Download CHAPTER 27: The Role of Monetary Policy

PART 7: CENTRAL BANKING AND
MONETARY POLICY
CHAPTER 21: The Role of Monetary Policy
FOCUS OF THE CHAPTER
This chapter begins with a brief introduction to monetarism and Keynesianism. The
adaptive expectations and rational expectations theories of inflation are discussed.
Short-run and long-run Phillips curves are used to explain the relationship between the
monetary and real sides of the economy. The link between inflation and money stock is
analyzed, as described in the quantity theory of money and the real bills doctrine. The
chapter ends with a discussion of the link between financial development and economic
growth.
Learning Objectives:





Define monetarism and main competing theories of monetary thought
Explain what the Phillips curve represents
Describe the role played by inflation expectations and how they are measured
Determine why there is inconsistency in optimal monetary policy
Explain the roles played by quantity theory and the real bills doctrine in
understanding the influence of monetary policy and what they predict.
 List the channels of monetary transmission mechanism, and discuss what we can
learn from them and why they are varied
 Determine whether monetary policy contributes to economic growth
SECTION SUMMARIES
Why Economists Disagree
Disagreements among economists arise for various reasons, such as differences in focus,
emphasis, and ideology. The issue as to whether the monetary sector influences the real
sector in the economy has produced one of the best-known disagreements between
"monetarists" and Keynesians. However, disagreements about the desirability of low
inflation and the design of monetary policies required to guarantee such an outcome have
narrowed considerably in the recent past.
Monetarism and Competitive Theories
"Classical economics" dominated the science of economics from the late 18th century to
the 1930s. The classical economists believed that the free-market economy is a selfcorrecting mechanism, and that demand and supply forces, free of government
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intervention, would ensure full employment and economic growth. They argued against
active government intervention in the economy. According to their view, changes in the
money supply directly influence only prices and not output level nor the employment
level.
During the period between the 1930s and the 1970s, Keynesians, who argued in
favour of active government intervention in the economy through regulation and fiscal
policy, dominated the debate. Since the 1970s, monetarists seem to have been
dominating the science of economics. They believe that: a) money is neutral in the long
run; b) the price level and inflation are monetary phenomena; and c) business cycles are
caused by monetary policy. Monetarism was succeeded in popularity by the new
classical economics.
The Neutrality of Money
We have already explained the important role that money plays in economic activity by
facilitating trade. We have also established that money used in modern economies is
credit-based money. That means that money simultaneously is both an asset and a
liability and thus, its creation cannot add to the net wealth of an economy. So, why
should an increase in the supply of money have any effect on the level of real output?
The answers to this question are potentially very complicated, but those answers must
involve the notion that changes in the supply of money will not have the same impact on
all sectors of the economy. The effect is likely to be much more immediate in financial
markets. This will affect interest rates and exchange rates and these changes in turn will
affect consumers’ and investors’ decisions leading to changes in aggregate demand. A
complete discussion of these effects is to be found under the heading of a transmission
mechanism.
While it is clear that changes in monetary policy can influence aggregate demand, the
question of neutrality remains unanswered until we incorporate aggregate supply. Here
we have to observe that aggregate supply ultimately depends on our resources,
technology and out ability to mobilize the factors of production. Changes in the money
supply cannot conceivably alter our stock of resources nor technology, but it may
influence our ability to mobilize resources. But why should a change in the money
supply, the price level or the inflation rate have any bearing on the willingness of people
to supply labour? The simple answer is that, if people were fully informed and were able
to fully and accurately anticipate these changes,(and therefore build these changes into
their wage-negotiations) any changes in the price level or inflation rate would have no
effect.
This is the essence of the concept of the neutrality of money. It is the theory that changes
in the stock of money (or in monetary policy) cannot affect the level of employment or
output in the long run. According to this view, the Phillips curve, which shows the
relationship between the rate of inflation and the unemployment rate, is vertical in the
long run. The long run Phillips curve is vertical at some particular level of
unemployment, usually referred to as the NAIRU, the non-accelerating inflation rate of
unemployment. This means that any inflation rate is consistent with the NAIRU rate if it
is fully anticipated.
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A trade-off between the rate of inflation and the rate of unemployment exists only in the
short run. The short-run Phillips curve is understood to be downward-sloping which
means that higher inflation rates correspond to lower unemployment rates. This can only
be explained by the fact that, in the short run, people do not fully realize that an increase
in prices have lowered their real wage. Therefore, the unemployment rate can be moved
from its long-run value only in the short run. In the long run, changes in the inflation rate
are factored into wage demands and thus can have no effect.
Expectations of Inflation in the Short Run: Theories about how individuals form
expectations about future inflation are discussed in this section.
Adaptive Expectations: According to the expectations hypothesis, people form expectations about
inflation by adapting to (extrapolating from) the past behaviour of prices and by continually
revising their forecasts on the basis of their previous errors.
An Algebraic Interpretation of Adaptive Expectations: An adaptive expectations model of
inflation is given by:
Pft = Pft-1 + b(Pt-1 - Pft-1)
where Pft is the forecast for the price level at time t (today), Pft-1 is the forecast for the price level
at time t-1 (last period), Pt-1 is the actual value of the price level at time t-1, and Pt- Pft-1 is the last
period's forecast error. If the coefficient b is zero, then Pft = Pft-1, and if the coefficient b = 1, then
Pft = Pt-1. According to this model, forecast errors rise over time during periods of inflation. This
is significant, because it implies that people can be consistently fooled into supply more labour,
and the therefore that the trade-off between inflation and unemployment can be exploited to lower
unemployment for an indefinite period of time.
Rational Expectations: This theory postulates that individuals are rational, and that they use all
the information available to them in forming expectations about the future. This implies that, in
effect, individuals have an economic model in their minds in forming expectations, and that
forecast errors in the past are irrelevant to future forecasts. More importantly, it implies that
people will not be consistently wrong, that while they may make forecasting errors, those errors
will be random and neither consistently high or consistently low.
An Algebraic Interpretation of Rational Expectations: Suppose the public believes the price level
(P) is determined by the past level of the money supply (Mt-1) as follows:
Pt = aMt-1 + vt
where vt is the unpredictable component. Assuming that, on average, vt = 0, a forecast of the
future price level (Pft) can be written as:
Pft = aMt-1
The average forecast error can be written as:
Pt - Pft = aMt-1- aMt-1 = 0
Rational expectations forecasts will not be consistently wrong, unlike those derived from the
adaptive expectations model.
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What Does It All Mean? Monetarists argue that the effects of monetary policy occur with
long and variable lags. This view stems largely from the assumption of adaptive
expectations. With rational expectations there is no trade-off (between inflation rate and
unemployment rate) worth considering. Adaptive expectations imply that the public can
be easily and consistently fooled. By contrast, rational expectations imply that it is almost
impossible to fool the public for any sustained period of time. The reality may be a
mixture of elements from both of the models.
Rules versus Discretion in the Conduct of Monetary Policy
Since monetary policy cannot have long-lasting real effects, it has been argued that the
authorities should follow a monetary policy rule (fixing the money supply according to a
rule) such as the one given by the equation Pt = aMt-1.
The Political Temptation to Stimulate the Economy: Even though the society prefers a
zero inflation rate which corresponds to the natural rate of unemployment (NRU) or the
non-accelerating inflation rate of unemployment (NAIRU), the political temptation of
policy-makers to achieve unemployment rates lower than the natural rate of
unemployment (NRU) or the non-accelerating inflation rate of unemployment (NAIRU),
results in higher inflation rates, both in the short run and in the long run. A decrease in
the unemployment rate increases the rate of inflation (a movement along the short-run
Phillips curve), which in turn increases the expected rate of inflation, causing an upward
shift in the short-run Phillips curve. The result is a higher rate of inflation. (See Figure
27.1 in the text.)
The Time-Inconsistency Problem: The time-inconsistency problem of monetary policy
refers to the argument that policy-makers have an incentive to implement inflationary
monetary policy and, therefore, that their commitment to a given rate of inflation is not
credible. The time-inconsistency problem does not sound like a reasonable depiction of
the facts to everyone.
An Algebraic Interpretation of the Credibility Problem: Many economists believe that the
loss function of monetary policy (which the government wants to minimize) may be an
equation like the one stated below.
L = 1/2 (-e)2 + /2 (u* - u)
Where,  and e are actual and expected rates of inflation, respectively, and u* and u are
natural and actual rates of unemployment, respectively. The coefficient  indicates the
importance attached to the unemployment objective. According to this equation,
unemployment rates higher than NRU and inflation rates higher than the expected rate of
inflation are costly. An inflation target that is fully credible might deliver an inflation rate
equal to the expected rate of inflation at all times.
Towards a New Trade-Off: A monetary policy rule called Taylor’s Rule is given by:
Rt = g gap + gyy gap
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Where, Rt is the rate of interest,  gap is the difference between actual and desired or
target inflation rate, y gap is the difference between actual and potential levels of real
GDP. The equation shows that volatility in Rt results from changes in  gap and y gap. If
both inflation and GDP are volatile the loss will be larger. Consequently, Taylor
advocates a rule that results in a trade-off between the variability of inflation and the
variability of the output gap.
The Base Drift Problem: Periodic revisions of the money growth target by the monetary
authorities lead to the base drift problem. The base drift problem is the upward revision
of the base from which monetary growth targets are adjusted. In a situation in which the
actual growth rate of the money supply exceeds the target growth rate and authorities
revise money growth targets often, based on the actual level of money supply, the base
drift problem arises. This makes it difficult to accurately predict the money supply and
the price level.
Two Theories of Money:
The quantity theory of money and the rejuvenated real bills doctrine presents two
contrasting views about the link between monetary policy and inflation. The quantity
theory holds that “inflation is always and everywhere a monetary phenomenon,” while
the rejuvenated real bills doctrine holds a contrasting view, but sees a connection between
inflation and printing money to cover government debts.
The Quantity Theory of Money: The quantity theory of money is represented by the
following equation:
MV = Py
where M is the stock of money, V is the velocity of circulation, P is price level, and y is
real aggregate income. On the assumption that V and y are fixed, changes in the price
level can be explained only by changes in the stock of money. It is in this sense that
inflation is a monetary phenomenon. The quantity theory endured as a theory of price
levels for at least two reasons: 1) the quantity theorists generally did not take a firm stand
on what constitutes money; and 2) the theory has been a reliable tool for predicting the
price level over the business cycle.
The Modern Real Bills Doctrine: The rejuvenated old idea called the real bills doctrine
argues that the value of money and its purchasing power can be explained by the value of
the assets that back it. As long as money is backed by assets that have value, there is no
need to link a particular money stock with a particular price level. Unless individuals
perceive that government debt eventually will be financed by printing increasing
quantities of money, there is no need for money supply changes to create price level
changes. If government budget deficits are financed through printing money (rather than
through the sale of bonds to the public), changes in the money supply will lead to
changes in price levels.
Two Theories of Money: Conclusion: The real bills doctrine can explain both high and
low episodes of inflation, and, therefore, represents an improvement over the quantity
theory. However, the quantity theory has worked well in predicting the price level over
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the business cycle and therefore will remain a prominent explanation of price level
movements.
What Transmission Mechanism?
The transmission mechanism refers to the manner in which the monetary side can
influence the real side of the economy. There are four views of the transmission
mechanism:
1) The interest rate channel: less money drives up interest rates which impact
negatively on output.
2) The exchange rate channel: higher interest rates attract capital inflows which
reduce exports and increase imports, thus lowering output.
3) The impact of asset prices more generally: a lower money supply makes stocks
less attractive to hold and lowers investment and, therefore, output.
4) The credit channel: a lower money supply implies fewer bank deposits and
fewer loans, which translates into lower investment and output.
Money, Financial Development and Growth
At least in the short run, inflation and money growth influence output. Empirical
evidence shows that before the 1973-74 oil shock, during a period of low inflation, the
economic growth rate and the inflation rate were positively related in the G-7 countries.
In the post-oil shock period, a period of high inflation and stagnation, the two rates were
negatively related. Thus the link between inflation and economic growth is not clear.
However, there is clear evidence that the development of the financial sector spurs
overall economic growth.
MULTIPLE-CHOICE QUESTIONS
1. The neutrality of money implies that
a) monetary policy cannot affect the price level in the short run.
b) monetary policy has no effect on the price level in the long run.
c) monetary policy cannot affect the output level in the long run.
d) monetary policy cannot affect the output level in both the long run and short run.
2. The short-run Phillips curve shows the trade-off between
a) the economic growth rate and the unemployment rate.
b) the inflation rate and the unemployment rate.
c) the inflation rate and the economic growth rate.
d) the interest rate and the inflation rate.
3. Monetarists believe that there is
a) a trade-off between the inflation rate and the unemployment rate in the long run.
b) no trade-off between the inflation rate and the unemployment rate in the long run.
c) no trade-off between the inflation rate and the unemployment rate in the short run.
d) a trade-off between the inflation rate and the unemployment rate in the long run and in
the short run.
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4. If P = price level, Pf = forecast of the price level, M = money supply, b is a constant,
and t refers to time period, which of the following is an adaptive expectations model of
inflation?
a) Pf t = Pf t-1 + b(P t-1- Pf t-1)
b) Pt = Pft + b(P t-1- Pf t-1)
c) Pt = Pft + bM t-1
d) Pf t = bM t-1
5. The natural rate of unemployment is the rate of unemployment that exists when
a) the economy is in recession.
b) the economy is operating at full employment
c) the economy has a negative inflation rate.
d) the economy has only cyclical unemployment.
6. Consider the following equation: t = 2 - 0.40Ut, where  is rate of inflation, U is
unemployment rate, and t refers to time. The non-accelerating inflation rate of
unemployment for this economy is
a) 10%.
b) 20%.
c) 8%.
d) 5%.
7. Policy-makers’ bias towards positive inflation provides the basis
a) for the neutrality of money.
b) for the base drift problem.
c) for high rates of unemployment.
d) for the time-inconsistency problem.
8. Consider the following data for a hypothetical economy: The real income level (y) is
fixed at $200 million and the velocity of circulation is fixed at 4.0. According to the
quantity theory of money, an increase in the nominal stock of money (M) by 10%
a) increases the price level by 20%.
b) decreases the price level by 20%.
c) increases the price level by 10%.
d) has no impact on the price level.
9. According to the real bills doctrine
a) there is no link between monetary policy and the price level.
b) the price level is proportional to the money stock.
c) printing money to finance budget deficits is inflationary.
d) the supply of money is negatively related to the price level.
10. During the period before the oil shock of 1973-74, the rate of inflation and the rate of
economic growth in the G-7
a) were both zero.
b) were negatively related.
c) were positively related.
d) were neither positively nor negatively related.
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11. After the oil shock of 1973-74, the rate of inflation and the rate of economic growth
in the G-7
a) were both zero.
b) were negatively related.
c) were positively related.
d) were neither positively nor negatively related.
PROBLEMS
1. Consider the following data for an economy:
Year
1991
1992
1993
1994
1995
1996
1997
1998
1999
Inflation rate (%)
10.0
9.5
9.5
8.6
8.0
6.0
6.0
5.5
5.2
Unemployment rate (%)
2.0
3.6
3.9
4.1
3.9
4.8
5.0
5.2
5.5
Is there a trade-off between the rate of inflation and the rate of unemployment in this
economy?
2. Consider the following two models:
i) Pf t = Pf t-1 + 0.8(P t-1- Pf t-1)
ii) Pf t = 0.15M t-1
where P = price level, Pf = forecast of the price level, M = money supply, and t refers
to time period.
a) What theories of the forecast of inflation underlie these models?
b) How do the underlying theories differ from each other?
3. What is the basis for the statement that “Inflation is always and everywhere a monetary
phenomenon”? Explain.
4. “Inflation is always detrimental to economic growth.” Does the empirical evidence
support this view?
5. Explain why rising prices can have a positive effect on aggregate supply in the short
run.
6. Identify the significant difference between the adaptive and rational expectations views
and explain the why this difference is highly significant.
ANSWER SECTION
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Answers to multiple-choice questions:
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
c
b
b
a
b
d
d
c
c
c
b
(see page 411)
(see page 411)
(see page 411)
(see pages 411-412)
(see page 417)
(see page 414)
(see pages 418-419)
(see page 424)
(see pages 424, 426)
(see page 428)
(see page 428,429)
Answers to problems:
1. Yes, there is a trade-off between the rate of inflation and the rate of unemployment in
this economy. The relationship between the inflation rate and the unemployment rate
is given graphically by the Phillips curve. In general, on a diagram which depicts a
Phillips curve, the rate of inflation is measured along the vertical axis and the rate of
unemployment is measured along the horizontal axis. A plot of the data given in the
problem on such a diagram would produce a scatter diagram with a negative trend.
This shows that there is a trade-off between the inflation rate and the unemployment
rate (i.e., a negative relationship between the two rates).
2. a) The theories underlying the first and second models are the adaptive expectations
theory and the rational expectations theory, respectively, about how individuals
form expectations about future inflation.
b) According to the adaptive expectations model, individuals form expectations about
future inflation by adapting to the past behaviour of prices and by taking into
account their previous forecast errors. For example, according to this model, the
forecast of the price level for the current period (Pf t ) is the sum of the forecast for
the past period
(Pf t-1) and 80% of the forecast error [0.8(P t-1- Pf t-1)]. According to rational
expectations theory, individuals are rational and use all the information available to
them in forming expectations about the price level. This means that they have an
economic model, like the second model given in the question.
3. The basis for this statement is provided by the quantity theory of money. According to
the quantity theory of money, the relationship between the price level and the money
stock is given by the following equation:
MV = Py
where M is the stock of money, V is the velocity of circulation, P is price level, and y
is real aggregate income. On the assumption that V and y are fixed, quantity theorists
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argue that changes in the price level can be explained only by changes in the stock of
money. This implies that a change in the quantity of money brings about a
proportional change in the price level.
4. No. The relationship between inflation and economic growth is not a clear. Empirical
evidence on the relationship is mixed. For example, empirical evidence from the G-7
countries indicates that the relationship between the inflation rate and the economic
growth rate was positive during the period before the oil shock of 1973-74. This was a
period of relatively low inflation. However, in the post-oil shock period of relatively
high inflation the relationship was clearly negative. Therefore, it cannot be argued that
inflation has not always been detrimental to economic growth but, now that we
understand its consequences, any inflation rate above a fairly low rate is now
considered by many economists to be detrimental.
5. Rising prices can positively affect aggregate supply to the extent that wages do not rise
at the same rate thus lowering the real wage and making labour relatively less
expensive.
6. The adaptive expectations view holds that people adjust their expectations based on
some fraction by which they were previously incorrect. If inflation is consistently
accelerating, they will be consistently wrong. The rational expectations view holds
that people use all available information and do not make consistent errors in
formulating their expectations. If this view is correct, there can be no long run tradeoff between inflation and unemployment.
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