monetary policy 32 chapter. objectives after studying this chapter, you will be able to distinguish...

MONETARY POLICY 32

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


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


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.


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.


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.


The Fed’s Performance: 1973–2003

The Fed’s performance depends on

Shocks to the price level

Monetary policy actions


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.


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.


Figure 32.1 summarizes monetary policy 1973-2003.


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.


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.


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.


The monetary policy regimes that can be used to stabilize aggregate demand are

Fixed-rule policies

Feedback-rule policies

Discretionary policies


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.


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.


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.


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.


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.


Aggregate demand fluctuates between ADLOW and ADHIGH.

Real GDP and the price level fluctuate between recession and boom.


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.


Figure 32.4 illustrates the behavior of the price level and real GDP under this feedback-rule policy if the policy is implemented well.


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.


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.


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.


Stabilizing Aggregate Supply Shocks

Two types of shock occur to bring fluctuations in aggregate supply

Productivity growth fluctuations

Fluctuations in cost-push pressure


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.



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.


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.


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


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.



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.


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.


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.


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.


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.


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.


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.


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.


Feedback Rules with Cost-Push Inflation Shock

Again, there are two feedback rules

Rule to stabilize real GDP

Rule to stabilize the price level


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.


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.


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.


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.

Policy Credibility

If expectations are fulfilled, the price level rises to 115.5—a 10 percent inflation—and real GDP remains at potential GDP.

Now suppose that the Fed unexpectedly decides to slow inflation.

Policy Credibility

The Fed raises the interest rate and slows aggregate demand growth.

The aggregate demand curve shifts rightward to AD2.

Real GDP decreases to $9.5 trillion, and the price level rises to 113.4—an inflation rate of 8 percent a year.

Policy Credibility

Figure 32.8(b) shows the same events using the Phillips curve.

The economy at full employment on long run Phillips curve, LRPC, and short-run Phillips curve, SRPC0.

Inflation is 10 percent and unemployment 6 percent.

Policy Credibility

When the Fed increases the interest rate, the economy moves along the short-run Phillips curve SRPC0 as unemployment rises to 9 percent and inflation falls to 8 percent a year.

Policy Credibility

The Fed’s policy has succeeded in slowing inflation, but at the cost of recession.

Real GDP is below potential GDP, and unemployment is above its natural rate.

Policy Credibility

A Credible Announced Inflation Reduction

Suppose the Fed announces its intention to slow inflation to 5 percent.

Suppose also that the Fed’s policy announcement is credible and convincing.

The expected inflation rate becomes 5 percent a year.

Policy Credibility

In Figure 32.8(a), the SAS curve shifts to SAS2.

Aggregate demand increases by the amount expected, and the aggregate demand curve shifts to AD2.

The price level rises to 110.25—inflation is 5 percent—and real GDP remains at potential GDP.

Policy Credibility

In Figure 32.8(b), the lower expected inflation rate shifts the short-run Phillips curve downward to SRPC1, and inflation falls to 5 percent a year, while unemployment remains at its natural rate of 6 percent.

Policy Credibility

A credible announced inflation reduction lowers inflation but with no accompanying recession or increase in unemployment.

Policy Credibility

Inflation Reduction in Practice

When the Fed in fact slowed inflation in 1981, we paid a high price.

The Fed’s policy action to end inflation was not credible.

Could the Fed have lowered inflation without causing recession by telling people far enough ahead of time that it did indeed plan to lower inflation?

The answer appears to be no.

People expect the Fed to behave in line with its record, not with its stated intentions.

New Monetarist and New Keynesian Feedback Rules

A monetarist rule

Prevents cost-push inflation at the cost of recession

Brings price level fluctuations in the face of productivity shocks

Brings price level and real GDP fluctuations in the face of aggregate demand fluctuations


A Keynesian feedback rule that targets real GDP

Brings cost-push inflation

Might not moderate fluctuations in the price level and real GDP that stem from aggregate demand shocks

A Keynesian feedback rule that targets the price level

Prevents cost-push inflation but at an even greater cost of recession than that of a monetarist fixed rule.


None of these rules work well, and none is a sufficiently credible rule for the Fed to commit to.

In an attempt to develop a rule that is credible and that works well, economists have explored policies that respond to both the price level and real GDP.

Two such policy rules are the

McCallum Rule

Taylor Rule


The McCallum Rule

Suggested by Bennett T. McCallum, an economics professor at Carnegie-Mellon University, the McCallum rule says

Make the monetary base grow at a rate equal to the target inflation rate plus the 10-year moving average growth rate of real GDP minus the 4-year moving average of the growth rate of the velocity of circulation of the monetary base.


If the Fed had a specific target for the inflation rate, the McCallum rule would tell the Fed the growth rate of monetary base that would achieve that target, on the average.

Figure 32.9 on the next slide shows how the monetary base has grown and how it would have grown if it had followed the McCallum rule.


The Taylor Rule

Suggested by John Taylor, formerly an economics professor at Stanford University and now Undersecretary of the Treasury for International Affairs in the Bush administration, the Taylor rule says

Set the federal funds rate equal to the target inflation rate plus 2.5 percent plus one half of the gap between the actual inflation rate and the target inflation rate plus one half of the percentage deviation of real GDP from potential GDP.


Figure 32.10 shows the federal funds rate and the rate if the Taylor rule were followed.


Differences Between the Rules

The McCallum rule and the Taylor rule tell a similar story about the inflation of the 1970s and the price level stability of the 1990s and 2000s.

During the 1970s, the quantity of money grew too rapidly (McCallum rule) and the federal funds rate was too low (Taylor rule).


Differences Between the Rules

During the 1990s and 2000s, both the growth rate of the quantity of money (McCallum rule) and the federal funds rate (Taylor rule) were consistent with low inflation and price level stability.

But the two rules differ in two important ways

Strength of response to output fluctuations

Targeting money versus the interest rate


Choosing Between the Rules

Monetarists favor targeting the monetary base because they believe that it provides a more solid anchor for the price level than does the interest rate.

Keynesians say that targeting the quantity of money would bring excessive swings in the interest rate, which in turn would bring excessive swings in aggregate expenditure.

For this reason, Keynesians favor interest rate targeting.

THE END

monetary policy 32 chapter. objectives after studying this chapter, you will be able to distinguish...

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