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Second Edition
Chapter 16
Monetary Policy
Chapter Outline
 Monetary Policy: The Best Case
 The Negative Real Shock Dilemma
 When the Fed Does Too Much
2
Introduction
 In this chapter we consider:
• The best case for monetary policy.
• Some reasons why the Fed doesn’t always
know which course of action is best.
• Why negative real shocks are harder for the
Fed to respond to.
• Some cases where it’s not clear what the best
monetary policy is.
• The financial crisis that started in 2007.
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Monetary Policy: The Best Case
 Suppose that entrepreneurs are suddenly
more pessimistic.
 This results in less borrowing and lending
and the growth rates of M1 and M2 fall.
 AD falls and the rate of growth of real GDP
falls.
 Eventually the growth rate of spending will
return to its higher level.
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Monetary Policy: The Best Case
 Eventually the economy will recover at the
original growth rate of real GDP and a
lower rate of inflation.
• If wages are sticky, this process takes longer,
and higher unemployment will last longer.
 The Fed can use monetary policy to shift
the AD curve back and reduce the length
and severity of the recession.
Let’s use the dynamic AD/AS model to see how this may work.
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Monetary Policy: The Best Case
Inflation
rate
(p)
Solow
Growth
curve
Negative shock to AD:
↓  → ↓ AD
a → b: ↓p, ↓ growth
Fed Response:
↑ M → ↑ AD
b → a: ↑p, ↑ growth
(1) Private
decrease
7%
6%
Short-run aggregate supply (SRAS)
(E(p) = 7%)
a
b
(2) Fed
increase
AD (M  v)  10%
AD (M  v)  5%
-1%
3%
Real GDP
growth rate
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Monetary Policy: The Best Case
 Two difficulties make it hard for the Fed to
get it right.
1. The Federal Reserve must operate in real
time
2. The Federal Reserve’s control of the money
supply is incomplete and subject to uncertain
lags.
Let’s look at each in turn.
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The Fed Must Operate in Real Time
 Data are often released on a quarterly or
monthly basis.
• Are often amended after the fact.
• Take time to analyze and interpret.
 Example: Recent financial crisis
• First major signs of trouble were seen in August
2007
• Most investors and the Fed had no idea as to the
magnitude of the problem.
• Spring 2008: GDP growth figures were still
positively strong.
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The Fed’s Control of the Money Supply Is
Incomplete and Subject to Uncertain Lags.
 The lag typically affects the economy with a
lag of 6 to 18 months.
 Monetary policy can undershoot or
overshoot:
• If banks aren’t willing to lend the Fed will
undershoot.
• If the economy recovers before the monetary
policy has an effect, the Fed overshoot.
Let’s use the model to illustrate undershooting and overshooting.
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Undershooting and Overshooting
Inflation
rate
(p)
(1) Private
decrease
d
7%
6%
SRAS
(E(p) = 7%)
Solow
Growth
curve
a
The Fed:
• “undershoots”
• “overshoots”
• Gets it “just
right”
c
b
-1%
3%
Real GDP
growth rate
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Rules vs. Discretion
 Two Positions
1. Monetary policy should be governed by
transparent rules.
 Fed should not try to respond to every shock, but…
• Set target ranges for M1 and M2.
• Milton Friedman’s rule: increase the money
supply by 3% a year.
• Allow some adjustments, stated in advance.
2. Fed should have the discretion to do what
they think best.
• Proponents believe discretionary policy has
resulted in less volatility.
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Reversing Course and Engineering a
Decrease in AD
 Most economists think that the Fed over
stimulated the economy in the 1970s.
• By 1980 the rate of inflation was 13.5% a year.
• The cost of reducing the rate of inflation to 3%
was very high.
 Worst recession since the Great Depression
 Unemployment → just over 10%
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Reversing Course and Engineering a
Decrease in AD
 An important distinction:
• Disinflation – a significant reduction in the rate
of inflation.
• Deflation – a negative rate of inflation.
 Since WWII – Fed has caused disinflation
six times by reducing money growth…
• In every case, real GDP declined.
• On average – industrial production 33 months
later was 12% lower than otherwise expected.
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Reversing Course and Engineering a
Decrease in AD
 A monetary contraction goes best when it
is credible.
• Credibility – When people expect the Fed to
stick with its policy.
• If the Fed lacks credibility, the resulting
unemployment will be higher for longer.
• Fed policy during the 1970s provides a good
example.
• Let’s see…
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Reversing Course and Engineering a
Decrease in AD
 Because the Fed allowed inflation to rise
during the 1970s, it lacked credibility.
• Result: It took longer for tight monetary policy
to bring down inflation.
 People continued to expect higher inflation in spite
of what the Fed was doing.
 This higher expected inflation was built into wage
demands.
 Result: higher unemployment for longer.
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Reversing Course and Engineering a
Decrease in AD
 The key to less painful disinflation is to
increase wage flexibility.
 Fed credibility increases wage flexibility.
 Lesson:
• If a central bank wants a successful
disinflation,...
 It must be willing to stay the course.
 It should announce and explain its policy.
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The Fed as Manager of
Market Confidence
 Market confidence – One of the Fed’s most
powerful tools is its influence over
expectations, not its influence over the
money supply
 When there is uncertainty:
• People to hold more cash →  
• Lending falls →  M
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Check Yourself
 How do problems with data affect the
Fed’s ability to set monetary policy that is
“just right”?
 Why did Milton Friedman argue for a set
rule of 3 percent money growth per year?
Why not 2 percent or 0 percent?
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The Negative Real Shock Dilemma
 Monetary policy is less effective at dealing
with a real shock.
 Example: a sudden and large increase in
the price of oil.
• Shifts the Solow growth curve to the left.
• Result: Lower growth and higher inflation.
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The Negative Real Shock Dilemma
 Dilemma: If the Fed responds by…
• Decreasing the money supply to deal with
inflation: real growth will fall and
unemployment will increase.
• Increasing the money supply to deal with the
decrease in real growth: Inflation will increase.
 We will look at these two cases
• Policy I –  M → ↓AD
• Policy II –  M → ↑AD
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The Negative Real Shock Dilemma
Inflation
rate (p)
New Solow Old Solow
growth
growth
curve
curve
8%
6%
(1) Real shock: Solow
growth curve shifts left:
p↑ →SRAS shifts up.
Old SRAS
a→b
(2) Fed responds
by  M → ↓ AD
b→c
Result: ↓ real growth even
further.
b
c
New SRAS
a
AD (M  v)  5%
-5% -3%
3%
Real GDP
growth rate
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The Negative Real Shock Dilemma
Inflation
rate (p)
New Solow Old Solow
growth
growth
curve
curve
c
16%
8%
(2) Fed responds
by  M → ↑ AD
b→c
Old SRAS
Result: ↑inflation
b
New SRAS
a
AD (M  v)  15%
AD (M  v)  5%
-3% -1% 3%
Real GDP
growth rate
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The Negative Real Shock Dilemma
 Argument: Fed actions to stem inflation in
response to 1970s oil shock made things
worse.
• Ben Bernanke, current Fed chairman, was a
critic of the Fed’s actions in the 1970s.
 His response as chairman was consistent with this
argument as oil prices rose in 2007-2008.
• The Fed didn’t contract the money supply.
• Consistent with current consensus.
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Check Yourself
 If the Fed wanted to restore some growth
to the economy to deal with the high
unemployment, what would it do? What
would be the problem of acting this way?
 Suppose that the Fed reacts to a series of
negative real shocks by increasing AD
every time. What will happen to the
inflation rate?
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When the Fed Does Too Much
 It is argued that Federal Reserve policy
contributed to the housing bubble and bust
that led to the financial crisis in 2007-2008.
 The lead-up to the housing crash:
• Recession in 2001 didn’t last long but
unemployment remained high.
• The Fed lowered the Federal Funds rate from
about 6.5% to below 2% during 2001-2004.
• Low interest rates encouraged speculation in
housing, driving housing prices up.
The next two figures show this
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When the Fed Does Too Much
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When the Fed Does Too Much
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Dealing with Asset Price Bubbles
 What, if anything, could or should the Fed
have done in advance of the crash?
 Easy to say that the Fed should have
raised interest rates sooner.
 Three problems with this line of reasoning.
1. Few people expected that a fall in housing
prices would wreak as much havoc as it did.
2. Not easy to know when a bubble is present.
3. Monetary policy is a crude means of popping
a bubble.
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Dealing with Asset Price Bubbles
 It is not always easy to identify a bubble.
• If everyone knew it was a bubble they would
have invested accordingly and stopped it.
 Few people expected that a fall in housing
prices would wreak as much havoc as it did.
• Risk of securitization of subprime mortgages on
was underestimated.
• The Fed must have judged that reducing
unemployment was worth the risk as it was
understood.
29
Dealing with Asset Price Bubbles
 Monetary policy is a crude means of
popping a bubble.
• It can’t push the demand for housing down
without pushing the demand for everything
else down.
 Fed could have restrained some of the
“sub-prime” mortgages sold during the
boom and later went into default.
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Check Yourself
 How can the Fed tell when increases in
asset prices reach the bubble stage?
 If the Fed thinks there is a bubble in
housing prices, and contracts the growth
in the money supply to pop it, what would
be the collateral damage?
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Takeaway
 The Fed has some influence over the
growth rate of real GDP through its
influence on the money supply and thus
AD.
 A negative shock to aggregate demand
can be dealt with through an expansionary
monetary policy.
• Getting it “just right” is not guaranteed.
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Takeaway
 Poor monetary policy can decrease the
stability of real GDP.
 If the Fed stimulates too much, it may have
to cause disinflation later, producing slower
growth and higher unemployment.
 A negative real shock creates a dilemma
for the Fed:
• Deal with unemployment → ↑ inflation.
• Deal with inflation → ↑ unemployment.
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Takeaway
 Positive real shocks may generate booms
that become bubbles.
• How to recognize and respond is not obvious.
 Real shocks and AD shocks are always
mixed and not easy to disentangle.
 Data is often slow to arrive and subject to
revision.
 Central banking is as much an art as a
science.
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Second Edition
End of Chapter 16