The Objectives of Monetary Policy Low, stable inflation Unstable inflation Adds to the risk of lending and borrowing Interferes with long-run financial planning Surveys People associate high rates of inflation with a general breakdown of government and the economy 1 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

The Objectives of Monetary Policy Full employment The absence of cyclical unemployment Concerns about cyclical unemployment Its opportunity cost The output that the unemployed could have produced if they were working Represents a social failure Can cause significant hardship 2 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

The Objectives of Monetary Policy Natural rate of unemployment Unemployment rate when there is no cyclical unemployment When unemployment rate < natural rate GDP is greater than potential output Economy’s self-correcting mechanism Will then create inflation 3 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

The Objectives of Monetary Policy When unemployment rate > natural rate GDP is below potential output Economy’s self-correcting mechanism Will then put downward pressure on the price level 4 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Figure 1: The Fed’s Performance: 1950 to Mid © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Annual inflation rate—percent rise in December CPI-U from previous December. Data for 2009 is annualized through August 2009.

Figure 1: The Fed’s Performance: 1950 to Mid © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Unemployment rate—average of monthly rates for each year. Data for 2009 is averaged through August 2009.

Federal Reserve Policy: Theory and Practice Simplifying assumption The Fed’s goal for the inflation rate is zero Responding to demand shocks Maintaining the money supply Maintaining the interest rate Neutralizing the shock 7 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Federal Reserve Policy: Theory and Practice Fully employed economy Experiences a positive demand shock And Fed’s policy is : constant money supply Then: Output will overshoot its potential Price level will rise in the short run Price level will rise further in the long run 8 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Price Level Real GDP $ Trillions (b) Interest Rate Money (a) Figure 2: A positive demand shock with a constant money supply 9 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. M1dM1d 7% MSMS 5% A M2dM2d B A positive demand shock would shift the AD curve rightward to AD 2 in panel (b), causing both the price level and output to rise. If the Fed maintains a constant money supply, the rise in the price level causes the money demand curve to shift to M 2 d in panel (a), driving the interest rate up from 5% to 7%. A higher interest rate causes some crowding out of consumption and investment spending, but not complete crowding out. In panel (b), output ends up higher than initially, and the price level rises as well (point H). AS AD 1 E AD 2 H F

Federal Reserve Policy: Theory and Practice Fully employed economy Experiences a positive demand shock And Fed’s policy is: constant interest rate Then: An even greater overshooting of potential output than a constant money supply An even greater rise in the price level 10 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Figure 3: A positive demand shock with a constant interest rate 11 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Price Level Real GDP $ trillions (b) Interest Rate Money (a) M1dM1d M1SM1S 5% A M2dM2d A positive demand shock initially shifts the AD curve rightward to AD 2 in panel (b), causing both the price level and output to rise. The rise in the price level shifts the money demand curve rightward to M 2 d in panel (a), which would ordinarily cause the interest rate to rise. But if the Fed maintains a constant interest rate target, it will increase the money supply to prevent any rise in the interest rate. There will be no crowding out of consumption or investment spending, so the AD curve in panel (b) shifts further rightward (to AD 3 ). As a result, the economy ends up at point J, with output and the price level rising by more than under a constant-money-supply policy. AS AD 1 E AD 2 AD 3 M2SM2S C J

Federal Reserve Policy: Theory and Practice Fully employed economy Experiences a demand shock Fed’s best policy is: neutralization Prevent any shift in AD at all Fed must change its interest rate target A positive demand shock Requires an increase in the target A negative demand shock Requires a decrease in the target 12 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Figure 4: A positive demand shock neutralized by monetary policy 13 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Price Level Real GDP $ Trillions (b) Interest Rate Money (a) M1dM1d 9% M1SM1S 5% A A positive demand shock begins to shift the AD curve rightward in panel (b), which would ordinarily cause both the price level and output to rise. But the Fed can neutralize the shock by increasing its interest rate target enough to cause complete crowding out of consumption and investment spending. To reach the new, higher interest rate target, the Fed must decrease the money supply in panel (a), moving the money market equilibrium to a point like. This reverses (or prevents) the shift in the AD curve, so the economy ends up at point in panel (b), at its initial output and price level. AS AD 1 E M2SM2S D

Federal Reserve Policy: Theory and Practice Responding to supply shocks - dilemma: If the Fed tries to preserve price stability It will worsen unemployment If the Fed tries to maintain high employment It will worsen inflation Even though supply shocks-usually temporary The shocks themselves—and the Fed’s response—can affect the economy for several quarters or even years 14 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Figure 5: Responding to Supply Shocks 15 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Price Level Real GDP AS 2 Y FE P1P1 Starting at point E, a negative supply shock shifts the AS curve upward to AS 2. With a constant money supply, a new short-run equilibrium would be established at point R, with a higher price level ( P 2 ) and a lower level of output ( Y 2 ). The Fed could prevent inflation by decreasing the money supply and shifting AD to AD no inflation, but output would fall to Y 3. At the other extreme, it could increase the money supply and shift the AD curve to AD no recession. This would keep output at the full-employment level, but at the cost of a higher price level, P 3. AD 1 Y2Y2 P2P2 R AS 1 P3P3 E AD no recession AD no inflation Y3Y3 T V

Federal Reserve Policy: Theory and Practice A negative supply shock The Fed - short-run tradeoff: It can limit the recession, but only at the cost of more inflation It can limit inflation, but only at the cost of a deeper recession 16 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Expectations and Ongoing Inflation U.S. economy Characterized by ongoing inflation Even though the economy was at full employment Prices were continually rising Even when the unemployment rate is above its natural rate Prices keep rising 17 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Expectations and Ongoing Inflation How ongoing inflation arises 1960s: positive demand shocks The Fed: maintain a low interest rate target When inflation continues for some time The public develops expectations that the inflation rate in the future will be similar to the inflation rates of the recent past 18 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Expectations and Ongoing Inflation A continuing, stable rate of inflation Gets built into the economy The built-in rate is usually the rate that has existed for the past few years Once there is built-in inflation The economy continues to generate inflation Even after the self-correcting mechanism has finally been allowed to do its job and bring us back to potential output 19 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Expectations and Ongoing Inflation In an economy with built-in inflation The AS curve will shift upward each year Even when output is at potential and unemployment is at its natural rate The upward shift of the AS curve will equal the built-in rate of inflation In the short run The Fed can reduce the rate of inflation below the built-in rate But only at the cost of creating a recession 20 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Figure 6: Long-Run Equilibrium with Built-In Inflation 21 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Price Level Real GDP AS 2 Y FE P1P1 During the year, the aggregate supply curve shifts upward by the built-in rate of inflation. To keep the economy at full employment, the Fed shifts the AD curve rightward by increasing the money supply. AD 1 AS 1 P2P2 A AD 2 B

Expectations and Ongoing Inflation Phillips curve A curve indicating the Fed’s choices between inflation and unemployment in the short run In the short run The Fed can move along the Phillips curve By adjusting the rate at which the AD curve shifts rightward 22 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Figure 7: The Phillips Curve 23 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Inflation Rate Unemployment Rate U1U1 3% PC built-in inflation = 6% 6% F E UNUN At E, the economy is in long-run equilibrium: unemployment at its natural rate (U N ) and inflation at the built-in rate (6%). To decrease the inflation rate to 3%, the Fed must accept higher unemployment (U 1 ) in the short run.

Expectations and Ongoing Inflation The Fed Moves the economy downward and rightward along the Phillips curve Unemployment rate increases Inflation rate decreases A decrease in the inflation rate - long run Lower built-in inflation rate Phillips curve shifts downward 24 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Figure 8: The Phillips Curve Shifts Downward 25 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Inflation Rate Unemployment Rate U1U1 3% PC built-in inflation = 6% 6% F E UNUN Initially, the economy is at point E, with inflation equal to the built-in rate of 6%. If the Fed moves the economy to point F and keeps it there for some time, the public will eventually come to expect 3% inflation in the future. The built-in inflation rate will fall and the Phillips curve will shift downward to PC built-in inflation=3%. The economy will move to point G in the long run, with unemployment at the natural rate and an actual inflation rate equal to the built-in rate of 3%. PC built-in inflation = 3% G

Expectations and Ongoing Inflation An increase in the inflation rate - long run Higher built-in inflation rate Phillips curve shifts upward Short run: tradeoff between inflation and unemployment Lower unemployment At the cost of higher inflation Lower inflation At the cost of higher unemployment 26 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Figure 9: The Phillips Curve Shifts Upward 27 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Inflation Rate Unemployment Rate U2U2 6% PC built-in inflation = 6% 9% H E UNUN Initially, the economy is at point E, with inflation equal to the built-in rate of 6%. If the Fed moves the economy to point H and keeps it there for some time, the public will eventually come to expect 9% inflation in the future. The built-in inflation rate will rise and the Phillips curve will shift upward to PC built-in inflation=9%. The economy will move to point J in the long run, with unemployment at the natural rate and an actual inflation rate equal to the built-in rate of 9%. PC built-in inflation = 9% J

Expectations and Ongoing Inflation Long run Unemployment always returns to its natural rate No tradeoff Long-run Phillips curve A vertical line In the long run, unemployment must equal its natural rate Regardless of the rate of inflation 28 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Figure 10: The Long-Run Phillips Curve 29 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part. Inflation Rate Unemployment Rate U1U1 3% PC built-in inflation = 6% 6% E UNUN The vertical line is the economy’s long-run Phillips curve, showing all combinations of unemployment and inflation the Fed can choose in the long run. The curve is vertical because in the long run, the unemployment rate must equal the natural rate. Starting at point E with 6% inflation, the Fed can choose unemployment at the natural rate with either a higher rate of inflation (point J ) or a lower rate of inflation (point G ). But points off of the vertical line are not sustainable in the long run. PC built-in inflation = 3% G PC built-in inflation = 9% U2U2 9% F H J Long-Run Phillips Curve

Expectations and Ongoing Inflation The Fed Tolerated measured inflation at 2 to 3% per year Because - true rate of inflation is lower Because - low rates of inflation may help labor markets adjust more easily 30 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Challenges for Monetary Policy Information problems Changing and uncertain time lags Policies meant to stabilize the economy could instead destabilize it Uncertainty about natural rate of unemployment Can create a period of higher-than-necessary unemployment, or higher-than-desired inflation 31 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Challenges for Monetary Policy Rules versus discretion Following a rule could help the Fed manage inflationary expectations Make it easier to take actions Beneficial in the long run Unpopular in the short run Taylor rule – proposed rule: Require the Fed to change the interest rate By a specified amount When real GDP or inflation deviates from target 32 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Challenges for Monetary Policy Avoiding deflation Expected deflation Creates a positive lower bound for the real federal funds rate = expected rate of deflation If the Fed wants to reduce real interest rates below that lower bound It will have to use unconventional tools 33 © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Should the Fed prevent (or pop) asset bubbles? 34 Argument for popping bubbles before they go too far: After each bubble: a rapid decline in wealth relative to GDP Fed chairs - argued against aggressive intervention: Trying to stop bubbles in their early stages has high costs and doubtful benefits © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Figure 11: Household net worth as percentage of annual GDP, 1945– © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.

Should the Fed prevent (or pop) asset bubbles? 36 Reasons for not popping bubbles: Difficult to identify a bubble in advance How would the Fed burst the bubble? Intervene in specific markets – leads to political pressure and threats to the Fed’s independence Raising the federal funds rate – will drive up all interest rates Not clear that the Fed could control a bubble Because overly-optimistic investors might not respond © 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible Web site, in whole or in part.