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CHAPTER 25
The Challenges of Monetary Policy
Learning Objectives
 The goals of monetary policy, including economic growth, stable prices, full employment,
and satisfactory external balance
 How numerical goals are formulated and why they can differ in the short run and the long
run
 The monetary policy goals in terms of aggregate demand and aggregate supply
 The monetary policy options available to respond to fluctuations in aggregate demand and
aggregate supply
Chapter Outline
I.
II.
III.
IV.
V.
VI.
Can the Business Cycle Be Mitigated?
The Goals of Monetary Policy
A.
Economic Growth
B.
Stabilization of Unemployment, Inflation, and the External Balance
The Source of Numerical Objectives for Unemployment and Inflation
Changes in Aggregate Demand and Policy
Demand-Induced Recession
Changes in Aggregate Supply and Policy
Answers to Review Questions
What are the goals of monetary policy?
The goals of monetary policy are to design and implement policies that will achieve maximum
sustainable economic growth in the long run. To achieve th is, policymakers pursue policy to
seek full employment, stable prices, and satisfactory external balances in the short run.
How are the goals of full employment and stable prices related to the long -run goal of
economic growth? How can policymakers affect long-run growth?
The goals of full employment and stable prices are related to the long -run goals of economic
growth. Stabilizing the economy in the short run at full employment and stable prices
contributes to the achievement of long run maximum sustai nable growth. Thus, for the United
States to reach its economic potential, policymakers should pursue policies to achieve full
employment and stable prices in the short run.
Why do policymakers have to be aware of the external balance?
Policy makers have to be aware of the external balance because the external balance affects
exchange rates, which in turn can have an affect on domestic employment and the price level.
For example, if the United States runs a large trade deficit, the dollar will depreciate. The
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The Challenges of Monetary Policy
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depreciation of the dollar can cause capital outflows that lead to higher interest rates and
increases in the prices of imports, contributing to higher inflation. Changes in exchange rates
feed back into the domestic economy via their effect on net export s and capital flows.
Explain why the short-run goal for inflation is not always 0 percent.
The short-run goal for inflation is not always zero percent because prices are not always stable.
The inflation goal over the near term is dependent on recent exp eriences and the historical and
political environment. If inflation has most recently been relatively high, then it is unlikely
that policymakers will seek to reduce it to 0 in the very near term. More than likely, they will
gradually reduce it. Also, the short-run goal may be for inflation in the 1 to 2 percent range.
A goal of 0 may put downward pressure on the economy and cause the economy to lapse into
deflation. Therefore, the long run goal may be for inflation in the 1 to 2 percent range.
What is deflation, and why do policymakers have to be concerned about it?
Deflation refers to a decline in the overall price level as measured by a price index.
Policymakers have to be concerned about this phenomenon as falling prices can lead to debt
deflation, defaults, and bankruptcies. Deflation is actually more onerous than inflation because
debts are denominated in dollars and the real value of debt increases with deflation.
Does the natural level of unemployment ever change? If it does, explain why.
Yes, the natural level of unemployment does change; it can change in response to a change in
the composition of the labor force, and the changing safety net of benefits available to the
unemployed. For example, unemployment affects young people more than o lder workers. If
the labor force becomes more (less) heavily weighted with young workers, the natural level of
unemployment will increase (decrease). Likewise, if the safety net improves, workers will
tend to stay off work longer when they become unemplo yed. This will increase the natural
rate.
Explain why the numerical objectives of policy change.
The numerical objectives of policy change because the prevailing economic and political
environment and the nation's historical experience all play a role in setting the priorities that
guide policy action. Since the policy makers and the economic and political environment
change over time, so does the weight given to each priority.
What is a supply shock? What is the appropriate policy response to a nega tive supply
shock? What determines whether policymakers should act or do nothing in the face of
adverse shocks to either aggregate demand or aggregate supply?
A supply shock is any event that shifts the short -run aggregate supply curve. The appropriate
response to a negative supply shock is to 1) boost aggregate demand via fiscal or monetary
policy, or 2) do nothing. The time the economy would take to return to full employment after
the shock determines whether or not policy makers should act. If market pa rticipants expect
policymakers to act, then the time the economy takes to adjust is longer.
In the context of monetary policy, what is accommodation? If the Fed usually increases
the money supply in response to decreases in aggregate demand, how will th is affect
the adjustment process?
Accommodation is when policy makers boost aggregate demand in response to an adverse
supply shock or in response to a decline in aggregate demand. If the Fed usually increases the
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money supply in response to decreases in aggregate demand, then market participants will
come to expect this from the Fed. In this case, if the Fed does nothing, the adjustment process
will take longer than without this expectation.
Define both cost-push and demand-pull inflation.
Cost-push inflation is triggered by increases in input prices. Producers raise prices because
their costs are increasing. Demand-pull inflation occurs when an excessive level of aggregate
demand pulls up the overall price level. Demand -pull inflation is associated with full
employment.
How is the natural level of real output related to the natural rate of unemployment?
The natural rate of unemployment is the level of unemployment that corresponds with the
natural level of output.
Can the economy experience a demand-pull inflation and a recession at the same time?
Demand-pull inflation is caused by an excessive level of aggregate demand. A recession is
caused by too little aggregate demand. Therefore, the economy cannot experience a
demand-pull inflation and a recession.
In the late 1990s, Congress and the president eliminated the federal deficit. What effect
has this had on aggregate demand?
A growing government surplus or declining government deficit, reduces the level of aggregate
demand.
Can a person be employed but not be in the labor force? Can a person be unemployed but
not be in the labor force?
No, a person cannot be employed and not be in the labor force. A person cannot be unemployed
and not in the labor force. The labor force consi sts of the employed plus the unemployed. To
be employed or unemployed, a person must be in the labor force.
Answers to Analytical Questions
Use aggregate supply and aggregate demand curves to analyze a supply shock.
An adverse supply shock shifts the short-run aggregate supply curve from SRAS1 to SRAS.
The shock causes unemployment and prices to both rise in the short run and output to fall. A
beneficial supply shock shifts the short-run aggregate supply curve from SRAS to SRAS1 and
causes the overall price level to fall, and the levels of employment and output to rise.
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Use aggregate supply and aggregate demand curves to illustrate demand -pull and costpush inflation.
Demand-pull inflation is caused by a rightward shift in the aggregate dem and curve. The
overall price level rises because of the increase in demand that can emanate from increases in
spending from any sector or from increases in the money supply orchestrated by the Fed.
Cost-push inflation is caused by an adverse supply sho ck that shifts the short-run aggregate
supply curve leftward. In this case, both unemployment and the overall price level both
increase.
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The nominal interest rate is 6 percent, expected inflation is 3 percent, and the tax rate is
20 percent. What is the real after-tax return? If the nominal interest rate and the
expected inflation rate both decrease by 2 percent, what is the real after -tax return?
The real after-tax return is the nominal return less the tax liability less the expected inflation
rate. In this case, the real-after tax return is 1.8 percent (6 percent - .2x6 percent – 3 percent
= 1.8 percent). If the nominal interest rate and the expected inflation rate both decrease by 2
percent, the real after- tax return increases to 2.2 percent (4 percent - .2x4 percent – 1 percent
= 2.2 percent).
The nominal interest rate is 3 percent but people expect prices to fall by 4 percent. What
is the real interest rate? If the tax rate is 20 percent, what is the real after -tax
return?
If the nominal interest rate is 3 percent but people expect prices to fall by 4 percent, then the
real interest rate is –1 percent. If the tax rate is 20 percent, the real after -tax return is -1.6
percent (3 percent - .2 x 3 percent – 4 percent = -1.6 percent).
Draw the long-run aggregate supply curves for successive long-run equilibriums with a
potential growth rate of real GDP at 2.5 to 3.0 percent per year. What is the
sustainable growth rate of output over time?
The sustainable growth rate of output is 2.5 to 3 percent over time.
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Graphically demonstrate the appropriate Fed policy in response to a severe unexpected
drop in aggregate demand.
A severe unexpected drop in aggregate demand is represented by a leftward shift of the AD
curve. If there is a severe unexpected drop in aggregate demand, the appropriate Fed policy in
response is to increase the money supply and lower interest rates in order to increase the level
of aggregate demand and shift the AD curve rightward .
Graphically demonstrate how changes in aggregate demand cause inflation or deflation
(falling prices) in the short run. Explain why only the price level changes in the long
run. What happens to the price level over successive long runs?
If aggregate demand increases, the aggregate demand curve shifts from AD to AD1 resulting in
inflation (higher prices). If aggregate demand decreases, the aggregate demand curve shifts
from AD to AD2, resulting in deflation (lower prices). In the short run, ou tput prices adjust
faster than input prices. Thus, changes in output are triggered by changes in demand. In the
short run, if output prices rise faster or slower than input prices, then production becomes more
or less profitable in the short run, and out put expands or contracts. In the long run, input
prices adjust in response to changes in aggregate demand. Full adjustment has occurred when
changes in input prices fully reflect changes in output prices. When full adjustment has
occurred, output returns to the full employment level at the natural rate of real output. Thus,
the long-run aggregate supply curve is vertical through the full employment level of output.
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In each of the following cases, explain whether the individual is in the labor force , not in
the labor force, employed, or unemployed:
a.
b.
c.
d.
e.
f.
A 14-year-old truant who is looking for work
A person who has started her own business
A college student
My retired mother who does volunteer work at a hospital
A discouraged aerospace worker who has given up looking for a job
A recent college graduate who is actively seeking a job
a. Not in the labor force (must be 16 years old)
b. Employed and part of the labor force
c. Not part of the labor force if not actively looking for work
d. Not part of the labor force
e. Not in the labor force because not actively looking for work
f. Unemployed and part of the labor force
Use aggregate demand and aggregate supply curves to show what will happen to output
and the price level if government spending is reduced at the same time the Fed takes
action to increase the money supply.
If government spending is reduced, the aggregate demand curve shifts from AD to AD I
resulting in a lower price level and lower output. If however, the reduction in government
spending is accompanied by an increase in the money supply, rather than the aggregate demand
shifting from AD to AD1, the aggregate demand curve shift will depend on the magnitude of
the money supply increase and government spending reduction. If the effect of the money
supply increase is greater than the government spending reduction, the new aggregate demand
curve could lie above the AD curve. If the effects of the money supply increase are less than
the government spending reduction, the new aggregate demand curve will lie somewhere below
the AD curve. If the effect of the money supply increase is equal to the government spending
reduction, the AD curve will return to the original position and t he Fed’s policy will fully
offset the reduction in government spending.