Inflation and Monetary Policy Slides by John Pamela

The Objectives of Monetary Policy • Fed was first established in 1913 – Chief responsibility was to ensure stability of banking system • Fed’s objective in 1950 s and 1960 s changed to keeping interest rate low and stable – In 1970 s, Fed’s objectives shifted once again – As stated in Federal Reserve Banking Act of 1978, which is still in force • Fed is now responsible for achieving a low, stable rate of inflation, and full employment of labor force 2

Low, Stable Inflation • When inflation rate is high, society uses up resources coping with it – Resources that could have been used to produce goods and services • In addition to keeping inflation rate low, Fed tries to keep it stable from year to year • Fed, as a public agency, chooses its policies with costs of inflation in mind – Fed has another concern • Inflation is very unpopular with the public • A Fed chairman who delivers low rates of inflation is seen as popular and competent – While one who tolerates high inflation goes down in history as a failure 3

Full Employment • “Full employment” means that unemployment is at normal levels • Different types of unemployment – Frictional unemployment is part of normal working of labor market – While structural unemployment is a serious social problem • Best solved with microeconomic policies – Such as job-training programs or improved information flows • Cyclical unemployment, by contrast, is a macroeconomic problem – Macroeconomists use term “full employment” to mean absence of cyclical employment • Fed is concerned about cyclical unemployment for two reasons – Opportunity cost • Output that unemployed could have produced if they were working – Cyclical unemployment represents a social failure • Why should Fed try to eliminate only cyclical unemployment? – Why not go further—pushing output above its full-employment level? – If unemployment is a bad thing, shouldn’t Fed aim for lowest possible unemployment rate possible? • No 4

Full Employment • Natural rate of unemployment—unemployment rate at which GDP is at its full-employment level – With no cyclical unemployment • When unemployment rate is below natural rate, GDP is greater than potential output – Economy’s self-correcting mechanism will then create inflation • When unemployment rate is above natural rate, GDP is below potential output – Self-correcting mechanism will then put downward pressure on price level • Natural unemployment rate is not etched in stone – Nor is it the outcome of purely natural forces that can’t be influenced by public policy • Why use the term natural for such a changeable feature of the economy? – Term makes sense only from perspective of macroeconomic policy – Isn’t much that macroeconomic policy can do about natural rate 5

Figure 1(a): The Fed’s Performance Since 1950 6

Figure 1(b): The Fed’s Performance Since 1950 7

The Fed’s Performance • How well has Fed achieved its goals? • Fed has mostly had a good—and improving—record in recent years – Inflation rate has been kept low and relatively stable – Unemployment has been near and even below most estimates of natural rate • Except for most recent recession 8

Federal Reserve Policy: Theory and Practice • We’ve assumed Fed’s response to spending shocks is a passive monetary policy – When Fed keeps money supply constant regardless of shocks to economy • In order to keep real GDP as close as possible to its potential, Fed must pursue an active monetary policy – Responds to events in economy by changing money supply • In some cases, proper response is easy to determine – Because the same action that maintains full employment also helps maintain low inflation • But in other cases, Fed must trade off one goal for another – Responses that maintain full employment will worsen inflation, and responses that alleviate inflation will create more unemployment • We’ll make a temporary simplifying assumption in this section – Fed’s goal for inflation rate is zero 9

Responding To Changes In Money Demand • Potential disturbances to the economy sometimes arise from a shift in money demand curve • How should Fed respond to shifts in money demand curve? • If Fed wants to maintain full employment with zero inflation—an unchanged price level – Passive monetary policy is wrong response • By increasing money stock—shifting money supply curve rightward— – Fed can move money market to a new equilibrium, preventing any rise in interest rate 10

Responding To Changes In Money Demand • Shifts in money demand curve present Fed with a no-lose situation – By adjusting money supply to prevent changes in interest rate • Fed can achieve both price stability and full employment – Fed sets and maintains an interest rate target and adjusts money supply to achieve that target • Fed can achieve its goals of price stability and full employment simultaneously 11

Figure 2: Responding to Shifts in Money Demand 12

How the Fed Keeps the Interest Rate on Target • Fed officials meet each morning to determine that day’s monetary policy – Based on information gathered previous afternoon and earlier that morning – Key piece of information is what actually happened to interest rate since previous morning • Using this and other information about banking system and economy, Fed decides what to do – At 11: 30 A. M. , if interest rate is above target, Fed buys government bonds – If interest rate is below target, Fed sells government bonds 13

Responding to Other Demand Shocks • There are other demand shocks as well, originating with a shift in aggregate expenditure line – Fed has a more difficult time responding to this kind of demand shock • Suppose there is a positive demand shock that originates with an increase in aggregate expenditure • Possible responses by Fed – Fed could follow a passive monetary policy, leaving money supply unchanged • Would lead to an increase in both output and price level – Fed could pursue active policy of maintaining an interest rate target • Would increase output and price levels even further – Pursue an active policy that shifts AD curve back to AD • Fed must change interest rate target – Positive demand shock requires an increase in target – Negative demand shock requires a decrease in target 14

Figure 3: Responding to Demand Shocks that Originate with Aggregate Expenditure 15

Figure 4: The Best Response to a Spending Shock (a) Interest Rate (%) M 2 s (b) Price Level M 1 s AS r 3 r 2 r 1 H F P 2 F E P 1 E AD 2 d d M 2 AD 1 Money YFE Y 2 Real GDP 16

Responding to Other Demand Shocks • In recent years, Fed has changed its interest rate target as frequently as needed to keep economy on track – If Fed observers that economy is overheating—and that unemployment rate has fallen below its natural rate—it will raise its target • When Fed observers that economy is sluggish— and unemployment rate has risen above its natural rate—Fed will lower its target • Demand shocks that originate with a shift of aggregate expenditure curve present Fed with another no-lose situation – Same policy that helps to keep unemployment at its natural rate also helps to maintain a stable price level 17

The Interest Rate Target and the Financial Markets • Members of Open Market Committee think very hard before they vote to change interest rate target • When Fed moves interest rate to a higher target level, prices of bonds drop • Stock market is often affected in a similar way – Lower the price of a stock, the more attractive the stock is to a potential buyer • When Fed raises interest rates, rates of return on bonds increase, so bonds become more attractive 18

The Interest Rate Target and the Financial Markets • Destabilizing effect on stock and bond markets is one reason Fed prefers not to change interest rate target very often • Financial markets are also affected by expected changes in the interest rate target – Whether or not they occur • This is why financial press speculates constantly about likelihood of changes in interest rate target – Good news about the economy sometimes leads to expectations that Fed—fearing inflation—will raise its interest rate target • This is why good economic news sometimes causes stock and bond prices to fall • Similarly, bad news about economy sometimes leads to expectations that Fed—fearing recession—will lower its interest rate target – This is why bad economic news sometimes causes stock and bond prices to rise 19

Responding To Supply Shocks • Demand shocks in general present Fed with easy policy choices • But adverse or negative supply shocks present Fed with a true dilemma – If Fed tries to preserve price stability, it will worsen unemployment – If it tries to maintain high employment, it will worsen inflation • Fed can respond with an active monetary policy – Changing money stock in order to alter short-run equilibrium 20

Figure 5: Responding to Supply Shocks 21

Responding To Supply Shocks • Let’s imagine two extreme positions – Fed could prevent inflation entirely by decreasing money stock • Shifting AD curve leftward to curve labeled ADno inflation – At the other extreme, Fed could prevent any fall in output • In practice, Fed is unlikely to choose either of these two extremes, preferring instead some intermediate policy • Adverse supply shock presents Fed with a short-run tradeoff – It can limit the recession, but only at the cost of more inflation – It can limit inflation, but only at the cost of a deeper recession • After supply shocks, there are often debates within Fed— and in the public arena—about how best to respond – Hawks lean in direction of price stability – Inflation Doves lean in direction of a milder recession • More willing to tolerate cost of higher inflation 22

Choosing Between Hawk and Dove Policies • When a supply shock hits, should Fed use a hawk policy, a dove policy, or should it keep the AD curve unchanged? • Proper choice depends on how Fed weights harm caused by unemployment against harm caused by inflation • In recent years, some officials at Fed have argued that having two objectives—stable prices and full employment—is unrealistic when there are supply shocks – Regardless of any future change in Fed’s mandate, debate between hawks and doves is destined to continue 23

How Ongoing Inflation Arises • Best way to begin analysis of ongoing inflation is to explore how it arises in an economy • What was special about economy in 1960 s? – Period of exuberance and optimism, for both businesses and households • Fed could have neutralized positive demand shocks by raising interest rate target – Shifting AD curve back to its original position • Alternatively, Fed could have done nothing – Allowing self-correcting mechanism to bring economy back to full employment with a higher—but stable—price level • Fed made a different choice – Maintained low interest rate target • Why did Fed act in this way? – No one knows for sure, but one likely reason is that, in 1960 s, Fed saw its job differently than it does today 24

How Ongoing Inflation Arises • As price level continued to rise in 1960 s, public began to expect it to rise at a similar rate in the future • When inflation continues for some time, public develops expectations that inflation rate in the future will be similar to inflation rates of recent past • Why are expectations of inflation so important? – Because when managers and workers expect inflation, it gets built into their decision-making process • A continuing, stable rate of inflation gets built into economy – Built-in rate is usually the rate that has existed for the past few years • Once there is built-in inflation, economy continues to generate continual inflation – Even after self-correcting mechanism has finally been allowed to do its job and bring us back to potential output 25

Figure 6: Long-Run Equilibrium With Built-in Inflation 26

How Ongoing Inflation Arises • In an economy with built-in inflation, AS curve will shift upward each year – Even when output is at full employment and unemployment is at its natural rate • Upward shift of AS curve will equal built-in rate of inflation • In short-run, Fed can bring down rate of inflation by reducing rightward shift of AD curve – But only at the cost of creating a recession • Would Fed ever purposely create a recession to reduce inflation? – Indeed it would, and it has—more than once • Creating a recession is not a decision that Fed takes lightly – Recessions are costly to economy and painful to those who lose their jobs 27

Ongoing Inflation and the Phillips Curve • Ongoing inflation changes our analysis of monetary policy – Forces us to recognize a subtle, but important, change in Fed’s objectives • While Fed still desires full employment, its other goal—price stability—is not zero inflation – But low and stable inflation rate • Phillips curve—named after economist A. W. Phillips, who did early research on the relationship between inflation and unemployment – Used to illustrate Fed’s policy choices • Phillips curve is downward sloping – Because it tells the same story we told earlier—with AD and AS curves— about Fed’s options in short-run • In short-run, Fed can move along Phillips curve by adjusting rate at which AD curve shifts rightward – When Fed moves economy downward and rightward along Phillips curve • Unemployment rate increases, and inflation rate decreases – In long-run a decrease in actual inflation rate leads to a lower built-in inflation rate and Phillips curve shifts downward 28

Figure 7: The Phillips Curve 29

Figure 8: The Shifting Phillips Curve 30

Riding Up the Phillips Curve • Process of moving down Phillips curve and thereby causing it to shift downward also works in reverse – Moving up Phillips curve will cause it to shift upward • At this point, if Fed returns economy to full employment, we end up at point J – Economy will be back in long-run equilibrium—but with a higher built-in inflation rate 31

Long-Run Equilibrium • In short-run, Fed can move along Phillips curve – Exploiting trade-off between unemployment and inflation – But in long-run—once public expectations of inflation adjust to the new reality—built-in inflation rate will change, and Phillips curve will shift • In short-run, there is a trade-off between inflation and unemployment – Fed can choose lower unemployment at cost of higher inflation or lower inflation at cost of higher unemployment – But in long-run there is no such trade-off • Since unemployment always returns to its natural rate 32

The Long-Run Phillips Curve • In long-run monetary policy can change rate of inflation but not rate of unemployment • Vertical line is economy’s long-run Phillips curve – Tells us combinations of unemployment and inflation that Fed can choose in long-run • Long-run Phillips curve is a vertical line at the natural rate of unemployment – Fed can select any point along this line in long-run • By using monetary policy to speed or slow rate at which AD curve shifts rightward 33

Why the Fed Allows Ongoing Inflation • Since Fed can choose any rate of inflation it wants, and since inflation is costly to society – We might think Fed would aim for an inflation rate of zero – Why doesn’t Fed eliminate inflation from economy entirely? • One reason is a widespread belief that Consumer Price Index (CPI) and other measures of inflation actually overstate true rate of inflation – If Fed forced the measured rate of inflation down to zero • Result would be an actual rate of inflation that was negative deflation • Some economists have offered another explanation for Fed’s behavior – Low, stable inflation makes labor market work more smoothly • Fed has tolerated measured inflation at 2 to 3% per year – Because it knows that rate of inflation is lower and – Because low rates of inflation may help labor markets adjust more easily 34

Using the Theory: Challenges For Monetary Policy • Might almost conclude that monetary policy is akin to operating a giant machine – And policy making might appear rather uncontroversial • But truth is very much the opposite – Fed faces frequent criticism from members of Congress, business community, media, and some academic economists • Not just over its policy choices, but also the way it arrives at them – Fed—rather than operating a well-understood machine—must conduct monetary policy with highly imperfect information about economy’s course and precisely how Fed policies will alter it – In early 2000 s, Fed found itself facing a new economic challenge • Possibility of deflation – Requiring Fed to develop some new, untested tools for monetary policy…just in case 35

Using the Theory: Information Problems • Federal Reserve has hundreds of economists carrying out research and gathering data – To improve its understanding of how economy works, and how monetary policy affects economy • Research at Fed is widely respected – But because economy is complex and constantly changing, serious gaps remain • Time lag before monetary policy affects economy • Knowledge of economy’s potential output 36

Using the Theory: Uncertain and Changing Time Lags • Monetary policy works with a time lag – Even after a rise in the interest rate, business firms will likely continue to build new plants and new homes they’ve already started constructing – Same applies in other direction • Time lag in effectiveness of monetary policy can have serious consequences • Even worse, time lag before monetary policy affects prices and output can change over the years – Just when Fed may think it has mastered the rules of the game, the rules change 37

The Natural Rate of Unemployment • In Phillips curve diagram, we’ve assumed that economy’s natural rate of unemployment is known and remains constant – Signified by vertical long-run Phillips curve at some value UU • Many economists believe that today natural rate is between 4. 5 and 5 %, but no one is really sure • What is the problem? – In order to achieve its twin goals of full employment and a stable, low inflation rate • Fed tries to maintain unemployment rate as close to natural rate as possible – If estimate of natural rate is wrong, it may believe it has succeeded when, in fact, it has not • Trial and error can help Fed determine true natural rate – But trial and error works best when there is continual and rapid feedback • Estimating natural rate of unemployment is made even more difficult because economy is constantly buffeted by shocks of one kind or another – This information is difficult to sort out • Although Fed has become increasingly sophisticated in its efforts to do so 38

Rules Versus Discretion and the “Taylor Rule” • Over last several decades, Federal Reserve has formulated monetary policy using discretion – Responding to demand supply shocks in the way that Fed officials thought best at the time • Should Federal Reserve have complete discretion to change its interest rate target in response to demand supply shocks as it sees fit? – Or should it stick to rules or guidelines in making monetary policy • Rules that it announces in advance, with a justification required for any departure? • Currently, most often-discussed rule is Taylor rule – Originally proposed in 1993 by economist John Taylor (currently Undersecretary of Treasury for International Affairs) 39

Rules Versus Discretion and the “Taylor Rule” • According to Taylor rule, Fed would announce a target for inflation rate, and another target for real GDP (based on its estimate of GDP in that period) – Then Fed would obligate itself to change its interest rate target by some pre-determined amount for each percentage point that either output or inflation deviated from its respective target • What would be advantage of such a rule? – By committing Federal Reserve to respond to the first signs that economy is heading toward a boom • Fed lets the public know that it will not allow the economy to continue overheating – Thus discourages formation of inflationary expectations 40

Rules Versus Discretion and the “Taylor Rule” • Taylor rule would give Fed ammunition to fight inflation with a higher interest rate – Even when doing so might prove unpopular at the time • Taylor rule is controversial – Opponents argue • Implies more advanced knowledge about the economy—and what an appropriate future response should be—than is realistically possible • Fed’s behavior, under Alan Greenspan, has conformed closely to specific numerical rule that Taylor has proposed over much of the recent past 41

Deflation • During first four years of Great Depression, price levels fell an average of 10% per year – Very serious episode of deflation • Why does deflation create difficulties for monetary policy? – Problem for Fed is that nominal interest rate cannot go below zero • Recall relationship between real and nominal interest rates – Real interest rate = Nominal interest rate – Rate of inflation • an also write this in terms of real interest rate that people expect to pay (or receive) on a loan – Expected real interest rate = Nominal interest rate – Expected Rate of inflation • Relationship tells us that when expected inflation rate is positive, real interest rate will be less than nominal rate • But suppose there is deflation—a negative rate of inflation —and suppose that people begin to expect continuing deflation – Equation tells us that expected real interest rate will be higher than 42 nominal interest rate

Deflation • Ongoing expected deflation puts a positive floor under expected real interest rate – Once this floor is reached, expected real interest rate cannot decrease any further during decreases in the nominal rate • Potentially limiting Fed’s ability to raise aggregate expenditure and output with monetary policy • In 2003—with annual federal funds rate set at 1% and annual inflation running at about 2% – Real federal funds rate was – 1% • Fear was this could create a dangerous vicious circle – Decreased spending—a negative demand shock—would further decrease the inflation rate (a greater deflation rate) • Which in turn would raise real interest rate even further 43

Deflation • Fed officials were very much aware of this problem – In early 2000 s they began to plan for contingency of deflation – While deflation of 5 or 10% a year would be a serious threat • A modest deflation rate was unlikely to create a downward spiral for economy – Fed announced that it was prepared to change the way it conducts monetary policy should need arise • Instead of limiting its open market operations to injecting reserves into federal funds market – It was prepared to start buying long term government bonds – Fed had one other tool • Ability to influence expectations • By announcing believable policies designed to raise inflation to a modest, positive level – Fed could create positive inflationary expectations even in the midst of deflation – Most economists believe that Fed would be able to convince the public, should the need arise – Even if all monetary policy tools were unable to stimulate spending, fiscal policy could be used • Government could increase purchases itself, or reduce taxes even further to raise disposable income 44

Deflation • Conducting monetary policy is not easy – Fed carries out research and gathers data to improve its information – Effort seemed to have paid off during decade leading up to 2001 • Will Fed continue to be as successful as it has been in recent years? – Difficult to say 45