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MONETARY POLICY
32
CHAPTER
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
Fed’s 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 Fed’s credibility
Describe and compare the new monetarist and new
Keynesian feedback rules for monetary policy
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?
Instruments, Goals, Targets, and the
Fed’s Performance
To discuss monetary policy if we distinguish among:
 Instruments
 Goals
 Intermediate targets
Instruments, Goals, Targets, and the
Fed’s Performance
The instruments of monetary policy are
 Open market operations
 The discount rate
 Required reserve ratios
The goals of monetary policy are the Fed’s ultimate
objectives and are
 Price level stability
 Sustainable real GDP growth close to potential GDP
Instruments, Goals, Targets, and the
Fed’s Performance
The Fed’s 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 Fed’s intermediate target is the federal funds rate.
Instruments, Goals, Targets, and the
Fed’s 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 people’s
economic calculations.
An inflation rate between 0 and 3 percent a year is
generally seen as being consistent with price level stability.
Instruments, Goals, Targets, and the
Fed’s 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.
Instruments, Goals, Targets, and the
Fed’s Performance
The Fed’s Performance: 1973–2003
The Fed’s performance depends on
 Shocks to the price level
 Monetary policy actions
Instruments, Goals, Targets, and the
Fed’s Performance
Shocks to the price level during the 1970s and 1980s
made the Fed’s job harder
 World oil price hikes
 Large and increasing budget deficits
 Productivity slowdown
These shocks intensified inflation and slowed real GDP
growth.
Instruments, Goals, Targets, and the
Fed’s Performance
Shocks in the 1990s made the Fed’s job easier.
 Falling world oil prices
 Decreasing budget deficits (and eventually a budget
surplus)
 New information economy brought more rapid
productivity growth.
Instruments, Goals, Targets, and the
Fed’s Performance
Figure 32.1 summarizes monetary policy 1973-2003.
Instruments, Goals, Targets, and the
Fed’s Performance
There is a tendency for the federal funds rate to fall as an
election approaches and usually the incumbent President
or his party’s 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.
Instruments, Goals, Targets, and the
Fed’s 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.
Instruments, Goals, Targets, and the
Fed’s Performance
Figure 32.2 provides a
neat way of showing how
well the Fed has done in
shooting at its target.
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.
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
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.
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 rule—“Stop 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.
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.
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.
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.
Achieving Price Level Stability
Aggregate demand
fluctuates between ADLOW
and ADHIGH.
Real GDP and the price
level fluctuate between
recession and boom.
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.
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.
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.
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.
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 can’t predict the precise timing and magnitude of
the effects of its policy actions.
A feedback policy that reacts to today’s economy might be
wrong for the economy at that uncertain future date when
the policy’s effects are felt.
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
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.
Achieving Price Level Stability
Figure 32.5 shows this
outcome.
With no shock, aggregate
demand is AD0 and longrun aggregate supply is
LAS0.
The price level is 105 and
real GDP is $10 trillion at
point A.
Achieving Price Level Stability
A productivity growth
slowdown shifts the longrun 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.
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
Achieving Price Level Stability
Feedback Rule to Stabilize Real GDP
Suppose that the Fed’s 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.
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.
Achieving Price Level Stability
Feedback Rule to Stabilize the Price Level
Suppose that the Fed’s 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.
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.
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.
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 rises—stagflation.
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.
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.
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.
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
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.
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.
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.
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 costpush inflation but at the
cost of recession.
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
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.
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.
Policy Credibility
If expectations are fulfilled,
the price level rises to
115.5—a 10 percent
inflation—and real GDP
remains at potential GDP.
Now suppose that the Fed
unexpectedly decides to
slow inflation.
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 113.4—an
inflation rate of 8 percent a
year.
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.
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.
Policy Credibility
The Fed’s 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.
Policy Credibility
A Credible Announced Inflation Reduction
Suppose the Fed announces its intention to slow inflation
to 5 percent.
Suppose also that the Fed’s policy announcement is
credible and convincing.
The expected inflation rate becomes 5 percent a year.
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
110.25—inflation is 5
percent—and real GDP
remains at potential GDP.
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.
Policy Credibility
A credible announced
inflation reduction lowers
inflation but with no
accompanying recession
or increase in
unemployment.
Policy Credibility
Inflation Reduction in Practice
When the Fed in fact slowed inflation in 1981, we paid a
high price.
The Fed’s 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.
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
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.
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
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.
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.
New Monetarist and New Keynesian
Feedback Rules
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.
New Monetarist and New Keynesian
Feedback Rules
Figure 32.10 shows the
federal funds rate and the
rate if the Taylor rule were
followed.
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).
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
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.
THE END