Macroeconomic Policy and Aggregate Demand and Supply Analysis Chapter 13 Macroeconomic Policy and Aggregate Demand and Supply Analysis

Preview To understand the objectives of macroeconomic policy To understand the relationship between stabilizing inflation and stabilizing economic activity To understand the Taylor rule of monetary policy To examine how policymakers use macroeconomic policy to stabilize inflation and output fluctuations 2

The Objectives of Macroeconomic Policy Two primary objectives of macroeconomic policy: Stabilizing economic activity Stabilizing inflation around a low level 3

Stabilizing Economic Activity Economic activity is commonly gauged by the unemployment rate because high unemployment: causes human misery leaves workers and other resources idle, reducing output Instead of a zero rate of unemployment, policymakers target the nature rate of unemployment that is consistent with the maximum sustainable level of employment at which there is no tendency for inflation to increase 4

Stabilizing Economic Activity (cont’d) The natural rate of unemployment includes: Frictional unemployment—exists when workers and firms need time to make suitable matchups Structural unemployment—exists as a mismatch between job skill requirements and worker availability At the natural rate of unemployment, output moves towards potential output, so the output gap (Y-YP) is zero 5

Stabilizing Economic Activity (cont’d) In practice, identifying the natural rate of unemployment is not straightforward Currently, most economists believe the natural rate of unemployment is around 5%, but still it is subject to much uncertainty and disagreement 6

Stabilizing Inflation: Price Stability High inflation is always accompanied by high variability of inflation, so it reduces economic growth So central banks pursue a policy goal of price stability—low and stable inflation Monetary policy is to maintain inflation, π , close to an inflation target, πT—a target level that is slightly above zero, so that the inflation gap (π - πT) is minimized 7

Establishing Hierarchical Versus Dual Mandates A hierarchical mandate requires stable prices as a condition of pursuing other goals Adopted by the European Central Bank (through the Masstricht Treaty), the Bank of England, the Bank of Canada, and the Reserve Bank of New Zealand A dual mandate requires co-equal objectives of price stability and other objectives The Federal Reserve the dual mandate of “stable prices and maximum sustainable employment” 8

The Relationship Between Stabilizing Inflation and Stabilizing Economic Activity What is a central bank’s appropriate policy response to an economic shock? In the case of a demand shock or a temporary supply shock, the central bank can simultaneously pursue stability in both the price level and economic output In the case of a permanent supply shock, however, policymakers can achieve either stable prices or stable output, but not both—a tradeoff for a central bank with dual mandates 9

Monetary Policy and the Equilibrium Real Interest Rate At long-run equilibrium, the real interest rate is the equilibrium real interest rate, r*: It is the rate of interest that maintains the quantity of aggregate output demanded equal to potential output, or (Y-YP)=0 The inflation rate is consistent with price stability, or π = πT It is also the long-run real interest rate for the economy 10

FIGURE 13.1 The Monetary Policy Curve and the Equilibrium Real Interest Rate, r* 11

Policy and Practice: The Federal Reserve’s Use of the Equilibrium Real Interest Rate, r* The Federal Reserve Board of Governors and the Reserve Bank presidents meet in Washington, D.C. every six weeks to formulate a target for policy interest rates Before each FOMC meeting, the Board staff distributes projections for the equilibrium real interest rate, r*, to FOMC members in a blue-covered document called the Blue Book Policy makers actively discuss the r* projections during FOMC monetary policy deliberations 12

Response to an Aggregate Demand Shock Policy responses to a negative demand shock: No policy response Results: Aggregate output will remain below potential for some time and inflation will fall Policy stabilizes output in the short run Policymakers can autonomously ease monetary policy by cutting the real interest rate, so that the AD curve shifts to the right and output quickly returns to YP Monetary policy has no effect on the equilibrium real interest rate, which is the long-run level of the real interest rate In the case of aggregate demand shocks, there is no tradeoff between the pursuit of price stability and economic activity stability The divine coincidence occurs as there is no conflict between the dual objectives of stabilizing inflation and economic activity 13

FIGURE 13.2 Aggregate Demand Shock: No Policy Response 14 14

FIGURE 13.3 Aggregate Demand Shock: Policy Stabilizes Output in the Short Run 15 15

Response to a Permanent Supply Shock Policy responses to a negative permanent supply shock (reducing YP): No policy response Results: The short-run AS curve keeps shifting up, so that both inflation and the real interest rate are higher Policy stabilizes inflation Policymakers can autonomously tighten monetary policy by raising the real interest rate, so that the output gap becomes zero, inflation is at πT, and the real interest rate finally falls The divine coincidence still remains true when there is a permanent supply shock: there is no tradeoff between the dual objectives of stabilizing inflation and economic activity 16

FIGURE 13.4 Permanent Supply Shock: No Policy Response 17 17

FIGURE 13.5 Permanent Supply Shock: Policy Stabilizes Inflation 18 18

Response to a Temporary Supply Shock Policy responses to a negative temporary supply shock (e.g., oil price surges) that shifts the short-run AS curve but not the LRAS curve: No policy response Results: The short-run AS curve shifts back to the initial position, so that output returns to their initial levels. In the long run, there is no tradeoff between the two objectives, and the divine coincidence holds 19

FIGURE 13.6 Response to a Temporary Aggregate Supply Shock: No Policy Response 20 20

Response to a Temporary Supply Shock (cont’d) Policy stabilizes inflation in the short run Policymakers can autonomously tighten monetary policy by raising the real interest rate, which lowers output further below its potential level, but in order to keep inflation at πT, policymakers need to subsequently reverse the autonomous tightening monetary policy Stabilizing inflation in response to a temporary supply shock has led to a larger deviation of aggregate output from potential, so this action has not stabilized economic activity 21

Response to a Temporary Supply Shock (cont’d) Policy stabilizes economic activity in the short run Policymakers can stabilize output rather than inflation in the short run by autonomously easing monetary policy, so that the output gap returns to zero while inflation rises Stabilizing output in response to a temporary supply shock has led to a rise in inflation, so inflation has not been stabilized 22 22

FIGURE 13.7 Response to a Temporary Aggregate Supply Shock: Short-Run Inflation Stabilization 23 23

FIGURE 13.8 Response to a Temporary Aggregate Supply Shock: Short-Run Output Stabilization 24 24

The Bottom Line: The Relationship Between Stabilizing Inflation and Stabilizing Economic Activity If most shocks to the macro economy are aggregate demand shocks or permanent aggregate supply shocks, then policy that stabilizes inflation will also stabilize economic activity, even in the short run. If temporary supply shocks are more common, then a central bank must choose between the two stabilization objectives in the short run. In the long run, however, there is no conflict between stabilizing inflation and economic activity in response to temporary supply shocks. 25

How Actively Should Policy Makers Try to Stabilize Economic Activity? Nonactivists believe that government action is unnecessary to stabilize economic activity because wages and prices are very flexible and so the self-correcting mechanism quickly returns the economy to full employment Activists, particularly Keynesians, argue that the government should pursue active policy to eliminate high unemployment because wages and prices are sticky, and so it takes a long time for the self-correcting mechanism to reach the long run 26

Lags and Policy Implementation Lags occur in activist policies that shift the AD curve: Data lag Recognition lag Legislative lag Implementation lag Effectiveness lag 27

Policy and Practice: The Activist/Nonactivist Debate Over the Obama Fiscal Stimulus Package When President Obama entered office in January 2009, he faced a very serious recession with unemployment over 7% and rising Many activists argued that the Fed should aggressively pursue monetary policy in addition to a massive fiscal stimulus package On the other hand, nonactivists opposed the fiscal stimulus because of its long implementation lags, which would lead to increased volatility in inflation and economic activity 28

The Taylor Rule The Taylor rule guides the Federal Reserve to set the real federal funds rate, r, at its historical average of 2%, plus a weighted average of the inflation gap and the output gap: r = 2.0 + 2(π - πT) + 2 (Y - YP) In terms of the (nominal) federal funds rate: Federal funds rate = π + 2.0 + 2 (π - πT) +2 (Y - YP) 29

The Taylor Rule Versus the Monetary Policy Curve As for the monetary policy curve, the Taylor rule incorporates the inflation gap and output gap: The Fed should raise the real federal funds rate with an increase in the inflation gap, and vice versa The Fed should raise the real federal funds rate with an increase in the output gap, and vice versa 30

Box: The Difference Between the Taylor Rule and the Taylor Principle The Taylor rule describes how the real interest rate is set in response to the output level and to inflation: It gives a complete description of the conduct of monetary policy in any situation The Taylor principle describes only how the real interest rate is set in response to the level of inflation (ignoring the output level): It gives only a partial description of the conduct of monetary policy 31

The Taylor Rule Versus the Monetary Policy Curve (cont’d) In the case of aggregate demand shocks, the Taylor rule suggests a positive relationship between the real federal funds rate and the output gap (shifting the MP curve) In the case of a temporary aggregate supply shock, the Taylor rule requires the Fed to focus on economic activity in addition to inflation 32

The Taylor Rule in Practice The Taylor rule describes the Fed’s control of the federal funds rate under its two most recent chairmen, Alan Greenspan and Ben Bernanke Evidence shows that the Fed does not follow the Taylor rule exactly as this rule does not explain all the movements in the federal funds rate 33

FIGURE 13.9 The Taylor Rule and the Federal Funds Rate, 1960-2013 Source: Author’s calculations and Federal Reserve. www.federalreserve.gov/releases 34 34

Policy and Practice: The Fed’s Use Of The Taylor Rule If the Taylor rule is useful as a policy guide, then why hasn’t the Fed putting monetary policy on autopilot with a Taylor rule with fixed coefficients? The economy changes all the time, so the Taylor rule coefficients are unlikely to stay constant over time Economists do not know the current inflation and output gap with certainty Because of lags, monetary policy conduct is a forward-looking activity the requires the Fed to forecast inflation and economic activity in the future 35

Inflation: Always and Everywhere a Monetary Phenomenon Our aggregate demand and supply analysis supports Milton Friedman’s adage that in the long run, “Inflation is always and everywhere a monetary phenomenon” Suppose the central bank chooses to raise the its inflation target, the results are: The monetary authorities can target any inflation rate in the long run with autonomous monetary policy adjustments Although monetary policy controls inflation in the long run, it does not determine the equilibrium real interest rate Potential output—and therefore the quantity of aggregate output produced in the long run—is independent of monetary policy The classical dichotomy and monetary neutrality (Ch.5) hold 36

FIGURE 13.10 A Rise in the Inflation Target 37 37

High Employment Targets and Inflation Causes of Inflationary Monetary Policy High Employment Targets and Inflation The primary goal of most governments (including that of the U.S.) is high employment but the pursuit of this goal can bring high inflation Activist stabilization policy to promote high employment can result in two types of inflation: Cost-push inflation—results either from a temporary negative supply shock or wage hikes beyond what productivity gains can justify Demand-pull inflation—results from policymakers pursuing policies that increase aggregate demand 38

Cost-Push Inflation Suppose a temporary negative supply (cost push) shock occurs, so that the short-run AS curve shifts up and the left, then: Initially output will to a level below its potential, inflation will rise and unemployment will rise In response to an increase in the unemployment rate, activist policymakers with a high employment target would implement expansionary policies to shift the AD curve to the right However, unemployment will rise again because the short-run AS curve will shift up and to the left as workers seek higher wages to keep their real wages from falling (due to higher inflation) This process continues and continuing inflation occurs 39

FIGURE 13.11 Cost-Push Inflation 40 40

Demand-Pull Inflation Suppose policymakers set an unemployment target (4%) that is below the natural rate of unemployment (5%), resulting in expansionary fiscal policy or an autonomous easing of monetary policy that shifts the AD curve upward, then: Policymakers would initially achieve the 4% unemployment rate target so that output is at its target YT However, wages would subsequently increase, shifting the short-run AS curve up and to the left, resulting in a steadily rising inflation rate 41

FIGURE 13.12 Demand-Pull Inflation 42 42

Application: The Great Inflation In 1965-1973, the U.S. economy experienced demand-pull inflation as a result of autonomous monetary policy easing that shifted the AD curve to the right as policymakers tried to achieve a low unemployment target of 4% Most economists today agree that the natural rate of unemployment was instead 5% or 6%, so that the 5% unemployment target initiated the inflationary episode After 1975, high expected inflation resulted from the demand-pull inflation shifted the short-run AS curve upward and to the left, causing rising unemployment that policymakers tried to reduce by autonomous monetary policy easing The process of shifting both short-run AS and AD curves resulted in a continuing rise in inflation 43

FIGURE 13.13 Inflation and Unemployment, 1965-1982 Source: Economic Report of the President. 44 44

FIGURE 13.13 Inflation and Unemployment, 1965-1982 (cont’d) Source: Economic Report of the President. 45 45

Monetary Policy at the Zero Lower Bound We have so far assumed that a central bank can always lower its policy rate, like the federal funds rate However, the federal funds rate can never fall below zero, which is referred to as the zero lower bound 46

FIGURE 13.14 Derivation of the Aggregate Demand Curve with a Zero Lower Bound (a) 47 47

FIGURE 13.14 Derivation of the Aggregate Demand Curve with a Zero Lower Bound (b) 48 48

Deriving the Aggregate Demand Curve with the Zero Lower Bound One segment of the MP curve becomes downward sloping The zero lower bound produces a kinked aggregate demand curve 49

The self-correcting mechanism is no longer operational The Disappearance of the Self-Correcting Mechanism at the Zero Lower Bound The self-correcting mechanism is no longer operational If output, Y, is below its potential, YP, and if policy makers do nothing, then both output and inflation will go into downward spirals: 50

FIGURE 13.15 The Absence of the Self-Correcting Mechanism at the Zero Lower Bound 51 51

Application: Nonconventional Monetary Policy and Quantitative Easing At the zero lower bound, conventional expansionary monetary policy is no longer an option Monetary authorities can use nonconventional monetary policy: liquidity provision, asset purchases, and management of expectations These nonconventional measures raise aggregate output and inflation by lowering financial frictions, , in the real interest rate for investment: 52

Liquidity Provision The zero lower bound often arises when there is a sudden shortage of liquidity, rising financial frictions and so shifting the AD to the left The central bank can increase its lending facilities to provide liquidity to impaired markets, lowering 53

Asset Purchases The monetary authorities can also lower by lowering credit spreads through asset purchases The purchase of an asset or security raises its price and thus lowers its interest rate and the real interest rate of investment 54

FIGURE 13.16 Response to Nonconventional Monetary Policy 55 55

Quantitative Easing Versus Credit Easing Quantitative easing refers to the expansion of the Fed’s balance sheet as a result of liquidity provision or asset purchases The expansion of the Fed’s balance sheet will not raise aggregate demand if the real interest rate for investment does not fall (e.g., buying only short-term government securities) Fed Chairman Bernanke also emphasized “credit easing” to lower the real interest rate for investment through changing the composition of the Fed’s balance sheet 56

Management of Expectations The Fed’s management of expectations refers to its strategy to lower the market’s expectations for future short-term interest rates by committing to a future policy action of keeping the federal funds rate at zero for an extended period The falling long-term interest rate will lower , causing the AD curve to shift rightward Management of expectations can also operate through the AS curve for raising inflation expectations 57

FIGURE 13.17 Response to a Rise in Inflation Expectations 58 58

Policy and Practice: Abenomics and the Shift in Japanese Monetary Policy in 2013 By 2012, the Japanese economy has experienced more than 10 years of low growth, deflation, and the policy rate was at the zero lower bound In 2013, prime minister Shinzo Abe promoted two major changes in monetary policy by the Bank of Japan: (1) raising its inflation target from 1% to 2%; and (2) committing to the 2% inflation target within two years with massive asset purchases The Abenomics program would (1) shift the AD curve to the right by lowering , and (2) shift the short-run AS curve to the left by raising expected inflation 59

FIGURE 13.18 Response to the Shift in Japanese Monetary Policy in 2013 60 60