Lesson 11-2 Problems and Controversies of Monetary Policy

Lags Lags are the greatest obstacle facing the Fed in the implementation of monetary policy. The recognition lag is the time after a macroeconomic problem arises before policy- makers become aware of it. Caused by the unavailability of adequate data in a timely manner.

Caused by different indicators leading to different interpretations. The implementation lag is the time it takes after recognizing a macroeconomic problem to put a policy in place to deal with it. The implementation lag is quite short for monetary policy. The FOMC meets regularly eight times a year and can confer between meetings with conference calls. Once a decision is made, the open market operations to buy or sell government bonds can be implemented immediately.

The impact lag is the delay between the time a policy is put inplace and the time that policy affects the economy. It takes some time for the deposit multiplier process to work itself out. Consumers and firms need some time to respond to the monetary policy with new consumption and investment spending. The exchange rate may change fairly quickly but it takes time for net exports to adjust. The time estimates of lags vary.

The impact lag is estimated to be from 6 months to 2 years. The lag time is not constant and policymakers do not know which particular time frame will apply to their actions. Policy should be aimed at expected future problems rather than current problems implied by recent data.

Choosing Targets Interest Rates The Fed has used the federal funds rate as a sign of pressure on bank reserves in the past. The current goal is explicitly couched in terms of interest rate targets. To raise interest rates, the Fed sells bonds. To lower interest rates, the Fed buys bonds. Money Growth Rates

The Fed is required by law to announce at the beginning of a year a money growth rate for that year. The Fed actually sets a wide band within which the money growth should fall because of difficulty inherent in controlling the money supply itself. The current Fed pays little attention to money growth rates in setting monetary policy.

Price Level If stable prices constitute the main monetary policy goal, then the price level could be a target. Such a policy goal could lead to contractionary policy when the price level rose with a recessionary gap and would worsen the problem. Price level targets imply reacting to past problems rather than anticipating future problems.

Political Pressures The U.S. Fed is one of the most independent central banks in the world. The EU has modeled its central bank on the German model and is also very independent. The Fed was created by Congress and could be abolished or have its powers changed by Congress. The Fed Board of Governors and the FOMC members are likely to be influenced to some degree by political pressures.

The Degree of Impact on the Economy The impact of monetary policy on the economy is uncertain and varies in different time periods. Investment is volatile and may react more after one policy action than another. If expectations are pessimistic about the future course of the economy, those expectations may prevent more investment even when the interest rates fall.

Trying to encourage investment in the face of negative expectations is sometimes called “pushing on a string.” A liquidity trap exists when a change in monetary policy has no effect on interest rates. The liquidity trap would occur if the money demand curve were horizontal. John Maynard Keynes presented the liquidity trap in his book, The General Theory of Employment, Interest, and Money.

Rational Expectations The rational expectations hypothesis is that people use all available information to make forecasts about future economic activity and the price level, and that they adjust their behavior to these forecasts. This theory alters the adjustment process of the economy to a change in the money supply. Suppose an economy is in long-run equilibrium. An increase in the money supply shifts aggregate demand to the right.

Instead of adjustment to this shift gradually over time until a new equilibrium price level is reached at the intersection of long-run aggregate supply and the new aggregate demand, the rational expectations theory presumes that the jump in prices will occur immediately. Prices adjust immediately upon news of the money supply increase because every-one expects the price level to rise based on past experience and therefore alters behavior immediately If this occurs, there is no change in real GDP even in the short run.

This theory depends upon flexible wages and prices rather than sticky wages and prices discussed earlier. An implication of this theory is that contractionary policy could be painless. Most rational expectations theorists oppose using monetary policy for stabilization purposes.