Inflation and Monetary Policy

ECONOMICS: Principles and Applications 3eHALL & LIEBERMAN© 2005 Thomson Business and Professional Publishing

Slides by: John & Pamela Hall

Inflation and Monetary Policy

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The Objectives of Monetary Policy

• Fed was first established in 1913– Chief responsibility was to ensure stability of

banking system• Fed’s objective in 1950s and 1960s changed

to keeping interest rate low and stable– In 1970s, 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

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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

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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

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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

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

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

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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

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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

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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

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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

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Figure 2: Responding to Shifts in Money Demand

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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

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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

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

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Figure 4: The Best Response to a Spending Shock

Money

Interest Rate (%)

M1d

M1s

r1

(a)

Real GDP

Price Level

YFE

(b)

P1 E

AD1

AS

E

3

M2s

Hr

FP2

AD2

Y2

2

r

M d

2F

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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

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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

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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

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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

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Figure 5: Responding to Supply Shocks

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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 trade-

off– 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

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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

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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 1960s?– 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 1960s, Fed saw its job differently than it does today

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• As price level continued to rise in 1960s, 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

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

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• 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

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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

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Figure 7: The Phillips Curve

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Figure 8: The Shifting Phillips Curve

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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

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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

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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

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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

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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 2000s, 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

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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

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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

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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

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Rules Versus Discretion and the “Taylor Rule”

• Over last several decades, Federal Reserve has formulated monetary policy using discretion– Responding to demand and 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 and 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)

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• 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

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• 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

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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

nominal interest rate

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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

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Deflation

• Fed officials were very much aware of this problem– In early 2000s 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

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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

Inflation and Monetary Policy

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