MONETARY POLICY

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MONETARY POLICY
CHAPTER
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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 Feds 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 Feds credibility
• Describe and compare the new monetarist and new
  Keynesian feedback rules for monetary policy

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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?

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Instruments, Goals, Targets, and the Feds
Performance

• To discuss monetary policy if we distinguish
  among
• Instruments
• Goals
• Intermediate targets

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Instruments, Goals, Targets, and the Feds
Performance

• The instruments of monetary policy are
• Open market operations
• The discount rate
• Required reserve ratios
• The goals of monetary policy are the Feds
  ultimate objectives and are
• Price level stability
• Sustainable real GDP growth close to potential
  GDP

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Instruments, Goals, Targets, and the Feds
Performance

• The Feds 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 Feds intermediate target is the federal
  funds rate.

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Instruments, Goals, Targets, and the Feds
Performance

• 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 peoples economic calculations.
• An inflation rate between 0 and 3 percent a year
  is generally seen as being consistent with price
  level stability.

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Instruments, Goals, Targets, and the Feds
Performance

• 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.

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Instruments, Goals, Targets, and the Feds
Performance

• The Feds Performance 19732003
• The Feds performance depends on
• Shocks to the price level
• Monetary policy actions

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Instruments, Goals, Targets, and the Feds
Performance

• Shocks to the price level during the 1970s and
  1980s made the Feds job harder
• World oil price hikes
• Large and increasing budget deficits
• Productivity slowdown
• These shocks intensified inflation and slowed
  real GDP growth.

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Instruments, Goals, Targets, and the Feds
Performance

• Shocks in the 1990s made the Feds job easier.
• Falling world oil prices
• Decreasing budget deficits (and eventually a
  budget surplus)
• New information economy brought more rapid
  productivity growth.

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Instruments, Goals, Targets, and the Feds
Performance

• Figure 32.1 summarizes monetary policy 1973-2003.

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Instruments, Goals, Targets, and the Feds
Performance

• There is a tendency for the federal funds rate to
  fall as an election approaches and usually the
  incumbent President or his partys 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.

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Instruments, Goals, Targets, and the Feds
Performance

• 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.

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Instruments, Goals, Targets, and the Feds
Performance

• Figure 32.2 provides a neat way of showing how
  well the Fed has done in shooting at its target.

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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.

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Achieving Price Level Stability

• The monetary policy regimes that can be used to
  stabilize aggregate demand are
• Fixed-rule policies
• Feedback-rule policies
• Discretionary policies

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Achieving Price Level Stability

• 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.

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Achieving Price Level Stability

• 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 ruleStop
  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.

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Achieving Price Level Stability

• 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.

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Achieving Price Level Stability

• 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.

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Achieving Price Level Stability

• 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.

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Achieving Price Level Stability

• Aggregate demand fluctuates between ADLOW and
  ADHIGH.
• Real GDP and the price level fluctuate between
  recession and boom.

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Achieving Price Level Stability

• 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.

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Achieving Price Level Stability

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

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Achieving Price Level Stability

• 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.

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Achieving Price Level Stability

• 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.

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Achieving Price Level Stability

• 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 cant predict the precise timing and
  magnitude of the effects of its policy actions.
• A feedback policy that reacts to todays economy
  might be wrong for the economy at that uncertain
  future date when the policys effects are felt.

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Achieving Price Level Stability

• Stabilizing Aggregate Supply Shocks
• Two types of shock occur to bring fluctuations in
  aggregate supply
• Productivity growth fluctuations
• Fluctuations in cost-push pressure

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Achieving Price Level Stability

• 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.

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Achieving Price Level Stability

• Figure 32.5 shows this outcome.
• 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.

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Achieving Price Level Stability

• 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.

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Achieving Price Level Stability

• 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

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Achieving Price Level Stability

• Feedback Rule to Stabilize Real GDP
• Suppose that the Feds 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.
• Figure 32.6 shows this outcome.

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Achieving Price Level Stability

• 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.

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Achieving Price Level Stability

• Feedback Rule to Stabilize the Price Level
• Suppose that the Feds 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.

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Achieving Price Level Stability

• 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.

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Achieving Price Level Stability

• 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.

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Achieving Price Level Stability

• 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
  risesstagflation.

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Achieving Price Level Stability

• 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.

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Achieving Price Level Stability

• 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.

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Achieving Price Level Stability

• 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.

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Achieving Price Level Stability

• Feedback Rules with Cost-Push Inflation Shock
• Again, there are two feedback rules
• Rule to stabilize real GDP
• Rule to stabilize the price level

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Achieving Price Level Stability

• 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.

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Achieving Price Level Stability

• 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.

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Achieving Price Level Stability

• 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.

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Achieving Price Level Stability

• 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.

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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

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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.

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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.

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Policy Credibility

• If expectations are fulfilled, the price level
  rises to 115.5a 10 percent inflationand real
  GDP remains at potential GDP.
• Now suppose that the Fed unexpectedly decides to
  slow inflation.

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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 113.4an inflation rate of 8
  percent a year.

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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.

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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.

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Policy Credibility

• The Feds 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.

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Policy Credibility

• A Credible Announced Inflation Reduction
• Suppose the Fed announces its intention to slow
  inflation to 5 percent.
• Suppose also that the Feds policy announcement
  is credible and convincing.
• The expected inflation rate becomes 5 percent a
  year.

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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 110.25inflation is 5
  percentand real GDP remains at potential GDP.

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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.

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Policy Credibility

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

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Policy Credibility

• Inflation Reduction in Practice
• When the Fed in fact slowed inflation in 1981, we
  paid a high price.
• The Feds 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.

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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

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New Monetarist and New Keynesian Feedback Rules

• 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.

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New Monetarist and New Keynesian Feedback Rules

• 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

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New Monetarist and New Keynesian Feedback Rules

• 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.

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New Monetarist and New Keynesian Feedback Rules

• 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.

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New Monetarist and New Keynesian Feedback Rules
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New Monetarist and New Keynesian Feedback Rules

• 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.

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New Monetarist and New Keynesian Feedback Rules

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

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New Monetarist and New Keynesian Feedback Rules

• 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).

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New Monetarist and New Keynesian Feedback Rules

• 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

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New Monetarist and New Keynesian Feedback Rules

• 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.