Download Chapter 17: Monetary Policy

Chapter
Seventeen
Monetary Policy:
Goals and Tradeoffs
Monetary Policy:
Goals and Tradeoffs
• The Fed faces a tradeoff between inflation
and unemployment
• Changes in monetary policy often have
opposite effects on each
• The Fed’s goals are assessed in terms of
– Output
– Unemployment rate
– Inflation rate
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Stabilization Policy
• Expansionary monetary policy causes the
economy to grow faster in the short run
– Increases in the money supply
– Output is higher, unemployment lower, and inflation
rate is higher over time
• Contractionary monetary policy causes the
economy to grow more slowly in the short run.
– Decreases in the money supply
– Output is lower, unemployment higher, and inflation
rate is lower over time
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Stabilization Policy
• Expansionary Monetary Policy
M ↑ ; Y ↑ short run; P ↑ long run
• Contractionary Monetary Policy
M ↓ ; Y ↓ short run; P ↓ long run
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Stabilization Policy
If monetary policy is used successfully to temper business cycle
fluctuations, cycles stay closer to the trend line
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Stabilization Policy
If monetary policy is not used successfully to temper business
cycle fluctuations, then the fluctuations are more severe
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Lags in Stabilization Policy
• Stabilization policy may not work if lags are
severe
• Types of lags
–
–
–
–
–
Data Lag
Recognition Lag
Decision Lag
Implementation Lag
Effectiveness Lag (long and variable lag)
• 6 to 9 months before maximum impact on output
• 12 to 18 months before maximum impact on inflation
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Goals of Monetary Policy
•
Goals at founding of Fed (Federal
Reserve Act, 1913)
1. Provide an elastic currency (gold standard
and interest rates)
2. Afford means of rediscounting commercial
paper (discount loans)
3. Establish a more effective supervision of
banking
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Goals of Monetary Policy (cont’d)
• Goals from Employment Act of 1946
– Fed should use its tools to increase
employment and production (based on
Keynesian theory)
• Goals from Humphrey-Hawkins Act of
1978
– Promote full employment and production,
increase real income and balanced growth,
and reasonable price stability . . .
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Goals of Monetary Policy (cont’d)
• Today
– Short run: maximize output to keep
unemployment low
– Long run: maintain a low rate of inflation
• Focus on three variables
– Output
– Unemployment rate
– Inflation rate
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Output
• A major goal of the Fed is to maximize
output
– Output above potential means more work
than people desire in the long run
– Output below potential means unemployed
resources, inefficiency
– The problem: determining level of potential
output in practice is difficult
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Output (cont’d)
Figure 17.4 U.S. Output Growth Since 1960
Gray bars denote recessions, when output growth always falls below zero
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Potential Output
• Potential output is the amount that would
be produced by the economy if all
resources were being used efficiently
• Monetary policy alone does not determine
output growth; potential output concept
was developed to help account for these
additional factors
• While actual output can exceed potential
in the short run, it is not sustainable
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Potential Output (cont’d)
Figure 17.5 Actual and Potential U.S. Output Since 1960
Actual output sinks below potential the most during recessions
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Unemployment
• The actual unemployment rate is ideally
equal to the natural rate of unemployment
• The natural rate of unemployment is
that rate when the economy is producing
output equal to its potential
• Natural rate of unemployment reflects
structural unemployment and frictional
unemployment, so it is never zero
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Unemployment (cont’d)
• Costs of high unemployment (above the
natural rate)
– Loss of output
– Societal costs, including crime
• Costs of low unemployment (below the
natural rate)
– Difficult to match workers and jobs
– Wage inflation
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Unemployment (cont’d)
• A key issue in
stabilization policy is
determining the natural
rate of unemployment
in real time.
– Not directly observable
– Estimates created long
after the fact
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Unemployment (cont’d)
Figure 17.6 U.S. Unemployment Rate Since 1960
Unemployment has only fallen below 4% in the expansion of the 1960s
and again in 2000
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Unemployment (cont’d)
Figure 17.7 Actual and Natural Rate of U.S. Unemployment Since 1960
Unemployment may rise high above the natural rate during recession
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Inflation
• Again not determined exclusively by
monetary policy
• The consumer price index (CPI) is most
widely used to measure inflation
• Exclude food and energy prices, to get
handle on long-term trend in short run
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Inflation (cont’d)
Figure 17.8 U.S. CPI Inflation Rate Since 1960
During the last 20 years, inflation has declined
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Costs of Inflation
• Costs of Unanticipated Inflation
– Prices are set wrong
– Wealth redistribution between borrowers and lenders
– Leads to greater uncertainty about the future inflation
rate
• Unanticipated inflation problems are worse the
higher the inflation rate, because people are less
able to tell the direction the rate will go
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Costs of Inflation (cont’d)
• Costs of Anticipated Inflation
– Inflation is an implicit tax on holding money
– Firms face menu costs of changing prices
– Hurts people on fixed nominal incomes
– Interacts with tax system to hurt saving and
investment
– Housing market distorted by mortgage tilt
problem
• The real value of nominal mortgage payments
declines over time
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Costs of Inflation (cont’d)
Figure 17.9 The Mortgage-Tilt Problem
Inflation erodes the real value of a constant-dollar mortgage payment
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The Ideal Inflation Rate
• The ideal inflation rate is the rate that
policymakers would like to achieve
because it minimizes the costs to society
of changing prices
• Also referred to as inflation targeting
because it represents the Fed’s long-term
goal for the inflation rate
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The Fed’s Objective Function
•
Assigns numbers to enable policymakers
to assess alternative policies
1. Output Gap: measures what output level
would be necessary if there were no
recessions
2. Unemployment Gap: measures how close
the unemployment rate is to the natural rate
3. Inflation Gap: measures how close the
inflation rate is to the ideal rate
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Output Gap
• Output gap = percentage deviation of
output from potential output
• Positive output gap means output above
potential output; negative means output is
below potential
yt  y t
~
yt 

100
*
yt
*
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Costs of Inflation (cont’d)
Figure 17.10 U.S. Output Gap Since 1960
Output gaps decline and become negative in recession
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Unemployment Gap
• Unemployment gap = difference between
unemployment and natural rate of
unemployment
• Okun’s law demonstrates negative relationship
between the output gap and the unemployment
gap
• Since the relationship is tight, we usually use
just one or the other; we use the output gap in
determining the Fed’s objective function
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Okun’s Law & the Unemployment Gap
Figure 17.11 Okun’s Law in U.S. Data Since 1960
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Inflation Gap
• Inflation gap = actual inflation rate minus
ideal inflation rate
• Ideal inflation rate is not widely agreed
upon, but probably about 0 to 2 percent
• The U.S. has more often struggled with an
inflation rate that is too high rather than
too low
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U.S. Inflation Gap
Figure 17.12 U.S. Inflation Gap Since 1960
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Equation for Fed’s Objective Function
• Combines measure of output and inflation
gaps in an equation
– Summarizes the total cost to the economy of
both gaps.
• Also called the Fed’s loss function
Total loss = Sum over time of [output
loss + (w x inflation loss)]
output loss = output gap squared
inflation loss = inflation gap squared
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Equation for Fed’s Objective
Function (cont’d)

 ~
yt2  (w  ~t2

time
• Weight on inflation terms (w) determines
aggressiveness of response to inflation
or the output gap
• The Fed places more weight to the
inflation loss and less to output loss
• The weight on inflation determines how
inflation and output change over time
after a shock hits the economy
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The Phillips Curve
• The Phillips Curve illustrates the trade-off
between inflation and unemployment
π = α – βU
• This relationship suggests that
policymakers may choose between
inflation and unemployment
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The Phillips Curve (cont’d)
Figure 17.13 Phillips Curve from 1948 to 1965
The solid trend line illustrates Phillips’ tradeoff
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The Phillips Curve (cont’d)
Figure 17.14 Phillips Curve Since 1948
The tradeoff seems to disappear after the 1960s
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The Phillips Curve (cont’d)
• Since the 1960, economists have modified
the theory to account for expected
inflation
π = πe – β(U – UN)
• There is a tradeoff in the short run, but not
in the long run
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The Phillips Curve (cont’d)
The long run Phillips curve is vertical at the natural rate of
unemployment, while the short run curve is associated with a particular
expected inflation rate
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The Phillips Curve (cont’d)
With a sudden, unexpected increase in the money supply, short run
inflation rises, but declines as the economy readjusts
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The Phillips Curve (cont’d)
A permanent increase in the money supply changes the inflation
rate in the long run
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The Phillips Curve (cont’d)
Figure 17.18 The Shifting Short-Run U.S. Phillips Curve Since 1948
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The Phillips Curve (cont’d)
• Rewrite equation in terms of gaps
π – πe = – β(U – UN)
• Inflation surprise = – β x unemployment
gap
• This better reflects the short vs. long run
Phillips curve tradeoffs
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The Phillips Curve (cont’d)
Figure 17.19 Expectations-Augmented Phillips Curve Since 1960
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