Chapter Seventeen Monetary Policy Goals and Tradeoffs Monetary

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Chapter Seventeen Monetary Policy: Goals and Tradeoffs

Chapter Seventeen Monetary Policy: Goals and Tradeoffs

Monetary Policy: Goals and Tradeoffs • The Fed faces a tradeoff between inflation and

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

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

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

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,

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

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)

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

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

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

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

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

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

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 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

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

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

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

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

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

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 –

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

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

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

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

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 •

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

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

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.

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 •

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

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

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

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

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

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

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

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

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

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

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

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

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 ©

The Phillips Curve (cont’d) Figure 17. 19 Expectations-Augmented Phillips Curve Since 1960 Copyright © Houghton Mifflin Company. All rights reserved. 17 | 44