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Transcript
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. 3 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. 4 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. 5 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 6 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. 7 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. 8 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. 9 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 10 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. 11 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% 12 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. 13 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… 14 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. 15 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. 16 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 17 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? 18 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. 19 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 20 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 21 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 22 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. 23 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? 24 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 25 When the Fed Does Too Much 26 When the Fed Does Too Much 27 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. 28 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. 30 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? 31 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. 32 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. 33 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. 34 Second Edition End of Chapter 16