = difference between unemployment and natural rate of unemployment • Okun’s law demonstrates negative relationship between the output gap and the unemployment gap • Since the relationship is tight, we usually use just one or the other; we use the output gap in determining the Fed’s objective function

30. Okun’s Law & the Unemployment Gap Figure 17.11 Okun’s Law in U.S. Data Since 1960

31. Inflation Gap • Inflation gap = actual inflation rate minus ideal inflation rate • Ideal inflation rate is not widely agreed upon, but probably about 0 to 2 percent • The U.S. has more often struggled with an inflation rate that is too high rather than too low

32. U.S. Inflation Gap Figure 17.12 U.S. Inflation Gap Since 1960

33. Equation for Fed’s Objective Function • Combines measure of output and inflation gaps in an equation • Summarizes the total cost to the economy of both gaps. • Also called the Fed’s loss function Total loss = Sum over time of [outputloss + (w x inflation loss)] output loss = output gap squared inflation loss = inflation gap squared

34. Equation for Fed’s Objective Function (cont’d) • Weight on inflation terms (w) determines aggressiveness of response to inflation or the output gap • The Fed places more weight to the inflation loss and less to output loss • The weight on inflation determines how inflation and output change over time after a shock hits the economy

35. The Phillips Curve • The Phillips Curve illustrates the trade-off between inflation and unemployment π = α – βU • This relationship suggests that policymakers may choose between inflation and unemployment

36. The Phillips Curve (cont’d) Figure 17.13 Phillips Curve from 1948 to 1965 The solid trend line illustrates Phillips’ tradeoff

37. The Phillips Curve (cont’d) Figure 17.14 Phillips Curve Since 1948 The tradeoff seems to disappear after the 1960s

38. The Phillips Curve (cont’d) • Since the 1960, economists have modified the theory to account for expected inflation π = πe– β(U – UN) • There is a tradeoff in the short run, but not in the long run

39. The Phillips Curve (cont’d) The long run Phillips curve is vertical at the natural rate of unemployment, while the short run curve is associated with a particular expected inflation rate

40. The Phillips Curve (cont’d) With a sudden, unexpected increase in the money supply, short run inflation rises, but declines as the economy readjusts

41. The Phillips Curve (cont’d) A permanent increase in the money supply changes the inflation rate in the long run

42. The Phillips Curve (cont’d) Figure 17.18 The Shifting Short-Run U.S. Phillips Curve Since 1948

43. The Phillips Curve (cont’d) • Rewrite equation in terms of gaps π – πe = – β(U – UN) • Inflation surprise = – β x unemployment gap • This better reflects the short vs. long run Phillips curve tradeoffs

44. The Phillips Curve (cont’d) Figure 17.19 Expectations-Augmented Phillips Curve Since 1960