Chapter Seventeen Monetary Policy Goals and Tradeoffs Monetary
- Slides: 44
Chapter Seventeen Monetary Policy: Goals and Tradeoffs
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 Copyright © Houghton Mifflin Company. All rights reserved. 17 | 2
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 Copyright © Houghton Mifflin Company. All rights reserved. 17 | 3
Stabilization Policy • Expansionary Monetary Policy M ↑ ; Y ↑ short run; P ↑ long run • Contractionary Monetary Policy M ↓ ; Y ↓ short run; P ↓ long run Copyright © Houghton Mifflin Company. All rights reserved. 17 | 4
Stabilization Policy If monetary policy is used successfully to temper business cycle fluctuations, cycles stay closer to the trend line Copyright © Houghton Mifflin Company. All rights reserved. 17 | 5
Stabilization Policy If monetary policy is not used successfully to temper business cycle fluctuations, then the fluctuations are more severe Copyright © Houghton Mifflin Company. All rights reserved. 17 | 6
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 Copyright © Houghton Mifflin Company. All rights reserved. 17 | 7
Goals of Monetary Policy • Goals at founding of Fed (Federal Reserve Act, 1913) 1. Provide an elastic currency (gold standard and interest rates) 2. Afford means of rediscounting commercial paper (discount loans) 3. Establish a more effective supervision of banking Copyright © Houghton Mifflin Company. All rights reserved. 17 | 8
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. . . Copyright © Houghton Mifflin Company. All rights reserved. 17 | 9
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 Copyright © Houghton Mifflin Company. All rights reserved. 17 | 10
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 Copyright © Houghton Mifflin Company. All rights reserved. 17 | 11
Output (cont’d) Figure 17. 4 U. S. Output Growth Since 1960 Gray bars denote recessions, when output growth always falls below zero Copyright © Houghton Mifflin Company. All rights reserved. 17 | 12
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 Copyright © Houghton Mifflin Company. All rights reserved. 17 | 13
Potential Output (cont’d) Figure 17. 5 Actual and Potential U. S. Output Since 1960 Actual output sinks below potential the most during recessions Copyright © Houghton Mifflin Company. All rights reserved. 17 | 14
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 Copyright © Houghton Mifflin Company. All rights reserved. 17 | 15
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 Copyright © Houghton Mifflin Company. All rights reserved. 17 | 16
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 Copyright © Houghton Mifflin Company. All rights reserved. 17 | 17
Unemployment (cont’d) Figure 17. 6 U. S. Unemployment Rate Since 1960 Unemployment has only fallen below 4% in the expansion of the 1960 s and again in 2000 Copyright © Houghton Mifflin Company. All rights reserved. 17 | 18
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 Copyright © Houghton Mifflin Company. All rights reserved. 17 | 19
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 Copyright © Houghton Mifflin Company. All rights reserved. 17 | 20
Inflation (cont’d) Figure 17. 8 U. S. CPI Inflation Rate Since 1960 During the last 20 years, inflation has declined Copyright © Houghton Mifflin Company. All rights reserved. 17 | 21
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 Copyright © Houghton Mifflin Company. All rights reserved. 17 | 22
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 Copyright © Houghton Mifflin Company. All rights reserved. 17 | 23
Costs of Inflation (cont’d) Figure 17. 9 The Mortgage-Tilt Problem Inflation erodes the real value of a constant-dollar mortgage payment Copyright © Houghton Mifflin Company. All rights reserved. 17 | 24
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 Copyright © Houghton Mifflin Company. All rights reserved. 17 | 25
The Fed’s Objective Function • Assigns numbers to enable policymakers to assess alternative policies 1. Output Gap: measures what output level would be necessary if there were no recessions 2. Unemployment Gap: measures how close the unemployment rate is to the natural rate 3. Inflation Gap: measures how close the inflation rate is to the ideal rate Copyright © Houghton Mifflin Company. All rights reserved. 17 | 26
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 Copyright © Houghton Mifflin Company. All rights reserved. 17 | 27
Costs of Inflation (cont’d) Figure 17. 10 U. S. Output Gap Since 1960 Output gaps decline and become negative in recession Copyright © Houghton Mifflin Company. All rights reserved. 17 | 28
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 Copyright © Houghton Mifflin Company. All rights reserved. 17 | 29
Okun’s Law & the Unemployment Gap Figure 17. 11 Okun’s Law in U. S. Data Since 1960 Copyright © Houghton Mifflin Company. All rights reserved. 17 | 30
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 Copyright © Houghton Mifflin Company. All rights reserved. 17 | 31
U. S. Inflation Gap Figure 17. 12 U. S. Inflation Gap Since 1960 Copyright © Houghton Mifflin Company. All rights reserved. 17 | 32
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 [output loss + (w x inflation loss)] output loss = output gap squared inflation loss = inflation gap squared Copyright © Houghton Mifflin Company. All rights reserved. 17 | 33
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 Copyright © Houghton Mifflin Company. All rights reserved. 17 | 34
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 Copyright © Houghton Mifflin Company. All rights reserved. 17 | 35
The Phillips Curve (cont’d) Figure 17. 13 Phillips Curve from 1948 to 1965 The solid trend line illustrates Phillips’ tradeoff Copyright © Houghton Mifflin Company. All rights reserved. 17 | 36
The Phillips Curve (cont’d) Figure 17. 14 Phillips Curve Since 1948 The tradeoff seems to disappear after the 1960 s Copyright © Houghton Mifflin Company. All rights reserved. 17 | 37
The Phillips Curve (cont’d) • Since the 1960, economists have modified 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 Copyright © Houghton Mifflin Company. All rights reserved. 17 | 38
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 Copyright © Houghton Mifflin Company. All rights reserved. 17 | 39
The Phillips Curve (cont’d) With a sudden, unexpected increase in the money supply, short run inflation rises, but declines as the economy readjusts Copyright © Houghton Mifflin Company. All rights reserved. 17 | 40
The Phillips Curve (cont’d) A permanent increase in the money supply changes the inflation rate in the long run Copyright © Houghton Mifflin Company. All rights reserved. 17 | 41
The Phillips Curve (cont’d) Figure 17. 18 The Shifting Short-Run U. S. Phillips Curve Since 1948 Copyright © Houghton Mifflin Company. All rights reserved. 17 | 42
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 Copyright © Houghton Mifflin Company. All rights reserved. 17 | 43
The Phillips Curve (cont’d) Figure 17. 19 Expectations-Augmented Phillips Curve Since 1960 Copyright © Houghton Mifflin Company. All rights reserved. 17 | 44
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